The first tier tax Tribunal has recently ruled in favour of HM Revenue & Customs ("HMRC") on the tax treatment of an employee bonus scheme involving forfeitable shares. The bonus scheme followed a structure which was relatively common before anti-avoidance legislation was introduced in 2004.
Background
Under this bonus scheme, rather than paying cash, the employer
awarded shares in a special purpose vehicle ("SPV") to
its employees which could be sold for cash very shortly afterwards
under arrangements funded by the employer. As a result,
employees effectively received their annual bonus but with much
more favourable tax treatment than an outright cash payment from
the employer.
The scheme sought to take advantage of a number of gaps which were
at that time perceived to exist in the system for taxing employee
receipts as employment income.
In this and other cases:
- Payments made by the employer into the scheme (including, for example, to an employee trust) did not give rise to a tax charge on any particular individual so long as they were not allocated to any particular employee, although an earlier tax charge could arise in the case of guaranteed bonuses;
- The payments into the scheme were used by the employer (sometimes via an employee trust) to acquire shares in an SPV;
- The employer then awarded those shares to employees subject to forfeiture restrictions. Providing the shares were "forfeitable" there was no tax charge on the employees receiving these shares;
- The schemes then differed in how they enabled employees to receive value from the shares in a way which did not incur income tax. In some schemes, employees received high dividends on the shares which were then cancelled for a nominal sum (to read our earlier Law-Now - Dividends were not employment income but were subject to National Insurance Contributions - click here) . However, in this particular scheme, shares could be sold by employees for an amount which was effectively equal to the bonus it was intended they should receive. It was argued that the gain was not subject to income tax because, as the employees were not employed by the SPV and the SPV was not controlled by their employer, they could rely on an exemption contained in the legislation. Any proceeds would instead be taxed as a capital gain. For certain employees who were non-UK ordinarily resident or domiciled, the proceeds would possibly be free of UK tax altogether because the SPV was incorporated outside the UK.
However, one of the difficulties with this type of scheme was that if any of the steps gave rise to an income tax charge on the value of the shares, the whole scheme failed.
Decision – were the shares forfeitable?
This case principally addressed whether the shares awarded by
the employer were "forfeitable" so that no income tax
charge arose when the shares were awarded by the employer. In
tax terms, "forfeitable" means the employee can be
required to sell his shares at less than market value if certain
circumstances do or do not arise.
In many schemes the forfeiture provision required employees to
sell their shares for considerably less than their market value if
they left in say a two week period after the award was granted but
before the shares were sold. However, in this scheme such a
provision was not possible for commercial reasons, which may in
retrospect have been regrettable. The forfeiture provision in
this scheme required that employees must sell their shares if the
FTSE 100 index rose above a certain level at any time during a
three-week period but would only receive 90% of the market value of
the shares in consideration.
On the particular facts of the case, the Tribunal appears to have
held that on its own this feature would indeed have made the shares
forfeitable and so avoided an upfront income tax charge on the
employees being awarded the shares. The Tribunal noted that
the legislation does not require the restriction to be
employment-related – so it was acceptable for the
restriction to relate to the movement in the FTSE 100 index
– and that the short period of time over which the
restriction applied did not of itself prevent it being treated as a
restriction.
However, the scheme was structured so that the SPV hedged the
difference with commercial options so that, if the forfeiture
provisions were triggered, the employee could be compensated for
the remaining 10% of value that they had not received for their
shares. The Tribunal found that this was a central part of
the scheme and that even though employees could receive less than
market value for their shares if the forfeiture provision was
triggered, this was not the only amount they could receive.
In practice they would always receive an amount equal to the market
value of their shares albeit from an alternative arrangement.
As a result, the shares were not forfeitable within the meaning of
the legislation and an income tax charge arose when the shares were
awarded to employees.
However, more worrying is that the Tribunal held that even if the
scheme had worked technically, it would have ruled that the Ramsay
doctrine, which sees through artificial steps, would have allowed
HMRC to tax the awards of shares as cash payments anyway.
This part of the judgment will be of concern to all advisers who
have put in place elaborate remuneration schemes for employers,
although real commercial features (such as leavers losing shares)
may well be a distinguishing feature from this case.
Comment
In practice, schemes like this one were mostly blocked by
anti-avoidance legislation announced in 2004 as part of a tougher
tax environment, although there are still a large number of bonus
schemes like this whose tax treatment is outstanding, where
HMRC's resolve will no doubt be fortified by this
judgment.
A copy of the judgment in this case, UBS AG v The Commissioners for
HM Revenue & Customs [2010] UKFTT 366 (TC), can be
found here.
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.
The original publication date for this article was 06/10/2010.