UK: Contracts For Difference (CFD)

Last Updated: 13 August 2013
Article by Smith & Williamson

A CFD can be used as a tax and national insurance efficient means of paying bonuses. The key advantage is that if the CFD increases in value from the time the employer and employee enter into the arrangement until the time the contract is satisfied the increase will be subject to capital gains tax, not income tax, and no national insurance liability will arise.

What is a CFD?

A CFD is a paper contract between two parties such as the employer and employee which stipulates what payments will be made between the parties and when such payments will be made. If at maturity, the CFD has grown in value then the employer will make a payment to the employee but if the value has decreased below a value agreed between the parties, the employee will be required to make a payment to the employer.

Why use a CFD?

The CFD will usually be linked to specific performance targets which will be aligned to the business objectives. The benefits are achieved when the value of the CFD increases and the employee is subject to capital gains tax on the growth in value. In addition, no national insurance is due on the amount paid on maturity of the contract.

The targets can be specific to the area of the business in which the employee works or generic across the business as a whole.

A CFD can be very effective for companies where the owners wish to implement a long term incentive plan without diluting their share ownership as a CFD does not use company shares.

How does a CFD work?

The employee and employer enter into the arrangement under which the employee will pay the market value for the CFD (potentially with a loan from the employer) or be given it for no payment by the employer as part of the remuneration package. The market value at the start will generally be low. This is because performance conditions are specified within the contract and under these conditions, payments can be due from either:

  • the employer to the employee if the value increases;
  • from the employee to the employer if value decreases below a specified level; or
  • no payment either way if a hurdle has not been met.

It is usual for a CFD to run for a 3 to 5 year period and to be used instead of or in conjunction with a cash long-term incentive plan. The CFD can be capped at a maximum value and it would be usual to specify a hurdle rate over which a payment will be due.

The agreement will set out what the position will be if the employee leaves the company.

Accounting

The accounting for a CFD is not straightforward and depends on a number of factors, in particular:

  • the measure that is to be used for the CFD, for example share price, turnover or profit;
  • whether the CFD is issued for fair value or at a discount; and
  • whether the business prepares its accounts using UK GAAP or IFRS, although on the introduction of FRS 102 the accounting treatment will be aligned.

Corporation tax

The corporation tax treatment of CFDs usually follows the accounting treatment. Accordingly the deduction will be spread over the life of the CFD as the debits or credits are reflected in the accounts. Given the various factors involved, and different accounting treatment noted above, each case would need to be considered on its own merits. It should also be noted that this is an area which HM Revenue & Customs (HMRC) has sought to challenge and tax relief should not be relied upon. In addition, if the company is close and there is a loan to a participator, consideration would need to be given as to whether a charge arises under the loan to participator rules. If the employee loan is written off, the tax treatment of the loan on write off will depend on whether the company is close and whether the borrower is a participator.

Income tax and NIC

If the employee does not pay market value for the CFD at the outset, a charge to income tax and NIC will arise on this value. If a loan is taken out by the employee to fund the acquisition of the CFD, the loan can be interest free or interest bearing. To the extent that the loan is interest free or provided at a rate lower than the HMRC official rate of interest, there would be an income tax and NIC charge on an imputed rate (4% per annum at the time of publication). If at any time the loan is waived by the company, an income tax and NIC liability will arise. However, if the company is a close company the loan waiver may in certain circumstances be treated as a dividend and taxed at the dividend rate.

No further liability to income tax or NIC will arise.

Capital gains tax

On maturity of the CFD, the employee will be subject to capital gains tax at 28% on the payment received less the price paid for the CFD or the amount on which income tax was paid.

For whom is a CFD suitable?

The use of a CFD is particularly attractive to the types of employer set out below.

  • Companies seeking to align senior employees' interests with those of the company.
  • Companies looking to lock-in key employees in the medium term.
  • Companies that cannot use company shares for reward or incentive.

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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