The tax issues for remuneration committees

he remuneration committee (RemCo) is no longer exclusively found in listed companies; many aspirational private companies take executive compensation seriously and have set up RemCos for this purpose. The RemCo often needs to put incentives in place that are effective in driving forward the management’s performance and has a duty to manage the company’s resources carefully. In order to do so, the RemCo should be mindful of the tax and accounting treatment of the proposals – and tax plays a large part in determining cost. So, what sort of issues should they be considering?

To put these in context, it is important to be mindful of a number of key developments and ‘hot topics’. These include:

• delaying bonuses: to take advantage of the rate reduction from 50% to 45% with effect from 6 April 2013;
• whether to pass the cost of employer’s national insurance contributions (NICs) due on share incentives to the executive;
• the introduction of malus/clawback provisions requiring adjustment of awards for poor performance into bonus and share schemes;
• consideration of widely recognised capital planning arrangements, such as joint share ownership plans (JSOP); and
• beneficial changes to approved share schemes, which will require amendments to plan documents and procedures.

Payment of bonus in next tax year

The top rate of income tax will be reduced from 50% to 45% on 6 April 2013. RemCos of companies with a December year-end who normally produce accounts in March/April may consider whether to defer payment of discretionary bonuses until the new tax year in order to take advantage of this lower rate of tax.

In deciding whether to allow such a deferral, RemCos will need to balance a number of competing factors:

• the balance of benefit – in this case, only the employee will benefit from the tax reduction, since neither the employer’s NICs or their corporation tax deduction will be affected; and
• the potential for adverse publicity of executives being seen to avoid tax, particularly in high profile companies, such as those in the financial, energy, retail or transport sectors.

There have been a number of recent press reports that some companies have allowed such deferrals. However, RemCos need to come to their own conclusion as to whether it is appropriate for their circumstances.

The tax perspective: If, taking into account these other factors, a RemCo does consider that a deferral would be appropriate, it is important that it is structured correctly for tax purposes. This means that it must be ensured that the tax point for the bonus arises after 5 April and not before. In this regard, the rules on the deemed receipt of income should be considered. Generally, employment income is deemed received on the earliest of the time when:

• the payment is made; and
• the individual becomes entitled to the payment (ITEPA 2003 s 686(1)).

For directors however, there are a number of additional deemed points of receipt, namely the earlier of:

• the date when earnings are credited in the company’s accounts or records;
• where the amount of the earnings is determined before the end of the period to which they relate, the date that period ends; and
• where the amount of the earnings is determined after the end of the period to which they relate, the date the amount is determined (s 686(1)).

For most companies discretionary bonuses will be determined as at a particular date by a RemCo meeting after the end of the company’s accounting period around the time of publication of financial results.

What do RemCos need to do now?
They should:

• consider whether to allow deferral of discretionary bonuses until the new tax year; and
• if they allow deferral then ensure this is done effectively.

Transferring employer’s NICs

It is possible to pass the burden of employer’s NICs on share incentives from the employer to the employee (Social Security Contributions & Benefits Act 1992 Sch 1 paras 3A(2), 3(B)). Where an award has been granted to an executive based on shares, the employer’s NIC liability is based on the value of the shares received at the time of vesting or exercise. However, this means that when the award is made, it is uncertain what value will vest and so uncertain what the ultimate employer’s NICs charge will be.

The tax perspective: By transferring the employer’s NICs liability to the executive the company reduces the cost of the award. The executive also gets tax relief for the additional cost. However, since this does give an effective tax rate of 50.28% for a higher rate taxpayer or 54.59% (from 2013/14) for an additional rate taxpayer, this level of tax can be very demoralising for executives. See Figure 1.

What do RemCos need to do now?
Employer’s NICs can be a significant liability for the company. RemCos should:

• look at the potential NICs costs and estimate the future exposure for the company and the potential return for the employee both with and without the employer’s NICs burden – if the estimated cost is not too high, the NICs can be borne by the company;
• if the potential employer’s NICs costs are high, the RemCo could award more shares (if the shareholder dilution limits allow);
• alternatively, the RemCo could cap the extent to which the company bears the employer’s NICs – for example, it may agree to pay the employer’s NICS up to a specified value, any excess over this figure will be borne by the executive; and
• consider the level of benefit to be received by the executive and the remuneration strategy. If the executive receives a low base pay and little/low bonus, bearing employer’s NICs on his share incentives may undermine the incentive effect.

Malus/clawback

Recent corporate governance trends are starting to extend more widely. In particular, there is a drive to see sustained improvements in performance and to move away from windfall gains. And, more importantly, to penalise executives if performance worsens in the following period. In this context, RemCos should consider whether to introduce malus/clawback provisions into their bonus and share schemes, if they have not already done so.

Malus is the most straightforward of the two, involving the deferral of vesting of at least part of the award to reflect readjusted performance. Clawback is similar in concept but operates after awards have vested. Although the latter is common amongst US companies, it does raise a number of adverse UK legal and tax implications (see the article ‘Back to basics: Tax implications of clawbacks’, Tax Journal, dated 18 October 2012 for a more detailed discussion). In particular, there is the cost and complexity involved in retrieving shares or cash that may have already been disposed of by executives. On balance, the UK position is that malus is a more expedient approach than clawback. In addition, if income tax has already been paid on receipt of the bonus/shares it will not be refunded if performance worsens and it is clawed back.

