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Employee benefit trusts

Share Incentive Plans must be operated with a specific form of employee trust, drawn up in accordance with the relevant legislation. Other schemes are sometimes operated in conjunction with non-statutory trusts. These are normally discretionary trusts in which the shares and other trust assets are held at the discretion of the trustees for a general class of beneficiaries, normally the employees of the sponsoring company, former employees and their families. Discretionary employee trusts are often used for the creation of internal markets in the shares of private companies and in succession planning. These uses are discussed further below.

Discretionary trusts do not pay tax on cash or assets settled on them. However, UK resident trusts are liable to tax on the income and gains arising from the assets they hold.1 The standard rate is 32.5 per cent. on gross dividends and distributions and 40 per cent. on other income and gains.2 However, the first £1,000 of income each year is taxed at 10 per cent. for interest and 20 per cent. in relation to rent and trading income. Where the settlor has made two or more settlements on the trustees the £1,000 is divided by the number of settlements provided that the low tax band for any settlement cannot be less than £200.3

If dividend income received by a discretionary trust is passed on to beneficiaries, it is treated as having been taxed at 40 per cent. and the 10 per cent. tax credit is not available. Beneficiaries paying tax at 20 per cent. will be able to reclaim some of the 40 per cent. tax paid by the trustees. Higher rate taxpayers will have no further tax to pay. Broadly, where the tax paid by the trustees would be insufficient to cover the tax due on the grossed up benefits, the trustees must pay the difference.4

In a discretionary employee trust, no specific beneficiaries are identified until the trustees exercise their discretion to make an appointment of benefit. This means that no individual employee can be taxed on transfers of assets into the trust, only when benefits pass out of the trust to individuals. When benefits are paid out, the value is normally subject to income tax as a benefit of employment.

In the past, some discretionary employee trusts were used for aggressive tax avoidance, typically for the benefit of directors and shareholders rather than employees. These trusts were usually operated by owner managed, private companies and as a result trusts run by close companies (see Glossary) are now subject to detailed anti-avoidance rules which can result in unexpected charges. However, most of these rules offer exemptions for trusts that (i) include at least 50 per cent. of the employees as potential beneficiaries and (ii) exclude from benefit the company itself and any persons who are interested, directly or indirectly, in five per cent. or more of the share capital and/or assets on liquidation. It is important that the trust deed is properly drafted with these requirements in mind and professional advice is essential.5

Employee trusts often acquire shares in their sponsoring company using company funds. The provision of these funds would normally constitute "financial assistance" by a company for the purchase of its own shares, which is currently prohibited by the Companies Act. However, this will generally not be a problem unless the shares are offered by a public limited company (see Glossary) to non-employees or in such a way that the net assets of the company are reduced.

An internal market for private company shares

Many private companies believe that they cannot offer employee share schemes because there is no market for their shares, and employees are therefore unable to obtain a useful benefit.

In fact, a private company can easily create an internal market in its own shares. This is normally done through an employee trust. For example, where a company operates a share option scheme, it can provide funds to the trustees of an employee benefit trust to enable them to purchase shares from employees who have acquired them through option exercise and wish to "cash in" their benefit.6 The shares supplied by these sellers can then be used for the next round of share incentives.

An offer to provide an internal market need not be a binding commitment. It may be prudent for companies to offer this facility "subject to prevailing business conditions".

Operation of the market

In addition to offering a re-purchase facility, a private company can provide an opportunity for employees to sell to each other. If employees are obliged to sell on leaving the company, shares are bound to become available from time to time. Where the articles require that shares being sold are offered to all shareholders, employees for whom shares are held in trust (but not option holders) are as entitled as any other shareholder to have the opportunity to buy.

To work well, an internal market should offer employees the opportunity to buy and sell on a regular basis and preferably more than once per year. In the case of a Share Incentive Plan, the trustees will not be liable for capital gains taxon any increase in value between acquisition of the shares and their subsequent appropriation to employees, as long as this period is not more than two years, or five years if the shares are not readily convertible assets.

Implications of an internal market

There are certain implications of offering an internal market:

If HM Revenue & Customs considers that the internal market gives employees the opportunity to readily exchange their shares for cash, (i.e. readily convertible assets then any gains on an employee sale which would be subject to income tax 7 will normally be subject to national insurance contributions as well.
The presence of a genuine internal market may also cause HM Revenue & Customs to increase the level of "market value" of the shares. If the shares are being acquired from existing shareholders, this will allow them to receive a higher level of consideration without potentially adverse tax consequences. However, this will be unhelpful if the objective is to transfer as much value as possible to employees within the statutory limits.
If the repurchase from employees is at a value higher than fair market value, income tax will be due on the difference. Fair value normally includes a substantial discount for the fact that the shares represent a small minority only of the share capital.

