Back to basics: The income tax exemption for employee bonuses

New tax exemptions promote employee ownership

Since 2012, following the Nuttall Review of Employee Ownership (BIS), the government has promoted the employee ownership of companies. The article 'The employee ownership business model'  (Graeme Nuttall) in Tax Journal, 13 July 2014, explained recent measures to promote this business model in all its forms and especially as a business succession solution. In particular:

• a capital gains tax exemption now encourages the sale of a controlling-interest in a company to an employee-ownership trust (EOT) (TCGA 1992 ss 236H-236U); and
• since 1 October 2014 a new income tax exemption provides a tax incentive for companies to become controlled by an EOT (ITEPA 2003 Part 4 Chapter 10A).

If an EOT has a controlling interest (as defined) in a company then there is an income tax exemption of up to £3,600 per employee each tax year on certain qualifying bonus payments (with NICs liabilities continuing to apply). It is the employing company (the employer) and not the trustee of the EOT that must pay the qualifying bonuses.

Qualifying bonus payments

The income tax exemption requirements are relatively straightforward especially if the scheme formula is kept simple. The bonus needs to be a genuine bonus. The payment must not be:

• regular salary or wages (ITEPA 2003 s 312B(1)(a)); or
• received, in broad terms, in return for giving up the right to receive general earnings, specific employment income or some other form of employment income (ITEPA 2003 s 312H).

A bonus has to be paid under a scheme which in broad terms, makes awards to all the employer's current employees (or, if applicable, all of a group's employees). This is the 'participation requirement' (ITEPA 2003 312C). Where a payment is made to a former employee, it must be made within 12 months of the employment ending (ITEPA 2003 s 312B(1)(h)). The scheme must also meet the 'equality requirement' (ITEPA 2003 s 312C). The 'participation requirement' and the 'equality requirement' are explained further below.

The other qualifying conditions relate to the employer and its ownership and governance arrangements. The employer (which cannot be a service company e.g. one providing staff services outside a group (ITEPA 2003 s 312G)) must meet the:

• 'indirect employee-ownership requirement" throughout a qualifying period of normally 12 months (ITEPA 2003 s 312B(2)-(3) and s 312E);
• 'trading requirement' throughout the qualifying period (ITEPA 2003 s 312D); and
• 'office-holder requirement' at the time the payments are made and throughout the qualifying period (except for up to normally 90 days) (ITEPA 2003 s 312F).

It is the indirect employee-ownership requirement which ensures there must be an EOT with a controlling interest in either the employer or (if applicable) the principal company of the relevant group. The trading requirement applies concepts that are familiar from other tax provisions e.g. non-trading activities must not be substantial. The office-holder requirement prevents the income tax exemption applying where the ratio of directors and other office-holders (and connected employees) to employees and office-holders is greater than two-fifths. The 90 days exclusion (ITEPA 2003 s 312B(4)) allows for recruiting to overcome temporary defaults prior to making bonus payments.

Participation requirement

It is possible to exclude recent joiners by setting a minimum qualifying period not exceeding 12 months. Employees can also be excluded in limited circumstances involving disciplinary matters. Subject to this, qualifying bonus payments must be awarded to everyone in employment with the employer (or in the relevant group) when the award is determined.

The legislation acknowledges that the payment date is likely to follow after the date the award is determined. ITEPA 2003 s 312C(4)(c) allows certain intervening severe disciplinary matters to stop an otherwise eligible employee from receiving an award. Apart from this exception, an individual employed on the determination date must receive the bonus even if he or she has left employment by the payment date (remembering that a qualifying bonus payment must be made within 12 months of the employment ending).

Equality requirement

Every eligible employee must participate 'on the same terms' (ITEPA 2003 s 312C(1)(b)). However, the legislation provides that this equality requirement will not be infringed if an award is determined by reference to:

• remuneration;
• length of service; or
• hours worked.

An award may be determined by reference to more than one of these factors but each factor must give rise to a separate entitlement and the total entitlement must be the sum of those entitlements and not the product (ITEPA 2003 s 312C(6)). Also, the scheme must not disproportionately benefit any particular group of eligible employees (ITEPA 2003 s 312C(9)).

The legislation provides no further guidance on the meaning of 'on the same terms'. In practice understanding this term will be a key area where professional advice is needed if employers wish to do anything other than pay the same amount to each employee. Care will be needed to ensure that the proposed calculation does not have the inadvertent effect of multiplying factors together. The Office of Tax Simplification commented in its final Review of tax advantaged employee share schemes (page 54) in the context of share incentive plans (SIPs) (ITEPA 2003 Sch 2) that an equivalent same terms requirement is 'complex' and 'difficult to operate'. The existing HMRC guidance relating to same terms for SIPs provides a starting point until HMRC publishes guidance for EOTs.

Action point for advisers

There is no express requirement for a set of rules but the reference to a 'scheme' means there must be a degree of formality to these bonus arrangements. Advisers should recommend that a client documents the scheme so as to demonstrate compliance with all the required conditions and, in particular, the same terms condition.