FA 2011 analysis: Disguised remuneration

 HMRC have long been known to be hostile to the use of employee trusts to provide benefits where income tax is avoided or deferred. The anticipated anti-avoidance legislation was widely trailed.

HMRC published two Spotlights in 2009 which focused on particular uses of Employer Financed Retirement Benefit Schemes (EFRBS) and employee benefit trusts (EBTs) and the June 2010 Emergency Budget promised legislation to tackle trust-based remuneration planning.

These pronouncements seemed to be aimed primarily at arrangements that claimed to accelerate corporation tax relief and/or provided potentially non-taxable benefits, mainly in the form of loans, to employees and their families.

The draft clauses were first published on 9 December 2010 and were heavily criticised for their wide-ranging nature.

After intense consultation and lobbying, HMRC clarified and redrafted a number of provisions both in Finance Bill 2011 Clause 26 and Sch 2 published on 31 March 2011 and at Public Bill Committee stage in May. The result is complex legislation over 80 pages in length, half of which comprises exclusions to the general taxing provisions.

HMRC also published Frequently Asked Questions (the latest (July) version is available via www.lexisurl.com/Llkq3). Further guidance for employers is expected to be given in August 2011.

All statutory references are to ITEPA 2003 unless otherwise indicated.

What do the rules do?

The legislation applies where (s 554A):

• there is an arrangement which relates to an existing, former or prospective employee;
• it is, in essence, a means of providing rewards, recognition or loans in connection with employment;
• the 'relevant third party' operating the arrangement takes a 'relevant step; and
• it is reasonable to suppose that, in essence, the step is pursuant to the arrangement or there is some other connection between them.

When the legislation applies, the value of the cash or assets which are the subject of the 'relevant step' is treated as employment income (s 554Z2), subject to PAYE and NIC (s 687A and s 695A).

Relevant third party

A 'relevant third party' includes (s 554A(7)):

• an employee acting as a trustee;
• an employer acting as trustee; or
• any person other than the employee or employer.

For the purposes of Part 7A any company in the same group as the employer at the time a relevant step is taken is treated as if they were the employer (s 554A(8)).

Therefore, a group company will not normally be a relevant third party unless it acts as trustee of an arrangement or if there is some underlying tax avoidance purpose. However Part 7A Chapter 3 catches arrangements where employers undertake to make payments or provide security to an EFRBS – see below.

Relevant steps

There are three categories of relevant step which may become chargeable if taken by a relevant third party:

• Earmarking of money or assets for an employee with a view to a later relevant step being taken (s 554B). This is drafted extremely widely. It does not matter that details of the later relevant step has not yet been worked out or conditions may need to be met before the later relevant step is taken or that the employee has no legal right to a further relevant step. This category has caused particular problems in the context of employees' share schemes and is also significant for EFRBS and other EBT-based long-term remuneration planning schemes where assets are allocated for the future benefit of individuals.
• Payment of sums to an employee, including the making of a loan, or the transfer or an asset to an employee (s 554C).
• Making an asset available to an employee as if the asset had been transferred outright (s 554D).

What arrangements are potentially affected?

Broadly, any arrangement which provides employment benefits through a third party, such as an EBT, is potentially chargeable unless a statutory exclusion applies.

Common historic uses of EBTs that will now fall within the scope of the legislation include:

• a loan from an EBT to an employee made after 6 April 2011 will be the payment of a sum within s 554C, even if it is subsequently repaid. A loan from an EBT to an employee made between 9 December 2010 and 6 April 2011 will fall within the anti-forestalling rules which impose an income tax charge on 6 April 2012 if the loan has not been repaid before that date;
• the allocation of assets from an EBT to a sub-fund established for the benefit of an individual employee and/or his family will be earmarked within s 554B;
• the distribution of assets from a sub-fund, even if the sub-fund was established before 6 April 2011 will be a payment or transfer within s 554C;
• the allocation of funds or assets to an EFRBS for the provision of retirement benefits to an individual will be earmarked within s 554B; and
• the acquisition of shares by an employee from an EBT on deferred payment terms will be a transfer of assets within s 554C (s 554Z8 only provides an exemption for acquisitions from an EBT where the employee provides consideration at or around the same time).

Exclusions for share schemes

Many companies operate EBTs in conjunction with their employees' share schemes.

Where trustees allocate shares held in an EBT in order to satisfy awards granted to employees under an employees' share scheme, this will be earmarking within s 554B, even if the employee is not aware that earmarking has taken place and the award may be subject to conditions.

There are a number of exemptions in the legislation for arrangements that support common types of employees' share schemes.

These exemptions are, for the most part, only applicable to exclude a charge for earmarking. If the trustees of an EBT grant awards or deliver shares to satisfy awards, these will be treated as separate relevant steps within s554C and separate exemptions may need to be found to cover these.

If an EBT acquires shares to meet future requirements of a company's employees' share schemes, there will be no Part 7A charge provided the shares are not earmarked for named employees but are simply retained as part of a general pool of shares (see HMRC’s FAQ 24).

The statutory exemptions overlap in some cases and are subject to conditions. They apply to:

• certain steps taken under HMRC approved share schemes, including the grant of awards, acquisition, earmarking and delivery of shares (s 554E);
• earmarking of deferred remuneration (s 554H);
• earmarking for share awards or their cash equivalent (s 554J), including where these vest only on an exit (s 554K); and
• earmarking for share options or their cash equivalent (s 554L), including where these vest only on an exit (s 554M).

The exemptions for steps taken under HMRC approved share schemes require that the total number of shares held for the relevant purpose must not exceed the maximum number of shares which might 'reasonably be expected to be required' for those purposes over a ten-year period.