Warehousing of employee shares

A company may decide to create a reserve of shares from which it will draw over a period of time for the purposes of employee incentives. Creating a fixed reserve ensures that the number of shares issued to employees cannot exceed a certain agreed proportion of share capital. Once that proportion has been agreed by shareholders, the directors may, depending on the nature of the incentives, be able to operate the share schemes for perhaps several years without having to seek any further shareholder permissions.

If the shares are to be new shares created by the company, the reserve can be created simply by ensuring that there are sufficient authorised but unissued shares to satisfy the requirements of the scheme. Alternatively, if shares are to be acquired from existing employees the company may decide to create a reserve of actual shares. This may also be helpful in demonstrating to employees that the share benefits are real, not merely promises of the company.

Prior to December 2003 it was not possible for a company to hold a physical reserve of shares in itself, whether or not for an employees' share scheme, because company law prevented a company being a member of itself. For this reason many companies set up employee benefit trusts as separate legal entities to hold the employee shares.

Use of employee trust

A company can settle funds on an employee trust, which are then used by the trustees to subscribe for new shares or to purchase shares from existing shareholders. If the company does not wish to provide finance to the trustees it can, with shareholder permission, simply allot the shares to the trustees credited as fully paid 8 or at nominal value.

Because the trust is a separate legal person, it is liable to tax on a similar basis to other individuals. This includes capital gains tax where applicable on shares acquired by the trustees and subsequently disposed of by the trust to beneficiaries. However in many cases the trustees will not incur a liability since they simply acquire the shares at a certain price and grant options over them to employees at the same price. For tax purposes the acquisition and the disposal are treated as a single transaction and no tax liability arises. Also, as noted above, the trustees of a Share Incentive Plan are protected against capital gains tax in certain circumstances.9

If a trust does incur a charge to capital gains tax, but then distributes the relevant funds to beneficiaries in a form subject to full UK income tax and national insurance contributions, the trust may be able to claim repayment of the capital gains tax under extra-statutory concession D35.

Trustees are entitled to receive dividends in the same way as other shareholders. In some cases however the sponsoring company may not wish the trustees to receive dividends. In such a case the trust can be established with a dividend waiver. This should be set out in the original deed, not after the trust has been established since a voluntary waiver of dividends by trustees will normally be a breach of their fiduciary duty to beneficiaries.

Trustees of discretionary trusts (not including trustees of Share Incentive Plans) cannot pass dividends directly to beneficiaries. They can however pay out the money in the form of discretionary payments and these will be subject to income tax in the hands of recipients. By virtue of extra-statutory concession A68 trustees may be able to recover amounts which would otherwise represent double taxation on such distributions.

The extra-statutory concessions mentioned above do not allow the trustees to reclaim tax if either the payment or the beneficiary is not subject to full UK income tax. A further concession is available in certain circumstances to beneficiaries who are not subject to UK tax. However in all these cases the relief is not available in certain circumstances and some practitioners consider that extra statutory concessions cannot be relied upon since HM Revenue & Customs can withdraw them at any time. For this reason the company may consider appointing offshore trustees.

Treasury shares

Since December 2003 it has been possible for companies listed on The London Stock Exchange, quoted on AIM or listed on a recognised stock exchange within the EEA to acquire shares and hold them as "treasury shares". Up to 10 per cent. of a company's shares can be held in treasury. They are not included in share capital for balance sheet purposes and are not included in calculating earnings per share. The shares must be purchased from distributable reserves. Shareholders' approval must be obtained before the shares are acquired.10 For tax purposes, the issue of treasury shares is regarded as a new share issue and therefore no tax should arise even if shares were previously purchased for treasury at a lower price.

Since treasury shares can be issued and repurchased as required, subject to shareholder approval, they can in principle be used for the purposes of an employee share scheme. Accordingly they could be a viable alternative to the issue and repurchase of shares by an employee trust.

The principal disadvantages of an employee trust by comparison to treasury shares are:

higher administration and costs in most cases;
surplus shares and/or cash may accumulate in the trust which then cannot easily be returned to the sponsoring company, because the company is not a beneficiary;
potential tax liabilities in certain circumstances (see above).

