Equity Incentives: Top Tax Tips (part 2)
Last month we offered our top tips for claiming Entrepreneurs' Relief on share scheme gains, and maximising Corporation Tax Relief. This month, we look at the taxation of employee trusts and how to avoid some nasty tax pitfalls.
There are several uses for bona fide Employee Benefit Trusts (EBTs). They can be used to warehouse shares that have been reserved for employee benefits. They can acquire shares from existing holders for later use in a share scheme. Private companies often use trusts to create an internal market in the shares, so that employees can obtain value for their shares without waiting for a flotation or company sale.
Unfortunately, over the years, some employee trusts have also been used for aggressive tax avoidance, including bogus claims for tax reliefs and paying benefits to company shareholders, not employees. Accordingly, the tax regime has become tougher and the anti-avoidance rules more complex.
RM2 Trustees Ltd, a subsidiary of The RM2 Partnership Ltd, administers more than 100 UK based employee benefit trusts. Used wisely, employee trusts can add value to employee share schemes but there can be large tax bills for the unwary and some of these may be quite unexpected. For example:
- Inheritance tax: unless correctly structured, transfers into trust by closely-held private companies can give rise to a potential charge to IHT at 20% on the company's shareholders, to the extent that the transfers exceed the nil-rate band of £325,000.
- Settlor liability: if the settlor of a trust, or the shareholders of a closely held company which settles a trust, are also potential beneficiaries they will be personally liable for tax on all the income and gains of the trust. They may also have to pay an annual income tax charge under the pre-owned assets regime.
- Periodic charges: discretionary trusts are subject to a potential tax rate of up to 6% every 10 years. (and also to an exit charge, but this rarely applies to employee share schemes).
To avoid the inheritance tax charge, make sure that the trust is properly drafted to qualify as a bona fide employee trust. In particular, make sure that 5% shareholders, and their families, are excluded from benefit. This should also provide exemption from the periodic charge, settlor liability and problems in relation to pre-owned assets.
Because of the use of trusts for aggressive tax avoidance, legislation is now being introduced to tax the whole value of "disguised remuneration" such as loans provided by trusts, even if the loans are later paid back. There are some exemptions to this, but it is now essential to take professional advice in relation to any deferred reward schemes operated by trusts, such as deferred awards of shares. Government sponsored share option schemes such as the Enterprise Management Incentive (EMI) and the Company Share Option Plan (CSOP) are exempt.
UK trusts are also subject to high levels of tax on income and gains. Income above £1,000 per year held within the trust is taxed at the top rate of 50% (dividends and interest at 42.5%) and Capital Gains normally at 28% with a tax free band of only £5,050 (half the personal rate).
To avoid high rates of tax on income within the trust, dividends and interest should be distributed to beneficiaries, not held in the trust. The trustees will normally be able to recover tax paid on any amounts which are taxed again in the hands of beneficiaries. It may not always be possible to prevent a Capital Gain arising in the hands of the trust and in these cases it may be necessary to place the trust offshore. This is expensive, however, and if gains are crystallised offshore but not repatriated to UK beneficiaries there will be a supplementary charge when the gains are eventually paid out.
Employee trusts can provide real flexibility and value-added in the operation of employee share schemes. But there are many ways in which large, and possibly unexpected, tax charges can apply. If you are considering an employee benefit trust, or already have one established, you should seek professional advice if you have not already done so.
If you would like more information about the matters raised in this article, please call us on 020 8949 5522 and ask to speak to one of our advisers.
Next month we'll be looking at the importance of tax compliance in the establishment and administration of employee share schemes, and how to avoid unnecessary charges and penalties.