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Employment tax: the period that earnings are ‘for’

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In Murphy v HMRC, the First-tier Tribunal decided that a retention payment was earned and taxable in the year of receipt, rather than over the entire retention period (which spanned three tax years). The tribunal was not persuaded that the period ‘for’ which the retention award was paid should be determined according to the factual test in Bray v Best, as the concept of earnings ‘for’ a period is now defined by ITEPA 2003 s 16. This is a retrograde step; the decision ignores HMRC’s own guidance and explanatory notes to the legislation which suggest that s 16, introduced as part of the tax law rewrite project, should not change the law.

Historical background

Before 1989/90, earnings were liable to income tax on the ‘earnings’ basis (see HMRC’s Employment Income Manual at EIM42205), though the (then) Inland Revenue did on occasion agree a non-statutory practice under which earnings paid to directors could be computed on the accounts basis (Malone v Quinn [2001] STC (SCD) 63).

Under the earnings basis, when earnings arose, they were assessed for the year or years that they were ‘for’. The main effects of this basis were:

  1. earnings ‘for’ a tax year in which the employee was not UK resident were not chargeable to income tax, except to the extent that the employee performed duties in the UK (the territorial rule);
  2. earnings ‘for’ a period spanning more than one tax year had to be apportioned and were liable to income tax by reference to the different tax rates, tax bands and tax allowances prevailing in the applicable tax years for which assessments were raised (EIM40008);
  3. earnings ‘for’ a tax year after the termination of the employment were not liable to income tax as earnings (but might be liable to tax under the termination payments regime, if above the exempt threshold). This was the effect of the source principle, under which income arising after the source had ceased to exist was not chargeable (Brown v National Provident Institution [1921] 2 AC 222; Bray v Best [1989] STC 159).

In Bray v Best, final distributions by an employee benefit trust in the tax year following that in which all the relevant employments had ceased were held to be ‘for’ the year of payment and could not, therefore, be charged to tax as earnings by virtue of the source principle. Lord Oliver said that the period to which earnings are attributable is a question of fact that depends on factors such as the intention of the payer.

As a result of Bray v Best, the law changed and, as from 1989/90, earnings are liable to income tax on the ‘receipts’ basis. This does not affect the territorial rule, as the exemption for the earnings of non-UK residents continues to apply on the ‘earnings’ basis (with the earnings being apportioned between tax years, if they are ‘for’ a period spanning more than one tax year). However, earnings are now assessed in full in the tax year of receipt and the source principle no longer applies to post-employment earnings (see EIM40008 and EIM42201).

The ITEPA 2003 re-write

The post-1989 approach under which earnings are assessed to tax in the year of receipt but the territorial rule exempts those earnings to the extent that they are ‘for’ a period in which the employee is not resident or working in the UK was rewritten without any material change when ITEPA 2003 was enacted.

However, it had been suggested to the rewrite team that it would be helpful to provide a statutory explanation of the meaning of earnings ‘for’ a period, but without changing the law, and this was done in ITEPA 2003 s 16. The explanatory notes to ITEPA 2003 suggest that s 16 does not change the law but EIM40008 is clearer:

‘Section 16 was drafted to clarify references to general earnings "for" a tax year. It was not intended to introduce any change. … Lord Oliver’s approach to determining the year that earnings are "for" continues to apply. Section 16 simply confirms the recommended approach’.

Change of practice by HMRC: end of the cliff-edge

Although Henry v Foster (1931) 16 TC 605 considered the taxation of a terminal bonus paid to directors who had held office for not less than five years, there was no case law on the correct application of the Bray v Best approach to modern performance bonuses, retention payments and other long-term incentive plans based on conditionality. HMRC tended to regard the entire payment as being ‘for’ the tax year in which the employee’s entitlement to the payment became unconditional (for instance, after completion of a retention or vesting period) (EIM40013). At the time, this was called the ‘cliff-edge’ approach.

However, this approach did not fairly reflect the employer’s likely intention to reward all of the duties performed throughout the entire vesting period (during much of which the employee may have been non-UK resident). In 2008, I was a member of the Joint Expatriate Forum which developed a new approach, agreed between HMRC and the professions in that year, as to how the Bray v Best approach should be applied to bonuses, retention payments and other conditional incentives. This highly satisfactory replacement to the cliff-edge approach is set out at EIM40009 onwards. In essence, the new approach tries to identify the duties of the employment that the employer’s incentive plan intends to reward and the period in which they are performed.

