Third Party Remuneration - Kafka Lives!
Literary-minded readers of this newsletter will recall the works of Franz Kafka, the Czech novelist writing at the beginning of the 20th Century. Probably his best known work is The Trial, which concerns the tribulations of a man subjected to a mysterious, surreal and menacing legal process.
We are reminded of this by Schedule 2 of the Finance Bill 2011, published last Thursday. Within the 60 pages of this document, the entities A, B and P conspire to construct relevant arrangements and relevant steps which must be ruthlessly hunted down and taxed. Also featured are relevant events and relevant times. What could it all mean?
Schedule 2 inserts a new Part 7A into the Income Tax (Earnings and Pensions) Act 2003 and originally came about because of concern at HM Revenue & Customs that certain benefits provided to employees by employee benefit trusts and other third party vehicles (such as pension funds) were not being properly taxed. One of the simplest of these arrangements was the loan-back scheme, whereby an employee trust or other vehicle would loan an amount of money to a beneficiary. Normally, the loan would be repayable over a defined term and might also carry a commercial rate of interest. However in practice the loan would simply be rolled over at the end of the terms and in effect was never repaid. Any interest paid would simply be accumulated to the credit of the individual's notional account in the employee trust.
There is no doubt that this practice resulted in a large amount of tax avoidance and that HMRC was right to tackle it. However, loan-backs and similar arrangements could have been tackled by relatively simple means, such as the imposition of a tax charge on the provision of the loan or other benefit, refundable when the loan or benefit was returned. A similar provision already exists for loans by close companies to their own shareholders.
Instead, however, HMRC chose to take a swipe at a range of other perceived evils, including deferred remuneration, and in so doing has created a preposterous and disproportionate piece of (draft) legislation, for which the term Kafkaesque might have been invented. We will make no attempt to summarise the proposed legislation here, but set out below the main practical results that seem to emerge:
From 6th April 2011, any amounts provided by way of loan by an employee trust or similar third person will be subject to PAYE. This effectively puts an end to loan-back schemes. However, the draft legislation also provides that if the loan is repaid, there is no refund of tax. This provision is particularly draconian and breaches the fundamental principle that taxation should be fair.
It seems however that it will be possible to claim for relief if an asset is promised to the employee (earmarked) but never actually provided, although the claim for relief must be submitted within four years and the amount if any of the refund will be decided on the basis of the rather subjective grounds of what an officer of HMRC regards as just and reasonable.
Many companies, especially quoted and listed companies, offer awards of shares as part of their remuneration packages. The awards may vest over time and made conditional on performance targets. Deferred equity rewards are in fact required by the new remuneration code for regulated firms published by the Financial Services Authority.
Under the new Part 7A, however, if the LTIPs are awarded by a trust, the whole value of the shares reserved will be subject to PAYE immediately unless the vesting period is less than five years* and there is a reasonable risk that the entire award could lapse as a result of performance conditions not being satisfied. Exactly what reasonable means in this context is anybody's guess. Provisions that result in partial lapsing will not be sufficient.
In general, share options are untouched by the new legislation and there are specific exemptions for the regulated schemes, namely the Company Share Option Plan, the SAYE Share Option Scheme and the Enterprise Management Incentive. There is also a carve out for awards made under a Share Incentive Plan, where shares can be placed in trust for employees and are potentially subject to tax relief the longer they are held in the plan.
Unapproved share options will normally not incur a tax charge on grant but if they are (i) offered by a trust or similar vehicle and (ii) granted at a discount and (iii) do not contain lapsing provisions that operate within five years,* the discount will be subject to PAYE at the date of grant.
Deferred Share Purchase
Some companies offer employees the opportunity to purchase shares in their employer, but on the basis of a small initial payment with the balance payable at some defined event such as a company sale or flotation. The unpaid balance is treated for tax purposes as a loan. Part 7A now requires that loans from trusts are subject to PAYE so if the shares are purchased from a trust a tax charge will arise. However no tax should arise if the shares in question are new shares offered by the company.
It is worth noting that group companies will not normally be caught by the draft legislation, so that a purchase from a holding company of shares in a subsidiary should not incur a tax charge, even if full payment for the shares is deferred.
Internal markets for private company shares
Some unquoted companies operate arrangements whereby employees who acquire shares through an employee share scheme can realise the value by selling them back to an employee trust. The trust will usually recycle these shares for the purpose of further equity incentives. In some companies, founder shareholders may also sell shares to an employee trust to provide them with the shares needed to satisfy option exercise against the trustees. These transactions will not normally give rise to a PAYE charge provided the shares are sold at fair value.
The draft legislation contains a number of additional exemptions. These include:
- salary sacrifice schemes (most commonly used with pensions);
- certain car ownership schemes;
- benefits offered to at least 50% of employees;
- short term loans, e.g. for option exercise.
Naturally, however, to avoid a tax charge on any of the arrangements mentioned in Part 7A, there must be no tax avoidance purpose. Further amendments may be made before the 2011 Finance Bill becomes law later this year.
If you would like more information on any of the matters raised in this note, or on Franz Kafka, please call us on 020 8949 5522 and ask to speak to one of our advisers.
*for unquoted companies only, a provision requiring that the awards vest only on sale or flotation of the company is an acceptable alternative to the five year rule.