Disguised remuneration Employment income through third party draft legislation

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1 Disguised remuneration Employment income through third party draft legislation STEP welcomes the opportunity to comment on the draft legislation published on 9 December 2010 which is intended to comprise of a new Part 7A of ITEPA General Overview It is our submission that the proposed rules are too wide in their application so that they catch totally innocent arrangements. This submission examines those parts of the draft legislation which we find to be too widely drafted. Given the great complexity and uncertainty of the legislation (which hopefully will be rewritten as a result of the consultation process) with potentially many simple and straightforward commercial transactions being liable to income tax under the new Part 7A, we consider that the commencement dates should be some time after Royal Assent. Furthermore, given that many structures have been in place for years and their taxation implications accepted, we consider that existing arrangements should be grandfathered and remain outside of the new Part 7A. 2. Reimbursement of tax The existing tax legislation provides in a number of situations (for example, Sch.5 para.6 TCGA 1992) for tax paid by an individual to be reimbursed by a trust without adverse taxation consequences. Under the new Part 7A such a reimbursement could fall to be regarded as a relevant step, namely the payment of a sum of money which is chargeable to income tax as disguised remuneration. This should not be the case. 3. Paragraph 48 Where draft paragraph 48 applies and the payment of a sum of money between 9 December 2010 and 5 April 2011 did not constitute a loan, then it is difficult to see how the amount concerned can be repaid in order to unwind the transaction before 6 April 2012 and thereby remove the charge on disguised remuneration as provided by paragraph 48. Also, where as provided by paragraph 48 a repayment is made that repayment might cause the payer to be treated as a settlor or transferor for

2 UK taxation purposes with adverse taxation implications which should not be the case. 4. Contractual obligation to pay employer s NIC Historically, it has not been untypical for companies to make contributions to an EBT with the EBT under a contractual obligation to pay out of the EBT Trust Fund any employer s NIC. Therefore, if the EBT pays a sum of money to the employer (which in relation to Part 7A could be a relevant person) to enable the employer to pay the employer s NIC or by way of reimbursement then as the draft Part 7A is presently worded that could be chargeable to income tax as disguised remuneration which should not be the case. 5. Relevant steps EBTs will quite commonly hold assets indirectly via a number of companies and so, for example, the EBT could own the issued shares of a holding company (Hold Co) which Hold Co in turn owns a number of subsidiaries whether directly or indirectly ((say) Sub 1 and Sub 2). Within the trust structure comprising the EBT together with Hold Co plus Sub 1 and Sub 2 there will typically be payments of sums of money representing for example, loans/loan repayments together with dividends, loan interest, rent, fees, payments for goods and services. All these payments could fall to be regarded as relevant steps creating charges to income tax under the draft disguised remuneration legislation, however, assuming that no value leaves the trust structure and that the director plus other linked persons who are individuals have not received a benefit or loans etc it is difficult to discern why this should be the case. The difficulty arises as a result of the very wide definition of linked person which goes way beyond an individual receiving the benefit or loan etc. 6. Relevant steps and change of trustees As currently drafted, a simple change of trustees will be a relevant step and a mere request by a beneficiary will also be a relevant step. This should not be the case. 7. Third parties and relevant steps Where a third party (say) an EBT takes a relevant step such as making a loan or transferring an income producing asset to a relevant person (the RP ) then if that event occurs after the commencement date for the new Part 7A, there is disguised remuneration and an income tax charge. Please confirm that after the relevant step income or money subsequently received by the RP from the loan moneys or the income producing asset concerned will not come within Part 7A. Similarly, if the step occurred before the commencement date, please confirm that going forward income or money subsequently received by the RP from the loan moneys or the income producing asset concerned will not come within Part 7A.

