UK: Cash Deferral Arrangements And Employee Benefit Trusts

Last Updated: 1 March 2013
Article by Amanda Solomon

Employee Benefit Trusts ("EBTs")

An EBT is a flexible trust arrangement which is established by an employer company for the benefit of some or all of its employees. The trustees are commonly offshore allowing future gains and income to be free from UK tax.

The employer will make a contribution directly to the EBT which is often allocated or earmarked for a particular employee. Prior to the introduction of the disguised remuneration legislation, subject to any contractual rights that the employee may have to otherwise receive remuneration, no tax charge would have arisen in respect of funding of the EBT by the employer or on allocation by the trustee.

Consequently, a tax charge would arise only when benefits were provided; the tax payable, if any, would depend upon the timing and form of the benefit and the identity of the recipient, enabling tax to be deferred indefinitely or avoided altogether. The company's corporation tax deduction would also be deferred.

The introduction of the disguised remuneration legislation (generally with effect from 6 April 2011) has fundamentally changed the landscape for remuneration delivered via trusts or other vehicles, such that the establishment of EBTs is likely to diminish significantly; there is still a place for EBTs to be used in conjunction with employee share arrangements, and the common practice of private companies using EBTs to create an internal market for employee-held shares is likely to continue, but great care is needed to ensure that inadvertent tax charges do not arise.

Under the disguised remuneration rules, where the other requirements are met (generally, the existence of an employee, an employer, an arrangement in the nature of reward or recognition, and a third person), a tax charge will arise where the third person takes a "relevant step", being:

  • the "earmarking", however informally, of a sum of money or an asset with a view to a later relevant step being taken;
  • the payment of a sum of money (including a payment by way of loan) or the transfer of an asset (including securities and securities options) to a "relevant person" (the employee, someone connected to the employee or someone who receives the payment or transfer at the suggestion or request of the employee); or
  • making an asset available to a relevant person without transferring title, such that the recipient enjoys the benefit in a manner similar to ownership.

The legislation is extremely widely drawn, and affords exemption or relief in certain prescribed circumstances. The main consequences of this legislation, relative to the prior rules, are that:

  • a tax charge may arise prior to a benefit being provided, where there is a relevant step of earmarking;
  • benefits, other than those provided before the legislation came into effect (see below), will be subject to an employment tax charge (even those provided after the death of the employee beneficiary); and
  • the charge is based on the value of the benefit provided, being the sum of money paid (including by way of loan) or the higher of the cost and market value of the asset transferred or made available. No relief is available on a loan repayment or the return of an asset, but there should be a reduction in the amount of a future tax charge.

Historically, employees have often enjoyed a benefit from the EBT tax-efficiently by way of a loan. To the extent that a loan was made before 9 December 2010, the original rules should continue to apply to it.

The assets in the EBT should be outside the scope of UK inheritance tax. However, this is something that HMRC is increasingly focussing upon (see HMRC Briefing 18/11).

HMRC is also offering a settlement opportunity to employers who have previously funded EBTs. This is something that we would be happy to discuss.

Employer Financed Retirement Benefit Schemes ("EFRBS")

An EFRBS is an unapproved pension arrangement. A typical EFRBS is a flexible trust alternative to a UK-registered pensions scheme and to EBTs.

The level of permitted EFRBS funding is not subject to either the annual allowance or lifetime allowance restrictions, both of which affect UK-registered pension schemes. EFRBS are often attractive to executives and senior employees looking to defer income tax charges (particularly following the restrictions on higher rate tax relief) and/or those who are considering retiring abroad.

Prior to the introduction of the disguised remuneration legislation, no tax charge would normally arise on either the funding of an EFRBS or the allocation in favour of an employee. In addition, trust-based EFRBS were commonly structured offshore, which allows the fund to accumulate free of UK tax (unless the income has a UK source). Generally, the deduction for the employer in respect of EFRBS funding is symmetrical with a tax event for an employee.

