On 9 December 2010 HMRC published controversial draft regulations designed to prevent so called "disguised remuneration" (usually in the form of bonuses structured as loans made to employees via off-shore trusts). The legislation has been widely drafted and potentially applies to the operation of bona fide employee share plans, in many cases it replaces the intended tax charge with an up front charge subject to PAYE and NIC on benefits which may never be received...
HMRC have been unhappy for some time about the use of off-shore employee benefit trusts ("EBTs") to pay bonuses tax free. The classic structure is for the employer to pay an amount equal to the intended bonus to an EBT which the trustee then allocates to a revocable sub-fund for the benefit of the employee. No tax arises at that point as the employee is not entitled to the money. The funds are then either lent to the employee (and the loan written off tax free on death) or invested (with the benefit of gross roll-up).
The big fear amongst incentives lawyers has been the regulations would fail to distinguish properly between aggressive bonus planning arrangements and incentives provided for legitimate commercial reasons. HMRC have exceeded the worst fears of the profession by publishing draconian legislation, the consultation phase ended on 9 February 2011, during consultations, HMRC said. They say they do not intend to penalise companies for operating legitimate incentive arrangements, they may refine the regulations and will in any case produce guidance.
The Draft Regulations
The draft legislation will insert a new Part 7A into ITEPA 2003. It applies (broadly) where a "third person" takes a "relevant step" and it is "reasonable to suppose" it is a means of providing rewards, recognition or loans in connection with that persons employment (or former or prospective employment). The "relevant steps" are set out in the new s554B-554D ITEPA and are the earmarking of money or assets, the payment of a sum or transfer of an asset and making an asset available. Where the legislation applies, the employee will be subject to an immediate PAYE and NIC charge with credit for later tax charges to avoid double tax.
An "employer" is not a "third person" for these purposes but the definition of employer covers only the employing company itself, it does not extend to other companies in the same group.
The legislation will take effect on 6 April 2011. Anti-forestalling provisions apply to certain steps (being the payment of sums (including loans) and the provision of readily convertible assets for the purposes of securing the payment of sums (including loans)) taken between 10 December 2010 and 6 April 2011, if these are not "reversed" by 5 April 2012, a PAYE and NIC charge will arise on that date.
Earmarking of money or assets
It is a relevant step where a third party earmarks cash or assets for the benefit of an employee, with a view to a later relevant step being taken either by the third party or any other person. The terms of that later step need not be determined at the time the asset or money is earmarked, even if it is unclear what the sum or money or asset will be, by whom or in whose favour the later step will be taken or how/when it will be taken.
A relevant step is therefore taken even if neither the employee nor any person linked with the employee has any legal right to insist upon a relevant step being taken in the future and also where the employee has not received the assets and may never do so. It will no longer be possible to argue that the discretionary nature of arrangements prevents a charge at that point.
Payment of sum or transfer of asset
It is a relevant step if a third party takes a step to pay a sum of money or transfer an asset to "relevant person", being the employee, a person chosen by the employee or within a class of people chosen by the employee. A relevant step also includes a step by virtue of which a relevant person acquires securities, securities options or an interest in securities, making available a sum of money as security for a loan or the grant of a lease for a term likely to exceed 21 years.
A loan made by a third party will therefore be taxed on its full value on receipt instead of as a benefit in kind or as an employment related loan.
Making an asset available
A relevant step occurs if, without transferring the property in an asset to an employee or relevant person, a third party makes the asset available so that the employee or relevant person benefits as if the property had been transferred outright.
The legislation is also drafted to apply where an asset is made available for the employee or relevant person at the end of or after a period of two years following cessation of the employee's employment, with the relevant step being considered to have taken place at the end of that two year period.
The new legislation will not apply to:
- relevant steps taken under HMRC approved share incentive plans, save as you earn plans and company share option plans
- relevant steps taken under an arrangement the sole purpose of which is the issue of qualifying EMI options
- relevant steps taken under a registered pension scheme or in respect of compassionate benefits on death or ill health
- a loan made on commercial terms similar to terms made available to the public
- relevant steps made under employee benefit packages which are available across the employer's workforce, provided the benefits are genuinely available to substantially all employees and cannot be accessed by only specially selected individuals. If the relevant step is the making of a loan, the exclusion will only apply if a substantial proportion of the business of the third party making the loan involves making similar loans to the public
- steps where employment related securities or options are acquired where there would not normally be an income tax charge
Implications for employee share plans
There are a number of common situations where the regulations will apply to the operation of employee share plans despite the exclusions listed above, examples include:
- Loans by brokers to employees to enable them to fund the exercise of options and other cashless exercise arrangements;
- Hedging of existing share awards by the trustees of an employee share ownership trust;
- Entering into operating agreements in which trustees of an employee share ownership trust agree to satisfy existing share awards; and
- The issue of nil paid shares or the sale of shares on deferred payment terms.
In all these cases an up front tax charge may be triggered on benefits never actually received by employees. The actions of a third person of which the employer and employee may have no knowledge could trigger the charge so exposing the employer to penalties for failure to operate PAYE and NIC and the employee to a "tax on tax" charge under section 222 ITEPA 2003 for failure to "make good" the employer within 90 days of the taxable event.
There seems no policy justification as in all these cases if the issuer happens to be the employer and the only two parties involved are the employer and employee, the legislation does not apply (as the employer is not a relevant third person).
The thrust of the regulation of remuneration in the Banking and wider financial services industry (as set out in the EU Capital Requirements Directive or "CRD 3" as it is referred to) has been to encourage bonuses to be deferred. The disguised remuneration legislation directly conflicts with that policy objective.
If an employee is awarded a deferred bonus (which may be subject to performance targets or time based vesting), no charge arises if the bonus is awarded by the employer but a charge does arise if the bonus is awarded by anyone else. If the employer awards a bonus and is then prudent enough to hedge its exposure (e.g. by making a payment into a trust), a charge may arise at the point. Any charges will arise on the full value of the bonus even though it may never be received by the employee.
This seems to us to penalise employers and employees for doing the "right thing" by complying with CRD 3.
We have no doubt HMRC will have to issue guidance setting out what arrangements are permitted if this legislation is not to penalise legitimate commercial arrangements. We have just been asked to estimate for the renewal of a performance share plan for a company listed on the full list of the London Stock Exchange. They need to seek shareholder approval for the new plan before HMRC are likely to issue guidance so it is possible to know how to draft the plan so as to comply with the legislation. We will keep you posted on developments.