3 8. Linked person The definition of linked person is far too wide and includes persons with whom there need be no real or meaningful present connection or involvement. For example, it includes members of all partnerships both current and past. If the individual was a member of a commercial partnership (eg a film or green energy partnership) possibly many years ago all the members remain linked persons. Apart from not understanding why such partnerships and their members should be caught by Part 7A, we consider that this definition of linked person will create many significant reporting difficulties. It is therefore suggested that (i) members of commercial partnerships should not be linked persons and (ii) if commercial partnerships are to remain within the definition of linked persons that former partnerships should be excluded. Also, if it is considered that former partnerships should remain within the definition of linked persons, then there should be a cut off point thereby avoiding the need to consider old partnerships of many years ago. This could be achieved by excluding former partnerships where the individual ceased as a partner more than (say) two years ago which is the period that is mentioned in the anti-avoidance transactions in securities legislation in section 686 ITA Similarly, the inclusion of close and other similar companies where there is an insignificant participation or a previous participation (possibly of many years ago) seems to take matters unnecessarily too far and poses the same reporting difficulties mentioned above. As with other legislation there could be a required minimum level of participation before the company becomes a linked person (eg the quite common 5% test). Also, for similar reasons mentioned above, former participation in close and similar companies (possibly subject to a cut off point) should be excluded. 9. Genuine commercial investments It is difficult to understand why a genuine commercial investment made by a third party involving a linked person should constitute disguised remuneration and this should not be the case. 10. Overlap provisions We are not convinced that the overlap provisions are sufficient to ensure that there is not double taxation in relation to the same moneys/asset where possibly different individuals are assessed by reference to the same moneys/assets or moneys/assets representing the same. 11. Clause 554A application of Chapter 2 The definition of the relevant arrangement is far too wide. For example, in sub-clause (6) it states that it does not matter if the relevant arrangement does not include details of the steps which will or may be taken in connection with providing, in essence, rewards or recognition or loans as

4 mentioned. communicated plan. So, in essence there does not even need to be a workable, understandable or In addition, the definition of a relevant third person includes not only A or B but also any other person. Thus, we can see a situation where a person could be a relevant third person without them even having any knowledge of the relevant arrangement, or indeed of A and B. The definition of trustee in sub-clause (8) is drafted to include any person who holds a sum of money or assets under the arrangement. Bearing in mind that a trustee need not be aware of any arrangement, this would therefore encompass any person who is holding money however innocently (including, presumably the company itself). Thus if a company holds its cash with a bank, the bank can be treated as a relevant third person and as being party to a relevant arrangement, even though it does not know it is part of such an arrangement. If the employer therefore makes a vague statement (which need only be verbal) to an employee to the effect that he may receive some reward in future, contingent upon his performance, then this would fall within the very wide definition of a relevant arrangement in sub-clause (6). This is because it is clear in that sub-paragraph that it does not matter that the arrangement does not include details of the steps which may or will be taken. Thus this vague statement by an employer made to an employee with regard to his future performance and rewards can clearly be treated as a relevant arrangement and therefore lead to a potential income tax charge because there is company money with a trustee which may (or may not) be used to fund a later relevant step. The other real risk with this legislation is in respect of the employers themselves. It is clear that this legislation is intended to include existing EFRBS, EBTS and other arrangements even those set up and funded in full prior to 9 December It is unfair to impose a tax charge on an employer in respect of an arrangement set up many years ago for an employee who has perhaps left their employment sometime ago. There were no relevant steps rules until 9 December An employer can therefore now be taxed on a relevant step taken by a trustee of an EBT which was set up many years ago. We believe that a substantial revision of the wording in clause 554A is required. Our recommendations are that a relevant arrangement should only exist where the details of the arrangement are sufficiently precise so that the employee in question will know to what extent he will benefit and on what conditions. There should be the same degree of certainty as there would be in, say, a short option scheme. In other words, there needs to be a legal right (under either contract or trust law) to any money before there can be a tax charge. Furthermore, where that right is subject to conditions or a contingency, the tax charge should only bite when those conditions/contingences are satisfied. This will align these measures with existing income tax and corporation tax rules. Furthermore, a relevant third party must be someone who knows he is party to the arrangements