The current ABI guidelines state that remuneration structures should ‘include provisions that allow the company to implement malus or claw-back arrangements’.

What do RemCos need to do now?
They should:

• consider whether to amend existing bonus and share schemes to include malus provisions. In most cases, for listed companies, such changes would not require shareholder approval since it is not an alteration ‘to the advantage of participants’ under the UK listing rules; and
• if the RemCo wishes to change the terms of existing awards, this normally has to be agreed with the executives concerned. New terms including malus provisions can be imposed on new awards. Care should be taken to ensure that any malus provisions are drafted so that no PAYE or NICs are due until the executive receives his award unconditionally.

Capital planning: the executive treated as a shareholder

A JSOP is a type of long-term incentive scheme that enables the growth in value of an award of shares to benefit from capital gains tax treatment rather than being subject to income tax and NICs. As mentioned above, a significant number of both listed and private companies have implemented such plans.

The tax perspective: In essence, a JSOP involves the current value of a share being held by the trustees of an employee benefit trust and the employee being awarded the right to any growth on that share above a hurdle. The right to the growth is subject to income tax at award, but dependent on the level of the hurdle, it should generally be low. Alternatively, the employee can pay the market value of the award at the outset. All subsequent growth in the share will then fall into the more favourable capital gains tax regime. See Figure 2.

The plan can use the same performance conditions as the company’s existing long-term incentive plan (LTIP) arrangements. In addition, many companies tend to mirror the commercial rationale of a ‘free share’ award by granting a regular award over the current value of the share and the gain up to the hurdle amount at the same time as the JSOP award (although this will be subject to income tax in the normal way at vesting/exercise).

See Figure 3.

In deciding whether to implement a JSOP, RemCos will need to balance a number of competing factors:

• the balance of benefit:
• the employee will benefit from a lower effective tax rate (reducing from up to 47% income tax and NICs for 2013/14 to up to 28% capital gains tax); and
• the company benefits from a reduction in employer NICs, but loses out on a corporation tax deduction for the growth on the shares. Some companies adjust downwards the value of employee awards to compensate for this. On this point, the ABI guidelines state ‘remuneration structures that seek to increase tax efficiency should not result in additional costs to the company or an increase in its own tax bill’.
• the incentive for the management – either they pay for the value of what they receive or there is a potential for an up-front income tax charge when management acquire their part share in equity for no charge. This applies to an award whether or not it vests; and
• it is possible to loan the executives the money to pay for their share or for the up-front income tax charge and in both cases is then repayable from the proceeds of the award. The hurdle can be adjusted to ensure that the up-front cost/tax charge is at an acceptable level.

What do RemCos need to do now?
They should:

• consider whether to amend LTIPs to allow awards to be made under a JSOP structure. In doing so, the RemCo would need to balance the factors mentioned above. In most cases, for listed companies, such changes would generally not require shareholder approval since they would be made ‘to obtain or maintain favourable tax…treatment’ under the UK listing rules.
• Similarly, consider whether to introduce a JSOP arrangement as part of a wider review of remuneration arrangements or on introduction of a new LTIP – such new plans would require shareholder approval for listed companies.

Approved scheme changes

The draft clauses issued in December 2012, which will form part of Finance Bill 2013, contain a number of significant provisions impacting tax-advantaged or approved employee share schemes that were originally recommended by the Office of Tax Simplification.

What are the main changes that affect executive pay?
These are:

• the harmonisation of retirement provisions and good leaver provisions. Currently company share option plans, share incentive plans (SIPs) and savings-related share option schemes all have different retirement provisions and ages. These will be standardised to ensure a simple and consistent approach. The leaver provisions will also be changed. In particular, option exercises and SIP share withdrawals within six months of a change of control, certain types of cash, Takeovers and Transfer of Undertakings (Protection of Employment) transfers will be tax free;
• enterprise management incentive schemes (EMI) – the tax beneficial exercise period following a ‘disqualifying event’ will be extended from 40 to a more manageable 90 days. In addition, the valuable entrepreneurs’ relief, bringing the effective tax rate on share gains down to 10% on the first £10m of gains, will be extended to shares from EMI options, where the grant date is at least 12 months before the sale of the shares; and
• widening who can use approved schemes – shares that are subject to restrictions, such as pre-emption provisions in private companies articles, will no longer be a bar to adopting approved schemes. As a result, if wished, a specific class of shares may be set aside to incentivise employees through these schemes.

What do RemCos need to do now?
They should:

• bear in mind that most of these changes will take effect when the Finance Bill 2013 receives Royal Assent, likely to be around July 2013. For existing schemes, the new provisions will have effect automatically, but the scheme rules should be updated to reflect these changes, along with supporting documents such as award documents, employee guides or website wording where appropriate. This will avoid confusion and likely mistakes going forward if the plan documents are out of kilter with current legislation. For listed companies, such changes are unlikely to require shareholder approval, because they will generally be ‘to take account of a change in legislation or to obtain or maintain favourable tax ... treatment’ under the UK listing rules;
• review administrative processes to ensure for example, where employees leave in situations where PAYE would previously have applied to awards, it will no longer apply in the new ‘good leaver’ scenarios; and
• for private companies in particular, also review whether approved schemes can now be adopted with resulting tax savings for both the employees and the company.

Amanda Flint is a partner at Grant Thornton UK.

Toby Locke is a senior manager at Grant Thornton UK.