Treasury shares however have disadvantages of their own:

even when purchased on the open market they are included in the ABI dilution limits;
UK Listing Authority Rules require that shareholder approval is obtained on every occasion that treasury shares are used for an employee share scheme, something not required in the case of an employee trust;
UK Listing Authority Rules also require that any purchase or transfer of treasury shares is announced to the market.
The UK Listing Authority used to require that no issue of Treasury Shares be made under an employee share scheme when any beneficiary was prohibited from dealing in the company's shares under the Model Code; however from August 2007 this does not apply to shares issued under an all-employee schemes such as a Share Incentive Plan or an SAYE Share Option Scheme.

Selection of trustees

When an employee trust is established the first trustees are normally appointed by the company. These may include one or more directors of the company. However, for trusts other than Share Incentive Plan trusts, there are advantages in using independent trustees. For example, if the trust is to purchase shares from existing shareholders for the purposes of the scheme, it would be better if the trustees can be seen to be genuinely independent of the company. This would lessen the force of any argument that the purchase is being made by the trust for the benefit of shareholders, rather than employees, and should therefore be subject to income tax.11

Independent trustees could include a solicitor or other trusted adviser. Generally, firms of accountants or employees of such firms will be unwilling to act as trustees if they also act as auditors, because of potential conflict of interest. Some share scheme practitioners have trustee companies which can act as corporate trustees. If independent trustees are being used, then it is preferable to safeguard that independence by arranging for the power of appointment of new trustees to reside with the trustees themselves rather than with the company.

There may be advantages in appointing one or more employee trustees. Unless they are also significant shareholders or directors, HM Revenue & Customs is likely to regard them as independent. They can also be helpful in demonstrating that the employee trust is being run in a transparent way for the benefit of employees.

Companies often set up special subsidiaries to act as corporate trustee.12 The "trustees" are now in effect the directors of the trustee company. Because of the relationship of the subsidiary to the parent, the advantages of independence will be wholly or partly lost. However, a corporate trustee has two main advantages:

Sponsoring companies can lend to, or guarantee third party lending, to the trustees.13 If any of the trustees are directors this will require shareholder approval since the Companies Act, broadly speaking, prohibits loans to directors even when they are acting in the capacity of trustee.
The directors of the trustee company are protected by the "veil of incorporation" so that if anything goes wrong the liability will first fall on the company, not directly on the directors of the trust company. This protection is not as valuable as it used to be, because of legislation introduced in recent years to increase the number of circumstances under which directors can be personally liable for their actions. However the protection is still worth having.

Additionally, where it is desirable for the trustees to deal in the sponsoring company's share capital, situations can arise where an individual trustee who is also a company director cannot authorise the transaction, because he is within a close period. If he does act, a stock exchange announcement may be needed. These restrictions would generally not apply to a corporate trustee, particularly if it is independent.

On the other hand, using a corporate trustee may occasionally create a problem by causing the sponsoring company to become a close company with potentially adverse tax consequences.

From time to time trustees will resign and will have to be replaced. If the trust holds assets, then a simple resignation by the outgoing trustee will not be sufficient. The assets jointly held by the former trustees must be transferred to joint ownership of the new trustees by means of a deed of transfer. In the case of shares, this will normally be a simple stock transfer form. There will normally be no stamp duty implications in relation to a transfer of this kind; the tax liabilities are transferred by means of a hold-over election.

Powers and responsibilities of trustees

The trustees of Share Incentive Plans have only narrow powers consistent with their role in operating the scheme. For example, they must take instructions from beneficiaries if there is a rights issue or take-over and they must pass any dividends directly to employees.

By contract the trustees of discretionary trusts normally have wide powers to invest, borrow, appoint agents and generally take any action they see fit. They must however act at all times in the interests of the beneficiaries, even where this might conflict with the interests of the sponsoring company or individual shareholders. In practice the responsibilities of the trustees of a discretionary employee trust are usually straightforward, being to:

receive funds endowed by the company;
preside over one or more employee share schemes;
ensure that any money held for the beneficiaries, or pending investment in shares, is prudently invested (normally as a bank deposit);
execute documents giving effect to the above.
The actual design and administration of employee share schemes will normally be handled on behalf of the trustees by the sponsoring company or professional advisers.

Most deeds indemnify the trustees against the consequences of actions taken by them in good faith, although not in cases of fraud or willful default. Notwithstanding such indemnities, the Trustee Act 2000 imposes a default duty of care commensurate with the knowledge and experience of the trustees. Part of this duty of care is to take external advice on any investments held by the trust, where this is reasonably necessary. In most cases, the investments of a discretionary employee trust will be cash or shares held for the purposes of an employee share scheme. The trust deed can provide that the trustees need not take advice on the value of sponsoring company shares.

