April 6th 2021 will see the tenth anniversary of the employment income provided through third parties rules, better known as disguised remuneration. At the time the rules were introduced, they were controversial in the broad way in which they were structured. However, they were implemented in a very different tax landscape to the one that now exists. Many of the concerns that HMRC had at the time are no longer so pressing, and the other powers that HMRC has at its disposal have greatly expanded.
As the ten-year milestone approaches, we think it is appropriate to question whether the disguised remuneration legislation remains fit for purpose or should be given a radical overhaul.
The Original Target
At the end of the noughties, it is fair to say that the appetite for complex tax planning was much greater than it is today. HMRC found itself firefighting against ever more complex structures which purported to deliver remuneration in forms that did not attract the full rate of income tax. Often these arrangements sought to utilise exemptions from taxation for purposes that they had not been intended.
One of the key targets that HMRC had long had in its sights was the use of employee benefit trusts (EBTs) as a mechanism for delivering the value of bonuses to employees and/or their families without suffering the same tax rate as would have been paid had the bonus been paid directly to the employee.
In essence, the employee would waive their right to a bonus and instead the employer would make an equivalent contribution to an EBT. The trustee of the EBT would hold the contribution for the benefit of the employee and his or her family and could use the contributions to provide benefits. Commonly, the bonus would be loaned to the employee, who could then use the whole amount of the loan to spend as they chose. The loan would act as a charge on their estate for inheritance tax purposes and the proceeds of repayment of the loan could then be distributed tax free to beneficiaries after the death of the employee. The fund could also be used for other purposes, such as the payment of school fees or the purchase of assets for the use of the employee.
It's not difficult to see why HMRC did not like this
planning. Originally used in certain parts of the financial
services sector, EBT schemes proliferated as the benefits became
more widely known, leading to increased losses to the Exchequer.
The problem was that each time HMRC tried to challenge these
arrangements through the courts, it lost. In spite of HMRC
continuing to state its view that these arrangements did not work,
this did nothing to stop their use – hardly surprising when
the courts kept ruling that they did.
The result of this frustration was the introduction of the disguised remuneration rules in December 2010, taking full effect on 6 April 2011.
The Way the Rules Operate
So far, so predictable. However, where things started to go wrong was the way in which the rules were structured. They stopped the target in its tracks, but they caught more. Much more.
The basic premise was to make the legislation as widely applicable as possible and then to provide exemptions to protect the innocent arrangements that would otherwise be caught. It is fair to say that there was a degree of paranoia on the part of HMRC that if the exemptions were too widely drawn, they would be used for purposes for which they were not intended; better that 99 innocents are caught than one guilty party escapes. Unfortunately, this meant that the exemptions were in many cases far too narrowly drawn.
In essence, an employee reward arrangement involving a third person (anyone other than the employer or a group company) taking a “relevant step” would potentially find itself in the sights of the rules and would then need to find an exemption or find itself subject to sometimes punitive tax consequences.
What it catches
Relevant steps include:
- earmarking: a nebulous concept where cash or an asset was, however informally, set aside for use for the benefit of an employee;
- use of assets: making an asset available for use by the employee; and
- payments of money: this specifically included the making of a loan.
Where a relevant step occurred, an immediate liability to income tax, withholding through PAYE and NIC, arose. The liability would be on the “value” of the relevant step (generally the amount of money or value of the asset). This could happen at a time when the employee had not actually received any value at all. In the case of loans, it did not matter if the loan was ultimately repaid; there would be no relief from the earlier tax liability.
It is easy to see how these relevant steps were evolved simply by considering the way in which the EBT schemes operated (see above). Earmarking was when the trustee of the EBT allocated the funds to a particular employee. Payment of money was primarily aimed at the advance of a loan (as paying cash would be fully taxable, this wasn't generally done). Providing assets also addressed a common use to which EBT funds were put.
What innocent things it catches
The legislation was an overnight success in stopping EBT schemes. Sadly, however, things didn't stop there. The wide scope of the rules, coupled with narrow framing of exemptions, meant that wholly innocent arrangements found themselves in the crosshairs.
Perhaps the worst outcome was in the case of loans being provided by individual shareholders of companies (usually owner managed businesses). These loans could be for perfectly innocent purposes. For example, helping the employee through a short-term cash flow issue, or helping them to subscribe for shares in the company. The loan would be a genuine loan, which was expected to be repaid. However, the disguised remuneration rules treat the loan as a payment of employment income with no relief on repayment. Although there is an exemption in the rules for certain loans, this is very narrowly framed and would not typically apply to shareholders.