Murphy v HMRC

We now have the first case on the correct application of the Bray v Best approach to a retention payment. In Murphy v HMRC [2019] UKFTT 409, it was announced, in 2013, that PwC intended to acquire Mr Murphy’s employer and a $50m staff retention pool was established to support the merger. To be eligible to participate in the retention plan:

(i) an employee had to be an active permanent employee in good standing on 31 December 2013;

(ii) the merger with PwC had to be completed; and

(iii) the employee had to continue in active employment in the merged group in good standing through to the award payment date (the payroll date following the first anniversary of completion of the merger).

If an employee took leave of absence for personal reasons during the retention period, the award would be reduced proportionately.

Under the retention plan, Mr Murphy became entitled to a payment of £30,000 on 28 April 2015. He was non-UK resident in 2013/14, returned to the UK in 2014/15 and was UK resident in 2015/16. If his award was ‘for’ the entire retention period from 31 December 2013 to 28 April 2015, an appropriate part of the award would not be chargeable to tax as earnings by virtue of the territorial principle. However, if the award was ‘for’ the year in which his right to the payment became unconditional (2015/16), the entire award was chargeable to tax as earnings, as he was UK resident in that year. This should have been an easy case. It was clear from the retention plan’s ‘stay in employment’ condition (and the leave of absence abatement) that Mr Murphy’s employer intended to reward the duties that he would perform throughout the entire retention period in support of the merger.

Under its new approach, HMRC recognises (at EIM40013) that the employer’s purpose in imposing a ‘stay in employment’ condition is rarely to ensure employment on the vesting date but, rather, to obtain satisfactory performance throughout the vesting period. Unfortunately, however, for Mr Murphy, his trip to the First-tier Tribunal went badly awry.

Firstly, and inexplicably, HMRC argued that the question of the year that earnings are ‘for’ is only relevant where earnings are chargeable on the (now abolished) ‘earnings’ basis. As a result, the employee’s residence had to be tested, for the purposes of the territorial rule, in the year of receipt. This flatly contradicts HMRC’s own guidance in EIM40008 and EIM42201. Then, the FTT fell into error by agreeing with HMRC, despite Mr Murphy drawing its attention to EIM40008 and EIM42201. However, the FTT redeemed itself by concluding that, as a result of a drafting amendment in FA 2008, the employee’s residence returned to being tested, for the purposes of the territorial rule, in each of the tax years throughout the period ‘for’ which the earnings were paid.

Mr Murphy then pointed out that the period ‘for’ which his retention award was paid should be determined according to the factual test in Bray v Best. This test indicated that the award was paid ‘for’ the entire retention period from 31 December 2013 to 28 April 2015 and resulted in part of it not being chargeable to tax as earnings by virtue of the territorial rule. However, the FTT decided that Bray v Best was not helpful or relevant, as the concept of earnings ‘for’ a period is now defined by ITEPA 2003 s 16. This overlooks the indication in the explanatory notes and the firm statements by HMRC in its guidance that s 16 (introduced by the rewrite in 2003) was not intended to change the law. As a result, the FTT does not consider HMRC’s new approach (at EIM40009 onwards) to retention awards payable only on satisfaction of a ‘stay in employment’ condition or HMRC’s rejection of the ‘cliff-edge’ approach to conditionality.

Although accepting that the conditions applicable to the retention plan reflected a need for continued employment by Mr Murphy throughout the retention period, the FTT decided that the period that his retention award was ‘for’ was determined by the fact that he did not become entitled to the award until 28 April 2015. Accordingly, the entire award was ‘for’ the tax year 2015/16, in which Mr Murphy was UK resident. As a result, the FTT did not allow any abatement in the taxable amount to reflect Mr Murphy’s non-UK residence in the early part of the retention period.

Where does this leave us?

Determining when earnings accrue by reference to when the entitlement to them becomes unconditional, rather than by reference to when the duties that the employer intends to reward are performed, is a retrograde step. It was decisively rejected by HMRC as long ago as 2008.

There is not a huge amount of tax at stake in Murphy v HMRC, and it would be understandable if Mr Murphy decided not to incur the expense of a further appeal.

If he does not appeal, it is vital that HMRC publish a statement confirming that this is a rogue decision and does not represent a rejection by HMRC of its new approach to conditional payments at EIM40009 onwards.