Offshore trustees

It may sometimes be appropriate to place the employee trust in an offshore location.14 This approach is followed by many companies, including large listed companies. Although the term "offshore trust" is sometimes associated with aggressive tax planning or tax evasion, the use offshore trusts in connection with employee share schemes is generally regarded as mainstream. Where an offshore trust is created this must be reported to the UK tax authorities within three months of formation.

To qualify as an offshore trust the trust must be non UK resident, as, in most cases, must all the trustees.15 It is also important that the actual direction and administration of the trust should occur outside the UK and that the trustees are not merely the servant of the sponsoring company. This requires that the trust document be correctly drafted to ensure that the trustees have full powers of discretion. All decisions of the trustees, and the reasons for them should be carefully minuted. The Special Commissioners have in the past deemed a trust to be UK domiciled, even where the trustees are offshore, in a situation where the effective decision making took place in the UK.

It is open to the sponsoring company to inform the trustees of their wishes in respect to the operation of the trust (usually done by means of a "letter of wishes") but the offshore trustees are not bound to abide by such wishes and, on occasion, they may decide on a different course of action. They will, of course, be bound by the terms of the trust only to act in the interests of the beneficiaries as defined by the trust deed.

Trustees will not normally provide technical advice but it is helpful if they have detailed knowledge of the issues involved. They should be able to demonstrate a high level of professional indemnity insurance cover in relation to the proposed size of the trust assets. Many firms of trustees are part of larger financial groups including multinational banks. Costs will vary with the expertise and brand-name involved but typically the fee for establishing a simple discretionary offshore trust in the Channel Islands will be around £3,000 to £5,000. Costs will be higher if the trustees are asked to originate the trust deed. Many employee trusts, although held and operated offshore, are drafted subject to English law and this can be helpful in clarifying any issues of interpretation and dealing with enquiries from HM Revenue & Customs.

A typical small employee trust will cost several thousand pounds a year to run assuming little or no trust activity. The costs may be considerably greater if the trustees have to undertake significant administration.

The Channel Islands are a popular choice for trust location since they have a strong regulatory framework, a legal system very similar to that of the UK and are relatively easy to reach. Firms of trustees in various Caribbean locations such as the British Virgin Islands or the Turks and Caicos may be somewhat cheaper, but offer few advantages. Switzerland has a well-established reputation in the field of custodian and trust services but the charges can be high and the procedures formal and inflexible.

Share purchases and succession planning

The shares to be used for an employee share scheme can be either new shares, created by the company, or shares acquired from existing shareholders. In either case the existing shareholders will be diluted, but in the latter case they can receive cash. The attractiveness of receiving cash will depend on whether the company has cash available for this purpose, currently or prospectively, and the rate of tax to be paid by the selling shareholder(s).

In quoted companies, shares can be purchased from existing shareholders on the open market. However, the shares may need to be acquired "off-market", that is, on private terms. This could apply if the purchase is to be from a specific shareholder or the number of shares to be acquired is too large for the market to supply without distorting the share price.

In order to finance the purchase of shares by the trust, the company will usually make contributions to the trust fund. An alternative method is to lend to the trust, or to guarantee lending to it by a bank or other third party. However, if the company is a close company this may result in a tax charge of "quasi-ACT" equal to 25 per cent. of the loan. This arises because of anti-avoidance rules designed to discourage loans to "participators", that is, those who are actually or prospectively interested, directly or indirectly, in the shares or profits of the company.16 The purpose of the rule is to penalise companies who try to make indefinite loans to shareholders rather than paying taxable dividends.

The rule applies if the trust or the trustees already own shares, or if the trust uses loan funds to acquire shares from a participator: in this case the loan is deemed to have been made indirectly. However, guidance from HM Revenue & Customs indicates that the rule applies only if the relevant party owns shares at the time the loan is made. It appears therefore that a first loan to a trust will not be caught if it does not already hold shares.

Loans to an individual are exempt if the amount does not exceed £15,000, the borrower works full time for the company or any of its associated companies, and has a direct or indirect interest (with or without associates) in no more than 5 per cent. of the company's ordinary share capital.

If a non-exempt loan to a participator has been made, the "quasi-ACT" must be paid nine months and one day after of the end of the financial year in which the loan was made. The tax is not payable if the loan is repaid within this period. Otherwise any quasi-ACT paid over will be refunded following the later repayment of the loan. Assuming the loan is eventually repaid, therefore, the main impact of this measure is on cash flow rather than profit.

If borrowings are to be used to finance an employee trust over a significant period of time, the sponsoring company should consider raising the finance directly and then settling it on the trust.

