Background

On 9 December 2010, HMRC published draft legislation designed to stop tax avoidance through “disguised remuneration”. The stated policy objectives were twofold – (i) to prevent tax avoidance or tax deferral and (ii) to prevent the annual and lifetime pension allowances being circumvented.

The draft legislation provides for an immediate income tax charge (and NICs) to be withheld under PAYE where an employee is provided with “disguised remuneration”.

The legislation is due to come into force on 6 April 2011 and includes anti-forestalling provisions for certain actions taken between 9 December 2010 and 5 April 2011.

“Disguised Remuneration”

HMRC’s focus is on structures which allow an individual full use of money or an asset, but which allow that individual to argue that he has no legal right to that money or asset and therefore should not be taxed on it.

For example, XYZ Ltd gifts £1000 to a discretionary family benefit trust. Mr K, an employee of XYZ Ltd, has no legal right to the money as he is one of a number of potential beneficiaries under the trust. However, the trustee decides to loan the full £1000 to him and after Mr K retires from XYZ Ltd, the loan is written off.

The draft legislation is very widely drawn. HMRC has identified three steps which, if taken by a relevant third party and if it is reasonable to suppose are concerned with reward for employment, would suggest disguised remuneration is being provided. These are broadly (i) earmarking a sum of money or asset, (ii) transferring money, property or an asset and (iii) making an asset available.

Publication of FAQs

HMRC has always said that in order to meet its policy objectives, it expected the legislation to have some hard edges. However, following consultation, HMRC has accepted that the draft legislation potentially caught many innocent arrangements including those which many companies routinely use in conjunction with their employee share schemes and deferred remuneration arrangements.

The FAQs attempt to clarify the scope of the legislation and carve out innocent arrangements. The legislation itself is currently being revised and will be brought into line with the FAQs. Set out below is an overview of the main points of clarification relevant to companies operating standard employee share schemes.

FSA Remuneration Code and Deferral Arrangements

It is perhaps a bit embarrassing for HMRC that the draft legislation potentially catches deferred remuneration arrangements which are currently being imposed on financial services firms by the FSA Remuneration Code. However, there is an inherent tension between the policy objective of preventing tax deferral (including EFRBS and other arrangements for retirement saving) and not prejudicing genuine deferred reward.

Recognising the good corporate governance reasons for deferred reward, the FAQs confirm that it is not the policy intention for innocent deferred arrangements to be caught. A specific exemption is to be included in the legislation if the following conditions are met:

i. the reward is subject to a condition which, if not met, will mean there is no possibility of the employee receiving the reward; ii. the reward must not be capable of vesting more than five years after the date of grant; iii. the deferred reward must give rise to an income tax charge on vesting; and iv. tax avoidance or deferral is not the main purpose or one of the main purposes of the arrangement.

This is a useful exemption provided that the deferral period is no longer than five years. If there are good governance or other reasons for having a longer deferral period in any particular circumstance, then these are likely to fall victim to tax considerations.

The other point to consider is what happens if the remuneration committee (or other body) has the discretion to allow the reward to vest even if the performance conditions have not been met. Arguably, this means that there is a possibility the employee will receive the reward even though the conditions have not been met – which could mean the exemption is unavailable. This point has been raised with HMRC and further clarification is expected soon.

Hedging share awards using an EBT

As drafted, the legislation raised a concern that hedging share awards would constitute “earmarking” and so employees would be subject to tax at the date share awards are hedged (even though they may never, in fact, vest).

HMRC has now provided a couple of important confirmations in the FAQs.

The first is that where a company undertakes general hedging through an EBT, without identifying employees or their awards for which the shares are to be used, this will not constitute earmarking and so will not amount to disguised remuneration.

The second is that even if awards for named employees are hedged, provided certain conditions are met, that hedging will not amount to “earmarking”. These conditions are very similar to those for deferred rewards, namely that:

  1. vesting of the share award is subject to conditions which, if not met, will mean that there is no possibility that the employee may receive the shares;
  2. the share award must vest no more than 5 years from the date of grant;
  3. on vesting of the award, the employee must be subject to income tax; and
  4. tax avoidance or deferral is not the main purpose or one of the main purposes of the arrangement.

This is good news and an important amendment. However, in addition to the question whether remuneration committee discretion means the exemption will not be available, there is a second question relating to options. Options typically vest (i.e. become exercisable) in under five years but an employee will only be subject to income tax at the date he exercises the option. This may often be up to ten years from the date of grant. At the moment, it appears that unapproved options with more than a five year life are at risk of triggering a tax charge when they are hedged.

Loans and Cashless Exercise Procedures

Under the draft legislation, any loan made by a third party to an employee after 9 December 2010 would be caught - albeit that the loan might be for genuine commercial purposes and be repaid in full in a very short time - for example under cashless exercise procedures. The draft legislation also does not take account of the existing tax regime for loans.

HMRC has acknowledged that as the definition of third parties currently includes group companies (other than the employing company) this would catch transactions entered into for “commercial and otherwise innocent purposes”. HMRC therefore proposes to amend the draft legislation, subject to an anti-avoidance purpose test.

HMRC is also considering including a short-term loans exemption where the purpose of the loan is for a restricted specified purpose (for example, the acquisition of shares). Any such exclusion would also be subject to an anti-avoidance test. This would be useful to groups that offer cashless exercise procedures via a (non group) third party.

It is important to note that unless a loan falls within an exemption, it will trigger a tax charge even if the loan is only for a very short period and the full amount of the loan is repaid in that period.

Employee Sales and Purchases

In the draft legislation, employees who bought assets from a relevant third party were potentially subject to tax on the market value of those assets. While credit was given for any undervalue which was subject to tax, no credit was given for any price the employee actually paid for the assets if that payment was made after the assets were transferred. For example, if an employee bought shares worth £100 from an EBT for £80, but the employee only paid the £80 after the shares were transferred to him, credit was given for the 20% discount (which was already subject to tax), but no credit was given for the £80 actually paid.

Equally, if an employee sold an asset to an EBT and received payment from the EBT for that, no credit was given for the value of the asset actually transferred (irrespective of the timing of the transfer). For example, if an employee (on leaving employment) sold shares worth £100 to the EBT and received £80 for them, the employee would be taxed on the £80 – even though they had given up shares worth £100.

HMRC has confirmed in the FAQs that credit will now be given for the market value of an asset which an employee sells. However, it appears that the exemption is designed to bring sales into line with purchases. Therefore, credit will only be given if the asset is transferred before payment is received.

Therefore, where employees are buying shares from and selling shares to an EBT, it will be very important to ensure the timing of the payments and transfers is carefully planned.

Other points to note

Finally, a further note of caution. HMRC issued Spotlight 11 on 3 March 2011 in which it said that individuals considering entering into products being marketed to avoid the effects of the disguised remuneration legislation “should be aware that HMRC will pursue people who seek to avoid tax on monies they earn, through the courts where necessary.”