The attractiveness of a trust-based EFRBS has diminished significantly as a result of the introduction of the disguised remuneration legislation in the 2011 Finance Act. Whilst the existing rules in respect of funding and of allocation in favour of an employee remain in place, there is nevertheless likely to be an immediate tax charge based on the value earmarked by the trustee, taking away the advantage of deferral. For this reason, we understand that the establishment of new trust-based EFRBS, as well as further funding of existing ones, has diminished since 5 April 2011.

The disguised remuneration legislation applies to the provision of EFRBS benefits. However, pensions paid to UK residents will continue to be taxed under the original rules. On the basis that the EFRBS is offshore (if it is from a UK source, a pension is taxable in the UK in full, absent relief under a double taxation agreement):

  • The remittance basis is available for taxpayers who utilise it; and
  • For others, a 10% abatement should be available.

Pensions paid to non-UK residents and other benefits provided by the EFRBS will be taxable in the UK under the disguised remuneration rules (lump-sum payments have the same territorial scope as applied under prior rules). If the recipient is resident in a country that has a double taxation agreement with the UK, it may be possible to claim relief from UK tax.

Whilst confirmation of the NIC position is still awaited, it is likely that it will be possible to structure the provision of benefits from an EFRBS in a way which continues to produce a NIC saving for employer and employee.

It will be noted that the tax difficulty with an EFRBS in a disguised remuneration landscape arises primarily where the obligation is "funded"; in fact, in a number of situations the employer is deemed to be a "third person" for the purposes of the legislation where no actual third person otherwise exists. However, it is possible to establish an unfunded arrangement (which does not mean that the employer cannot take steps to finance its future liabilities arising from the pension promise). We would be happy to discuss implementation with you.

However, a note of caution. During the consultation process in relation to tax-relieved contributions to registered pension schemes, the government announced that the disguised remuneration legislation would apply only to funded EFRBS, and that it "...will also continue to monitor changes in patterns of pension saving behavior for all other forms of EFRBS, on which it will be ready to act if necessary to prevent additional fiscal risk". Whilst there is no evidence that further change will be introduced, it is not possible to rule out the possibility completely.

Other forms of "Contract-Based" Deferrals

Deferred remuneration structures are attractive for employees who have no immediate need for net (i.e. post-PAYE and NIC) cash, as they are inherently wealth creative:

  • The deferral of tax creates leverage (effectively, the tax deferred can be seen as an interest-free loan).
  • It is possible to offer participants the choice of notional investments which the deferred amount can track. The mechanics of deferred compensation mean that there is further leverage generated on "switches" within the plan, since these take place on a tax-free basis.
  • The delivery on a promise made under a cash-based deferral falls within the employment tax regime, as a result of which personal taxes (such as income tax and capital gains tax) are avoided.

On the assumption of static tax rates and of a positive investment return within the plan, the UK tax take will in fact increase as a result of the deferral of remuneration. However, the important feature is that the participant will also be wealthier in net terms. The position of a participant may be improved if he or she will be subject to lower effective tax rates in the future (for example, if the government reduces the top rate of income tax), at the point at which deferral comes to an end.

Essentially, a voluntary contract-based deferral offers the employee the choice between a net payment in cash, or remuneration delivered in the form of an asset on a gross basis.

It is possible to structure the delivery of deferred remuneration in a number of different ways, dependent upon the terms of the contract, as follows:

  • Fixed-term deferral – based on a period of time, possibly with the ability to accelerate or extend the deferral.
  • Deferral based upon a future event, (such as retirement - see "unfunded" EFRBS above – sale of a business, etc.).
  • Flexible deferral, potentially for an extended period of time, where the employee has control over the timing of exit.

The UK tax treatment afforded depends upon the form of the promise made. Implementation will take into account the mechanics of delivery (including the way in which an employer would go about hedging its liabilities in respect of awards made); the key point to note is that there is little difference in the administrative requirements, whatever form of contract-based deferred remuneration plan is adopted.

We would be happy to discuss these and other arrangements with you in more detail.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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