Share purchase by company

When company shares become available for sale, the company itself may be a potential buyer. However, if the company is not listed then, unless exemptions apply, the gains to shareholders will be taxed as a distribution, that is, as if it were a dividend, not as capital gains. This is an anti-avoidance rule to prevent companies continuously creating share capital and then repurchasing it in order to make capital payments to shareholders from cash resources that would otherwise be taxed as dividends.

If the gains are taxed as distributions the effective tax rate on the cash dividends is 25 per cent. for a higher rate tax payer. This is less favourable than the capital gains tax rate of 18 per cent.

A sale of unlisted shares back to the company must meet a number of requirements if the transaction is to be treated as capital in nature. In summary these are as follows:

the whole or main purpose of the repurchase is to benefit the trade of the company and it must not form part of an arrangement for the avoidance of tax;
the vendor must be UK resident and have held the shares for at least five years;
the proportion of share capital owned by the vendor after the sale must be at least 25 per cent. less than that owned before the sale;
after the sale the vendor must not be connected with the company. In broad terms, "connected" here means having direct or indirect control of more than 30 per cent. of the share capital, voting power or assets of the company. Loan relationships may count as equity in certain circumstances.

Taxpayers can apply to HM Revenue & Customs for prior clearance that a proposed sale will be treated as a capital transaction and not a distribution.

Purchases by listed companies of their own shares are not normally treated as distributions. This is because the purchases are usually made indirectly, through a market maker, and sales to market makers do not count as distributions.

Purchase by employee trust

If the sale is made not to the company but to an intermediary such as a bona fide employee benefit trust on arm's length terms then the transaction is outside the scope of the "deemed distribution" provisions. Accordingly the sale should be subject to capital gains tax not income tax. The use of the shares for the purposes of an employee share scheme also provides prima facie evidence of a commercial purpose. Some practitioners have speculated that HM Revenue & Customs could seek to challenge the capital treatment on the basis of general anti-avoidance provisions. We are unaware of any cases where this has occurred in relation to a bona fide employee share scheme.

To minimise the risk of any challenge, we recommend that:

the trustees of the trust should be independent of the company, although employees unrelated to the principal shareholders would be regarded as an acceptable choice; and
the terms of the purchase should be demonstrably at arms' length with professional valuation advice taken where appropriate.

If possible, the terms of the transaction should be such that, if the shares had been purchased directly by the company, the purchase would have qualified for capital gains tax treatment. Sales into a Share Incentive Plan trust would appear to be immune from any risk of attack.

Deferred shareholder sale

The value that an existing shareholder can obtain through the sale of shares into an employee share scheme may be disappointing in comparison to what that shareholding might fetch if the business were sold or floated. One way to achieve a higher value may be to defer selling the shares to the employee trust until the shares are needed by the trustees to satisfy their obligations - for example on the exercise of options. This is likely to occur when the shares have risen substantially in value, for example when the company is sold or floated.

This approach requires the trustees of the share scheme to enter into obligations - such as the grant of share options - before they have acquired the necessary shares. The trustees will require certainty that they can obtain the shares they need to satisfy their obligations. A promise from one or more individual shareholders to sell to the trust in the future may not provide the required level of certainty. The only entity that can offer a guaranteed availability of shares is the company itself. The trustees and the company may therefore enter into an arrangement whereby the company, subject to suitable shareholder permissions, offers irrevocable rights to the trustees to acquire the shares when they are needed to satisfy scheme obligations, at a price equal to the ruling fair market value at the date of acquisition. When the time comes to exercise this right, the trustees will still be able to purchase the shares they need from existing shareholders rather than the company and in practice will normally do so if the shares are offered by existing shareholders at a price fractionally lower than fair market value.

Succession planning

The previous section has obvious relevance to situations where, in a private company, one or more of the shareholders wish to retire. The other shareholders may not be able or willing to purchase the shares. They may also be reluctant to invite an outsider to buy them, even if such a buyer could be found.

An employee trust could be used to make an offer for the shares. The trustees would also have the power to borrow to finance the purchase, and the borrowing could be guaranteed by the company.17 The shares could then be held and used to provide employee incentives.

Those who are to receive the shares will pay no tax on their value until they are distributed, perhaps on flotation or sale of the entire company, at which point shares can be sold to raise the funds necessary to pay the resulting tax charge. Alternatively, it may be possible to distribute some or all of the shares to employees in a tax efficient manner via a statutory employee scheme or deferred share purchase plan.