Likewise, a shareholder who decides to use some of his or her shares to incentivise employees and grants the employee an option to acquire some shares, or otherwise promises to deliver some shares, would be within the scope of the legislation. There are several exemptions applying to employee share schemes but not all will qualify. For example, a vested option or an option with a life of greater than 10 years would not fall within the exemption so would give a worse tax treatment than if an equivalent option had been granted by a group company.
In spite of their chequered history, EBTs still have a valuable role to play in the context of employee share arrangements. They can operate to warehouse shares pending their use under share plans. There is no tax avoidance purpose here; just an administrative benefit. However, if trustees grant options they will be earmarking so, unless the exemption applies, there will be an immediate income tax charge.
A ‘relevant third person' is the employer or a group company. This is relatively straightforward where the group contains only corporate entities, but what about a group that contains one or more partnerships? Bizarrely, if the partnership is a subsidiary of a corporate parent, it will be treated as a third person, but in the opposite case, where a limited liability partnership is the parent, it will not be. There seems no rationale for this inconsistency.
All of these pitfalls can be avoided with proper advice and planning. The problem is that in many cases, the arrangements being entered into are so innocent that the parties may not even consider the necessity to get tax advice. Many advisers will have met with incredulous responses when they suggest that disguised remuneration is an issue with transactions like those described above.
If these perverse results were not reason enough to recast the legislation, the developments in the tax avoidance landscape since disguised remuneration was introduced, make the case compelling still.
Firstly, HMRC finally won a tax case in relation to EBTs. Known as the Rangers case (after the Glasgow football club) the Supreme Court held that allocations by EBT trustees to individual family trusts should be treated as employment income of the beneficiary. Following this, HMRC gave taxpayers operating EBT schemes the chance to settle their outstanding liabilities. Many employers signed up to this settlement opportunity. In April 2019 there was a deemed income tax charge on the amounts of any pre-disguised remuneration loans that remained outstanding.
Secondly, the disclosure of tax avoidance schemes (also known as DOTAS) rules were expanded to introduce a hallmark that applied to require the disclosure of arrangements with a purpose of avoiding the application of the disguised remuneration rules. The introduction of accelerated payment notices also makes arrangements like the EBT scheme less attractive.
Thirdly, the general anti-abuse rule (GAAR) was introduced. This rule gives power to override a purported tax outcome where it is predicated on an interpretation of the legislation which stretches the bounds of reasonableness. Any complex structure designed to circumvent the rules prohibiting the use of EBTs for bonus planning would in all probability stumble when confronted by the GAAR.
Fourthly, in the case of banks and building societies, the code of practice on taxation for banks was introduced in 2009 and subsequently expanded. This dictates the way that relevant institutions are expected to behave in relation to their tax affairs and includes a prohibition on engaging in tax planning that is contrary to the intentions of Parliament. Again, it's difficult to see how an EBT scheme would not be in breach of this code.
Finally, the reputational considerations of entering into artificial tax planning structures are significantly different from ten years ago. We would expect that many large or high-profile businesses would shy away from planning of this type, even if there were no legislative prohibition.
In the light of these developments it's legitimate to question whether EBT schemes would continue to be used even if there were no disguised remuneration rules at all.
What would we recommend?
In our view, a wholesale repeal of the disguised remuneration rules would be a step too far. However, there are two relatively straightforward ways in which these unfair outcomes could be addressed. In our view, neither of these would be likely to lead to a re-starting of the use of EBT schemes for bonus planning purposes.
Firstly, provide some broader exemptions that cover the whole range of innocent arrangements. Many of the unfair outcomes are now well known and can easily be covered by a recasting of the rules.
Secondly, and perhaps preferably, a tax avoidance purpose gateway could be introduced. This would automatically exempt any innocent arrangements. Of course, it is not always possible to assess purpose, but the concept of a tax avoidance motive is found in numerous other areas of the tax legislation and seems to operate non-contentiously. If necessary, a clearance process could be established for HMRC to approve commercial motives. This would seem, with one fell swoop, to save all of the inadvertent transgressions we highlight above.
The disguised remuneration rules in the form as originally introduced have long outlived their necessity and the case for revision of the rules is compelling. The rules were always a sledgehammer to crack a nut but when the nut is well and truly cracked, it's time to stop hammering.
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