5 and that the definition of a trustee must be made narrower so that the trustee is also aware that he is acting as a trustee of a relevant arrangement and is not simply as a bank or custodian of the money. Finally, as noted above, these provisions should only take effect in respect of contributions made by employers after 9 December Clause 554B Relevant Steps Earmarking of Sum of Money or Asset Our main issue with the earmarking provisions is one of principle. The whole purpose of income tax legislation is to tax individuals on income that they receive or are entitled to receive. Sub-clause (2) states that it does not matter if the details of the later relevant step have not been worked out (for example details of the sum or amount of assets which will be subject to the step or details of how or when or by whom or in whose favour the step will or may be taken). It goes on to say that it does not matter if the employee has no legal right to have a relevant step taken in relation to any relevant sum or asset. The scope of these earmarking provisions is too wide ranging. What this is saying is that we have a relevant step if there is a vague indication of an unascertained amount made to an employee. It does not matter if the employee has no idea whatsoever how or when that benefit will be paid or by whom and that he has no legal right to that benefit. Leaving aside the practical issues of valuing that benefit, how is it proposed that the tax be levied? What happens if the employee never receives the benefit? There are no provisions in this draft legislation to reimburse the employee if that benefit is never received. Even if there were such provisions, how long would the employee have to wait to get the refund? Will this be a claim by his executors on his death? This draft legislation is so wide and so vague as to potentially catch many innocent arrangements where the employee may never receive any benefit at all. Finally, how is the employee in question supposed to find the money for that tax, given that the taxable remuneration in question has not been received? It is our submission that these earmarking provisions must be removed. Bearing in mind the EBTs and EFRBs are somewhat analogist to trusts we would suggest that any taxation of these vehicles be harmonised to those of trusts. Under trust taxation law, beneficiaries are not taxed until such time as a benefit is received by the beneficiary. We can understand that the Government would not want employees to receive benefits from their employers in an indirect way which circumvents the Employment Tax provisions. However, the mere earmarking of an amount of money or an asset which could potentially be used to benefit an employee in the future is not the mischief which the Government should seek to prevent. Such earmarking happens everyday as part of the normal relationship between employee and employer. For instance, let us take a company which has cash reserves of 1m. The business has decided that it is not going to use that cash for reinvestment in the business or for any other purpose than

6 potentially benefitting its employees in the future. The company decides that it wants to hold that money in a separate deposit account at the same bank it normally holds a trading account with. The employer tells its employees that there is a bonus pool for them. Rightly it wants to incentivise and retain its best people. Those rewards are left vague as to possible percentages of salary and dependent on a number of conditions with regard to performance and the employees remaining with the company. This is a perfectly normal arrangement. Yet, we have a relevant arrangement. We have a trustee (the bank) and we have earmarking (however vague). Thus we have a tax charge. It is difficult to see why the Government would want to tax the employer and the employee if that money is earmarked for those employees in a vague manner such that earmarking is made. The money has not left the ownership of the company and the employee is not legally entitled to it. Yet as far as the current drafting of the legislation is concerned, because that money is held by a third party the bank then a tax charge is applied. But what if the employer pays the money across to the trustees of an EBT or an EFRB? No actual benefit has been received by the employee so why should there be a corresponding tax charge? Bear in mind that the company does not get a CT deduction for the payment across to the EFRB or EBT and so tax has been paid on that contribution. How is the payment of the money across for an EBT/EFRB any different to the company earmarking funds within its ownership? It is our view that this provision is unworkable. The consequence of this legislation is to catch many innocent arrangements whereby employers wish to incentivise their employees. Furthermore, due to the very vague nature in the way in which the rules are drafted it is entirely possible that there will be multiple charges to tax on the same individual or overlapping tax charges where there are various individuals involved. For example, if there is a wide class of beneficiaries and the amounts earmarked are vague then it is easy to see how each of those beneficiaries could be taxed and that the tax charges could exceed the total amount capable of being paid out. 13. Clause 554C Relevant Steps; Payment of sum, transfer of assets, etc We agree that it is acceptable for employees to be taxed on any benefits they actually receive from remuneration trusts. However, we do not understand the treatment of loans proposed in this legislation. Under the legislation affecting loans directly from employers or, indeed, loans from nonemployment related trusts, the beneficiaries/employee will only be taxed on the benefit element of the loan. It is not fair to tax an employee on the full amount of the loan made. The right approach would be to tax the employee on the benefit element of that loan in line with other legislative measures. Bearing in mind that loans must be repaid; we would suggest that the right approach would be for the official rate of interest to be applied to the sum in question in the same way as loans from employers are treated.