Such arrangements are convenient and tax-efficient for the company, shareholders and employees. No outside investors have been involved.

Occasionally, founding shareholders may want to pass control of a company, or even its entire share capital, to the employees. This may involve a gift of shares into the employee trust. The gift will be a disposal for capital gains tax purposes but hold-over relief will be available if (i) the transferor is an individual or the trustee of another settlement; (ii) the shares are not listed or the transferor holds at least five per cent. of the voting rights; (iii) the company is a trading company 18 and (iv) the trustees are UK resident.19 Hold-over relief results in the trustees being deemed to acquire the shares at the same cost as they were acquired by the transferor, so that the trustees become liable to any tax on the total gains since their original acquisition.20

Gifts made prior to the abolition of business asset taper relief will have resulted in the taper relief clock being restarted. This means that the transferee will be liable to tax at 18 per cent. if the gift was made less than a year prior to Budget Day 2008 even if the transferor would otherwise have been subject to a rate of only 10 per cent. under the old taper relief rules.

Gifts to discretionary trusts are normally subject to inheritance tax but gifts of company shares receive 100 per cent. relief providing that they are unlisted shares in a trading company. The transferor must have held the shares for at least two years before the transfer. Relief at 50 per cent. is available on listed shares if the transferor had a controlling stake before the gift. The gift is exempt altogether if within a year of the gift the trustees acquire control of the company.

Employee trusts can also used in connection with management buy-outs. It may be appropriate to reserve a proportion of share capital in trust for the provision of equity linked incentives going forward. Employees can be invited to contribute to the pay down of debt in the new company by subscribing for shares, or by participating in an SAYE Option Scheme or a Partnership Share Agreement under a Share Incentive Plan.

Treatment of non-share benefits

In the past, companies could often obtain corporation tax relief on contributions made to employee benefit trusts, reflecting the basic principle of tax law that the expenditure was "wholly and exclusively" for the purposes of the trade. This was increasingly resisted by HM Revenue & Customs from the late 1990s and the Finance Act 2003 finally made it clear that any corporation tax relief due would not be available until a benefit had passed to beneficiaries on which income tax and NICs are chargeable, or would be chargeable if the beneficiaries were liable to UK tax. The value of shares transferred to employees from a SIP trust is dealt with separately under the SIP rules.

The Finance Act 2003 provided for deferment of corporation tax relief but did not address the question of whether the relief itself would be available. HM Revenue & Customs has in the past argued, for example, that certain company payments into trust are capital in nature and therefore not eligible for corporation tax relief. It is understood, however, that following the introduction of the Finance Act 2003 Act HM Revenue & Customs is taking a less aggressive line in this area. Meanwhile, in relation to both statutory and non-statutory employee share schemes, the legislation provides specific relief.

Other tax issues

The anti-avoidance legislation surrounding employee trusts contains pitfalls for the unwary. Aspects not so far covered include the following:

Potential inheritance tax charge on participators

If the sponsoring company is a close company, and the trust deed has been drafted so that certain participators 21 in the company are not excluded from benefit, then contributions to the trust by the company will fall to be treated as personal contributions by the shareholders and these contributions will not be potentially exempt transfers for inheritance tax purposes. At best, this will diminish the amount of life-time inheritance tax exemption remaining to the shareholders.22 At worst, it could lead to an immediate charge to inheritance tax at one half of the death rate (i.e. 20 per cent.).23

The participators who must be excluded from benefit are those who, on or after the date of the contribution or at any time in the previous ten years, have or have had an interest of five per cent. of more in the capital of the close company or in its assets on liquidation. This treatment does not apply to non-close companies or if the potential benefits to participators in a close company are limited to payments which are income for the purposes of UK tax, or would be if the participator was subject to UK tax, or if the trust is operating a Share Incentive Plan.

Similar rules apply where existing shareholders gift shares into a discretionary employee benefit trust. Such a gift might be made altruistically, for example to create an employee-controlled company; even so, the gift will not be a potentially exempt transfer if any five per cent. participators can receive capital benefits.

Tax on settlor retaining interest

If a shareholder gifts shares into a discretionary trust in which he or she retains a potential interest, whether or not at the trustees' discretion, the shareholder will be subject to tax on all the income and gain of the trust ("settlor liability"). The shareholder can however reclaim the tax from the trustees.

Under the pre-owned assets regulations, a shareholder who gifts shares into a trust in which he or she retains an interest may also be subject to an amount of tax related to the value of the assets transferred. This is computed as the value of the shares times the official interest rate, expected to be 6.25 per cent. in 2008/09. There is a de minimis deemed benefit of £5,000 per year below which no tax is paid but above which tax is payable on the whole amount.

