HM Revenue & Customs (“HMRC”) has won yet another case on the tax treatment of an annual bonus scheme involving shares, which was used before 2004 since when legislation has been significantly tightened so as effectively to block further use of these schemes.
The case was heard with a recent case on a similar scheme operated by UBS, which HMRC also won.
It will be of interest to those companies still negotiating with HMRC as to how these arrangements should be taxed, and may also serve as a useful reminder to those thinking of what would now be aggressive bonus tax planning.
Although the structure used was extremely complicated, at its simplest the scheme involved employees receiving shares in a special purpose vehicle (“SPV”) which paid a large dividend and/or could be redeemed. As a consequence, the schemes were more favourably taxed than straight employment income, which is taxed under PAYE and has NIC consequences.
When awarded, the shares were subject to forfeiture provisions which meant that if the employees left employment within a short period (just under two months) they would cease to be beneficially entitled to their shares.
Under the legislation at the time, it was argued that this meant that no tax charge arose when the shares were awarded because of the exemption from tax on award where the shares were “restricted shares” which were “forfeitable”. Other exemptions could also be used to avoid an employment income tax charge arising when the forfeiture provisions were lifted.
HMRC argued that the shares were not restricted securities or, if they were, that the exemptions in the legislation did not apply. In addition, it argued that the scheme as a whole went against the intention of Parliament when it adopted the anti-avoidance legislation and so the restricted securities regime should be disapplied in this case, as what was in essence happening was just the straight payment of bonuses.
Were the shares “restricted securities” and did the exemptions apply?
Here HMRC lost. The Tribunal held that the shares were restricted securities, on the basis that:
- they were subject to genuine forfeiture provisions which would result in the employees losing beneficial interest in the shares and receiving less than market value. Although the restrictions were limited in scope and time, they were not so limited as to be ignored; and
- the restrictions reduced the market value of the shares, even though by only a small amount (thought to be 2-3%). This is relevant because restrictions must reduce the market value of the shares to be restrictions within the meaning of the legislation.
This part of the ruling is in contrast to the UBS decision where the Tribunal found that those shares were not restricted securities because, although technically they were subject to forfeiture, in practice employees always received at least market value on forfeiture as part of ancillary arrangements.
The exemptions were also available. An income tax charge did not arise when the shares were acquired because the forfeiture restrictions did not last more than five years. Further, an income tax charge did not arise when the forfeiture restrictions were lifted because all of the shares ceased to be subject to forfeiture restrictions at the same time and the majority of the shares were not held by employees of the SPV.
Did the scheme fail because its sole purpose was tax avoidance?
In very broad terms, there is a tax principle that HMRC can cut through a structure and apply tax on the basis of what is actually happening if the structure is artificial. This is known as the “Ramsay” doctrine. When assessing any “scheme”, a company therefore needs first to check whether it works technically and secondly consider whether HRMC can cut through the details and just tax the scheme as if it were a straight payment of cash bonuses. In this case, the first test was passed - the Tribunal held that the shares technically fell within the restricted securities legislation and the exemptions outlined above – but the second test was failed because the Tribunal held that the sole purpose of the scheme was tax avoidance and so the restricted securities legislation should not apply. Accordingly, PAYE and NICs were due on the underlying bonuses being received as if they were outright cash payments.
The Tribunal held that the scheme should be viewed as a whole, rather than separate steps, and that it should look at the reality of the scheme. Having done so, the Tribunal held that the scheme was a closely co-ordinated, pre-ordained scheme which had the sole aim of falling within the exemptions in the restricted securities legislation so that no income tax or NICs would be payable under the arrangements which ultimately provided cash sums to employees. The Tribunal did not consider that Parliament intended that in these circumstances employees should be able to rely on the double exemption afforded by the legislation.
This approach had been trailed in the UBS decision where the Tribunal held that even if the UBS scheme in that case had worked technically (which it did not), it would have applied the Ramsay doctrine to see through artificial steps and allow HMRC to tax the share awards as cash payments in any event.
In practice, schemes like this and the one used by UBS were mostly blocked by anti-avoidance legislation announced in 2004. Another reason why this activity has decreased is that many banks have now signed up to the Government’s Code of Practice on Taxation for Banks which prevents banks, who were often the biggest users of these arrangements, engaging in tax avoidance schemes such as these.
This decision may still have some uses for taxpayers, in that the case demonstrates that the Tribunal will not in a technical analysis ignore genuine restrictions even where they are limited in scope and time and have only a marginal impact on the market value of the shares. However, the fact is that the technical defences which advisers have often relied upon have now been shown for a second time not to be a strong enough defence to the Ramsay doctrine of tax avoidance.
A copy of the judgment in this case can be found by clicking here.
A copy of our previous Law-Now on the UBS case can be found by clicking here.