7 Bearing in mind that in the later parts of this draft legislation outright distributions from remuneration trusts are to be treated as if they were made directly by the employer, it is difficult to see why there would be a different treatment for loans from remuneration trusts. Surely if the principle is that the remuneration trust is to be treated as if it were the employer, then the loan should be treated in the same way as an outright distribution. Furthermore, the commercial transaction let out in relation to loans is incomprehensible. As we read the provisions it appears that even where a market value loan is made by an employer to an employee via a remuneration trust there will be no commercial benefit let out. It would appear that the only type of employer or lender that would qualify would be a financial institution which is in the business of making loans to the general public. Thus the only example we can think of where this commercial let out would apply would be if the employer was a bank. There are a number of consequential problems as a result of this drafting. For instance, if a trustee of a remuneration trust lends 100,000 to an employee at 6% above base rate we would contend that this is a market value loan. So the employee is paying a market rate of interest. Yet, as we read this legislation the employee will be taxed on the whole amount of the loan received with no abatement for the interest actually received. There is no provision for the employee to get a tax deduction for the interest paid even though he is being taxed (to NIC) on the entire amount of loan advanced. Further, we do not see that this draft legislation is consistent with other legislation on the making of loans or the receipt of benefits from non-remuneration trusts or, indeed, from employers directly. We would therefore recommend that the legislation in this respect is made consistent with these other measures in our tax code and that only tangible benefits are taxed. 14. Clause 554G Exclusions; transactions under employee benefit packages The definition of a genuine employee benefit package is far too narrow to be of use to most businesses. It is vital that businesses are able to retain and attract key staff and yet the effect of the limited exclusions under this clause means that most employee benefit packages will not gain any protection. There are some obvious drafting problems with this provision including the fact that there is no definition of a senior employee. There are some real practical considerations, but it should be taken into account that the real value is often created by the senior employees and executives. Businesses should be encouraged to attract and retain the best possible talent so that businesses can thrive. 15. Personal representatives Paragraph 7 amends section 13 ITEPA 2003 and provides that where a relevant step is taken after the death of the employee concerned then the personal representatives are liable for the income tax under the new Part 7A. However, given the very wide definitions of (i) relevant steps, (ii) relevant

8 persons and (iii) linked persons, it must follow that a relevant step or steps that might occur years possibly even decades after the date of the death and over which the personal representatives have no control. This would expose the personal representatives to an income tax liability of totally unknown proportions which poses great, if not impossible difficulties, in winding up the estate of the deceased employee. This should not be the case. 16. Conclusion We believe that the provisions relating to earmarking are unfair and unworkable. We strongly urge the Government to withdraw these provisions and that they should be replaced with measures which only impose tax when a legal right to money or assets is obtained by the employee. We believe that the impact of these measures, even if the earmarking provisions are removed, will act as a disincentive for businesses to enter into genuine employee benefit packages for those employees who generate wealth for UK businesses and therefore the UK economy. This legislation is not consistent with other tax legislation relating to benefits received by individuals from companies or trusts. We strongly urge the Government to rethink its approach in this regard and to introduce, instead, a more logical, consistent and fair set of rules. This should be based on the principle that individuals should not be taxed unless they have a legal right to an asset or a sum of money. Furthermore, the basis of taxation should be on the benefit actually received and therefore the provisions relating to the taxation of loans and the provision of assets should be substantially revised. The treatment under these provisions should mirror those for the taxation of benefits from non-remuneration trusts and/or benefits from employers when provided directly. The rules should exclude all normal and genuine employer incentive arrangements and any pensions which are already taxable under ITEPA. All pre-existing schemes should be excluded, in particular pre-a Day corresponding schemes as well as pre- and post-a Day section 615(6) schemes. Submitted by STEP UK Technical Committee on 9 February 2011