The tax is reduced by any amounts paid out under the settlor liability provisions mentioned above. The effect therefore is that if the deemed benefit from the settled is worth at least £5,000 per year the settlor may pay more, but cannot pay less, than the tax on 6.25 per cent. of the value of the settled shares annually. The settlor must submit an updated share valuation each year.

Possible association of beneficiary with trustees

Employee benefit trusts often hold shares in the sponsoring company. If employee beneficiaries were associated with the trustees for tax purposes, this could affect their ability to participate in statutory employee share schemes because of rules that exclude employees who, together with associates, have a "material interest" in the employing company.24 The default treatment is that, because an employee benefit trust normally has discretion as to who should benefit from the trust and when, no individual beneficiary has any certainly of benefit and is therefore not associated with the trust. However, if an employee has actually received a benefit, he or she will be attributed an interest in the trust which in broad terms equates to the value of benefits received over the last 12 months as a proportion of the average of total benefits paid by the trustees over the previous three years.

Time-based charges on discretionary trusts

There are detailed rules to discourage discretionary trusts from holding assets over long periods. These include a special periodic charge at the 10th anniversary of the creation of a trust and an exit charge when property leaves the trust.

In respect of the 10 year charge, the assets of employee benefit trusts are "excluded property" and are exempt from the charge. They are not however completely exempt from the exit charge. This arises when the value of property held by a trust is reduced as a result of value being transferred to a beneficiary, and the benefit does not qualify as a "payment" subject to income tax in the hands of a recipient. It is possible that the grant of a nil-cost option could be a transfer of value which is not a "payment", even if the benefit is subject to income tax. Fortunately, the charge is just 0.25 per cent. per quarter, or 1 per cent. per year, for the first 10 years from inception. It then declines by stages to reach a maximum of 30 per cent. after 50 years. This charge will not be of concern to most employee trusts where benefits are awarded within a short time of the relevant shares being acquired. If a significant charge seems likely to arise, this may be an additional reason to consider an offshore trust.

If offshore trustees crystallise a capital gain, but the gain is not remitted to UK beneficiaries until a later date, a supplementary charge is payable in respect of the period prior to remittance equal to 10 per cent. per annum of the UK tax that would have been payable had the gain been immediately remitted, subject to a maximum of 60 per cent. The charge runs from 1st December in the tax year following that in which the trustees' gains arose to 30th November in the tax year after that in which the gain is distributed to the beneficiary. The maximum additional tax payable is therefore 60 per cent. of 40 per cent. equal to 24 per cent.

Relief for tax paid by trustees

If the trustees of a discretionary trust make a payment to a beneficiary which, if received directly, would be eligible for relief under a double taxation agreement, or is not be chargeable to UK tax because the beneficiary is not a UK resident, the beneficiary may be able to obtain an equivalent relief under Extra-Statutory Concession B18. This relief must be applied for or it will be lost.

In order to receive the relief, the payment must arise from payments made to the trustees within the previous six tax years. The trustees must have made full returns of trust income to HM Revenue & Customs and paid all taxes due. Relief may be available to a beneficiary of an offshore trust if he or she would have been entitled to such relief but only in respect of UK taxes paid by the trustees.

Termination of trusts

It may be desirable to terminate a trust when an employee share scheme comes to an end or the sponsoring company is sold or liquidated.

A non-statutory trust is normally prohibited by its deed from paying benefits back to the sponsoring company, since the purpose of the trust is to provide benefits to employees. On termination of the trust, therefore, the trustees should first consider how they can distribute any remaining assets of the trust to the beneficiaries, who will normally include both present and former employees and their families. However, if there are no remaining beneficiaries, the trustees will normally have the power to appoint default beneficiaries, usually charities selected at the discretion of the trustees. If the trust deed is properly drafted and the trustees act reasonably, they are likely to be immune from attack by potential beneficiaries because the liability of the trustees will be limited to acts of wilful fraud or negligence.25

When a Share Incentive Plan is to be terminated, any remaining shares held on behalf of participants will remain in trust until the later of (i) the end of the notice period or (ii) the first date the shares can be removed from the trust without giving rise to a tax charge. Shares can be removed from trust earlier than this but only with the consent of the participants, since a charge to tax and possibly national insurance contributions will arise. If Partnership money is held which has not yet been invested, it can be returned immediately to the employees, subject to deduction of tax and national insurance contributions.

At final termination the company issues a formal termination notice to HM Revenue & Customs, the participants and the trustees. The trust deed normally provides that any other shares or assets still held by the trustees are then returned to the sponsoring company.