The conditions in ss 554H, 554J and 554L have some common features in that:

• the main purpose of the award is to defer the receipt of shares or cash to a specified vesting date;
• the specified vesting date is not more than ten years from grant (for ss 554J and 554L) or five years (for s 554H) and the award is revoked if specified conditions are not met. There must be a reasonable chance that those conditions will not be met. See FAQ 17 for further guidance on this condition; and
• the number of shares earmarked does not exceed the maximum number which might reasonably be expected to be needed.

The conditions for exit-only schemes in ss 554K and 554M are similar except there is no requirement for a vesting date or vesting conditions.

Deemed charges can arise under all the exclusions after the final vesting/exercise date unless the employee receives taxable income as a result of vesting/exercise or the award lapses.

Exclusions for other employment-related securities and other relieving provisions

Further exclusions are contained in ITEPA 2003 s 554N. Broadly, there will be no Part 7A charge for:

• the acquisition of restricted securities ,the grant of an employment-related securities option or the transfer of shares following its exercise (s 554N((1)–2));
• the acquisition of shares where this has given rise to an income tax charge (s 554N(4)–(6));
• the acquisition of shares where full market value has been paid or where an employee has paid tax on this amount (s 554N(7)); or
• short term loans for the sole purpose of paying the exercise price of a share option, providing this is repaid within 40 days (s 554N(13)).
• There are also potential relieving conditions that apply to avoid double tax charges where:
• there is an overlap with an earlier relevant step (s 554Z5) or with other employment earnings (s 554Z6);
• an employee pays the exercise price of a market value share option (s 554Z7);
• an employee gives consideration for a relevant step at or around the same time (s 554Z8);
• there is a subsequent income tax liability following a relevant step (s 554Z13); or
• earmarking has taken place but by reason of an event, is not followed by a further relevant step, provided an application for relief is made to HMRC within four years of that event (s 554Z14).

Exclusions for other benefits

There are certain other exclusions for the provision of employment-related benefits:

• Exclusion for relevant steps taken for the purpose of the purchase of a car or its sale-back under an Employee Car Ownership Scheme (s 554O).
• Exclusion for construction industry holiday pay schemes (s 554E(1)(e)).
• Exclusion for loans made on ordinary commercial terms, provided a substantial proportion of the third party's business involved similar transactions with members of the public (s 554F).
• Exclusion for transactions under employee benefit packages where these are provided to a substantial proportion of employees (s 554G).
• Exclusions where employment income is provided that is exempt under ITEPA 2003 Part 4 (eg, relocation expenses, travel and subsistence, redundancy payments etc) (s 554P).
• Exclusions for employee pension contributions (s 554T).

Residence

A tax charge can arise under Part 7A to the extent that the value of a relevant step can be attributed to periods that it would have been ‘for’ had it been employment earnings (s 554Z4). This means that a charge can arise if a relevant step is taken in a tax year in which the employee is non-resident (FAQ 54). The value is reduced so far as it is not in respect of duties performed in the UK.

Pensions

The introduction of the disguised remuneration rules will significantly affect the use of EFRBS.
There are various exclusions for payments from, and transfers between, certain types of pension funds, to the extent that payments/transfers derive from rights accrued at specified dates. For example:

• transfers can be made between EFRBS or payments can be made from EFRBS without being treated as a further 'relevant step' to the extent that these derive from taxed contributions prior to 6 April 2006 (s 554U). Contributions to pre-6 April 2006 EFRBS would normally have been taxed;
• a lump sum payment can be made from an EFRBS without being treated as a 'relevant step' within ITEPA 2003 s 554C to the extent that the rights to receive lump sum payments accrued before 6 April 2011 (s 554W);
• an annuity can be purchased without incurring a Part 7A charge to the extent that rights to receive the annuity accrued before 6 April 2011 (s 554V); and
• other payments out of an EFRBS could constitute a 'relevant step' within s 554C but the normal tax charge on regular pension income under ITEPA 2003 Part 9 will take priority over any Part 7A charge (s 554S). This is likely to be favourable in that, where relevant, the remittance basis will continue to apply for pension income. UK residents who receive a pension from outside the UK will also continue to be entitled to the 10% abatement (ss 573–575).

While wholly unfunded arrangements are intended to be outside the scope of the rules, Part 7A Chapter 3 will apply where an unfunded pension arrangement becomes funded after the employee leaves employment or where security is given for a future contribution. In those circumstances, the employer will be treated as earmarking funds.

Other EBT-based remuneration planning

The disguised remuneration rules will make the use of EBTs for the provision of remuneration unattractive to the extent that the arrangements do not fall within a statutory exclusion.

Funds may become trapped in EBTs or sub-funds in that they cannot be distributed or allocated without incurring immediate income tax charges.

There is some protection for income arising on funds or assets already earmarked (s 554Q) and for reinvestments deriving from previously earmarked funds or assets (s 554R).

The full value of further relevant steps under ss 554C or 554D will still be chargeable where they are funded by income or gains from the original contribution.

It should be possible for outstanding loans, made before 9 December 2010, to continue, provided that they are not reallocated or reassigned in a manner that would result in a new payment being made.

However, HMRC are continuing to scrutinise arrangements that were in existence before the legislation came into force and are mounting a two-pronged attack by:

• offering the opportunity to settle outstanding PAYE/NIC on benefits provided before 6 April 2011 to the extent that these would now be taxable under the disguised remuneration legislation; and
• considering the scope for IHT charges on contributions made to an EBT by a close company (IHTA 1984 s 94) and transfers out of EBTs to sub-funds (IHTA 1984 s 72) (see Revenue & Customs Brief 18/11).

Karen Cooper, Partner, Osborne Clarke 

Natalie Smith, Senior Associate, Osborne Clarke