It is unlikely to occur to a testator or, often, to his advisers that the legislation on "employment income provided through third parties", more commonly known as the disguised remuneration rules, could apply to a proposed testamentary gift.  But a possible, albeit probably unintended, effect of the rules is that employees in a company in which the testator is a shareholder could, if given a testamentary or inter vivos cash gift or shares in the company which employs them, find themselves saddled with an immediate and unwelcome tax charge.

These rules, introduced in April 2011, are primarily targeted at the use of third parties, such as employee benefit trusts and unregistered pension schemes, in a way that avoids income tax and national insurance contributions on benefits. Often, such arrangements involve the making of loans to employees that, prior to the introduction of this legislation, provided a more tax efficient method of remuneration than salary. Given the perceived widespread avoidance in this area, the broad scope of the legislation was deliberate, but its lack of specificity means that many innocuous arrangements are seemingly at risk from unexpected tax charges.

In broad terms, the legislation applies where there is an arrangement under which an employee is provided rewards in connection with his employment and a relevant third person takes a relevant step connected with the arrangement. A relevant third person includes "any person other than the employee or employer" and could therefore include a shareholder in a private company. There are a number of relevant steps listed in the legislation, but the most likely to be relevant in the context of a will is "earmarking".

Earmarking will take place when moneyor assets are earmarked for an employee, however informally, with a view to a later relevant step being taken. Where a shareholder in a company (a relevant third person) decides to leave a bequest of cash or shares in his will to employees of that company, that cash or those shares would appear to be earmarked for the employee, with the later relevant step being the transfer of the cash or shares. If this is the correct interpretation of the legislation, the value of the cash and shares will be treated as employment income for the (future) recipient of the gift and will be subject to income tax and national insurance contributions (NICs) at the time of the earmarking, i.e. the signing of the will, collected through the PAYE system. The primary liability will therefore fall on the employing company, which will also have a liability to employer's NICs, though in practice it may be that the company will be unaware of the gift.

What, though, if the employees are also friends of the testator? An obvious argument would be that the cash or the shares are provided not in connection with employment, but as a result of friendship between the testator and the legatee. HMRC guidance recognises that where the relevant third person is an individual, that individual "may take a step in the normal course of domestic, family or personal relationships and not as a means of providing rewards, recognition or loans in connection with employment". This suggests that HMRC will consider the existence of relationships outside the employment sphere when determining whether an arrangement falls within this legislation. Frustratingly, though, the exception is only present in HMRC guidance, not the legislation, despite the fact that the guidance is clearly modelled on the wording of the statutory exception in the employment-related securities legislation (section 421B). It may not be easy to convince HMRC that a gift of cash or shares to someone who was an employee of a business owned by the testator was motivated by friendship rather than a desire to provide a reward for years of service. This may be particularly difficult in the case of shares, since a gift of shares to someone with a vested interest in the company concerned would appear to be an apposite bequest.

Wills are frequently rewritten and the bequests to the employees may be withdrawn. If the company has accounted for income tax and NICs on the potential gift, can these be repaid? Whilst there is a provision in the legislation for the repayment of income tax where the assets are no longer earmarked for the employee, which would be the case where a bequest is withdrawn, there is no equivalent provision in the NICs legislation. A bequest of cash or shares to an employee that is later withdrawn may, therefore, lead to an irrecoverable NICs cost.

These rules are largely untested and until a court has the chance to consider their intended scope, areas of uncertainty abound.

This article by Stephen Green first appeared in the February 2014 edition of the STEP Journal.