Offshore trustees may be exempt.»
Gains of up to £4,800 (2008/09 rates) are exempt from CGT in the hands of the trustees of a discretionary trust (half the personal rate).»
This includes any settlements made during the tax year in question. If there is more than one settlor the £1,000 is divided by the largest number of settlements made by any one settlor.»
Non-payable dividend tax credits are excluded in calculating the amount of tax deemed to have been paid by the trustees. This amount is known as the "tax pool".»
A UK discretionary trust is similar to a US "Rabbi Trust" in that the assets of the trust are held at the discretion of the trustees on behalf of the beneficiaries. However, a Rabbi trust's assets are available to the creditors of the sponsoring company, and because of this difference, contributions to a Rabbi Trust by a UK company would not qualify for IHT exemption.»
Where shares in an unquoted company are to be acquired by an employee trust and the articles of association contain pre-emption rights (see Glossary) it may be necessary for the shareholders to agree amendments to the articles of association.»
Income tax is payable on any benefits under a non-statutory scheme (other than in a purchase scheme where full value is to be paid) but under statutory schemes only in certain circumstances - see the relevant sections of this Guide dealing with the statutory schemes.»
Providing the company has sufficient distributable reserves or some other legitimate means of paying up the shares.»
The length of time that trustees of a Share Incentive Plan may hold shares without being exposed to a potential liability to capital gains tax is extended to 10 years if the trustees hold 10 per cent. or more of the share capital of the company and have acquired this from one or more individual (non-corporate) shareholders over a period of not more than 12 months commencing on the date of the first acquisition.»
If the purchase is from the open market, an ordinary resolution is required stating the maximum number and the highest and lowest price that can be paid. The company must acquire the shares within 18 months. If the shares are to be acquired privately ("off-market") a special resolution is required to authorise the transaction.»
When a company repurchases its own shares the payment is treated as a distribution unless certain requirements are met. As far as we know, HM Revenue & Customs has not yet sought to extend this treatment to the purchase of shares by bona fide employee trusts for the purposes of employee share schemes but some practitioners argue that they might.»
The Companies Act prohibits a company from becoming a shareholder in itself (other than Treasury Shares) but a subsidiary may hold shares in its parent company for the purposes of an employee share scheme.»
However if the company is close lending to the trustees of an employee trust which already holds shares will incur a charge to quasi-ACT.»
The trustees of a Share Incentive Plan must be UK resident.»
If some of the trustees are UK resident and ordinarily resident and some are not, then (from 6th April 2007) if any settlor is UK resident, ordinarily resident or domiciled, all the trustees are treated as resident. Otherwise the trustees are treated as neither resident nor ordinarily resident. A trustee will be regarded as UK resident if, in general terms, it carries on any part of its business in the UK and this extends to making use of UK business premises. It is understood that HMRC take the view that, if a firm of offshore trustees is part of a UK resident group then this alone will not cause the trustees to become resident.»
In this case the term "participator" is not subject to a de minimis exemption.»
Individual trustees act in a personal capacity and any loans to the trust will be treated for Companies Act purposes as loans to them. In general terms, loans to directors must be approved by shareholders, so if any trustees are directors of the sponsoring company shareholder approval of the loan will be needed.»
Companies mainly engaged in property, investment or dealing in securities are excluded. »
Relief is available for quoted shares if the transferor owns at least 5 per cent. of the issued equity or the transferor is a trust holding at least 25 per cent. of the equity.»
The time limit for relief applications is five years from the end of the relevant tax year.»
In broad terms a participator is a person who is interested in the income or capital of the company (see Glossary). »
The nil rate band is £312,000. This can be carried over from one spouse to the other so that on the second death, a total of £624,000 is exempt (2008/09 rates).»
It appears that an employee trust that excludes 5 per cent. participators from benefit could validly create a 5 per cent. participator by distributing shares or granting options to a beneficiary, but such a participator could not then receive further benefits.»
A participant in an SAYE Option Scheme, CSOP Scheme or Share Incentive Plan may not have an interest, together with associates, of more than 25 per cent. of the share capital of the sponsoring company. In the case of the Enterprise Management Incentive the limit is 30 per cent. and the rules are somewhat different.»
Non-statutory employee trusts are normally discretionary and accordingly no beneficiary can sue directly for loss of benefit since they would normally be unable to show any specific entitlement. The Attorney General has the ability, in theory, to pursue a claim on behalf of potential beneficiaries but we are not aware of any case where this has occurred.»