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A client has recently sold his company. The terms of the sale were such that he received some immediate proceeds, plus an earnout based on the profitability and rate of growth of the company over the next four years. The client has recognised that the efforts of three or four key employees are vital to ensure that the performance of the company, and hence his earnout, is maximised.
A client has recently sold his company. The terms of the sale were such that he received some immediate proceeds, plus an earnout based on the profitability and rate of growth of the company over the next four years. The client has recognised that the efforts of three or four key employees are vital to ensure that the performance of the company, and hence his earnout, is maximised.
He would therefore like to incentivise these employees by paying them a bonus linked to the earnout that he receives. The basis of the bonus will be agreed with the employees shortly and is likely to be subject to a written agreement between the client and each of the employees. This will be paid by him personally from the proceeds that he receives. As the sale has taken place, we can see no means by which he can claim a deduction for the bonuses that he will pay against his capital gain. As the employees will only be receiving the bonuses as a result of their employment with the company, and will receive nothing if they cease to be employed, it seems clear that the bonuses are assessable under Schedule E.
We should be grateful for readers' views as to whether the bonuses are subject to employer's National Insurance contributions and whether pay-as-you-earn should be operated. If PAYE or employer's National Insurance contributions are due, who will be responsible for collecting them?
(Query T15,796) – Gift Horse.
Unfortunately, pay-as-you-earn and National Insurance contributions will be due on the bonuses paid to the employees. Pay-as-you-earn will be the responsibility of the person who pays the emoluments (section 203, Taxes Act 1988 and Regulation 2(1) of Statutory Instrument SI 1993 No 744). The ex-shareholder should deduct the pay-as-you-earn from the cash paid using the BR only tax code and remit it to the Inland Revenue within fourteen days of the end of the tax month. If this is not done, the Inland Revenue is likely to pursue the ex-shareholder for the pay-as-you-earn rather than the employer. Section 203B, Taxes Act 1988 will not apply to the employer, as the ex-shareholder would not be acting on behalf of the employer. If the ex-shareholder does not collect the pay-as-you-earn, the employees may well be able to claim that the PAYE (on a grossed-up basis) should be paid by the ex-shareholder (as per Black and others).
The National Insurance contributions position is different. The employer's National Insurance contributions liability is the responsibility of the secondary contributor (section 7, Social Security Contributions and Benefits Act 1992). This will be the contractual employer, not the ex-shareholder. How the employer is supposed to know about the National Insurance contributions due if nobody tells it is another story. If it is not paid, then the Inland Revenue is likely to pursue the employer and not the ex-shareholder. Employee's National Insurance contributions are also due (subject to the upper earnings limit on combined earnings).
There is no scope for arguing that the payment will be a gratuity and so disregarded (paragraph 5, Part X, Schedule 3, Statutory Instrument SI 2001 No 1004) – although there is no harm trying it on with the Inland Revenue before the payment is made!
From an inheritance tax perspective, the payments will be potentially exempt transfers unless it can be shown that they were not intended to be gratuitous transfers. If the ex-shareholder could demonstrate that, for example, incentivising the employees was expected to enhance the value of his earnout (after taking into account the payments) then there should be a case for relief under section 10, Inheritance Tax Act 1984. If so, a contemporaneous letter to his solicitor setting out the facts might come in handy if the ex-shareholder should die within seven years.
To create a capital loss, how about granting an option (with a nil exercise price) over shares in the parent to the value of the bonus? There would be a complicated formula to adjust the number of shares capable of being exercised so as to ensure that the value of the shares on exercise is equal to the cash bonus. Provided the option cannot be exercised after more than ten years, this should not change the tax treatment for the employees. However, a capital loss should be realised when the option is exercised which may be of some use (combination of section 149A, Taxation of Chargeable Gains Act 1992 applying on grant and section 17, Taxation of Chargeable Gains Act 1992 not applying on exercise). If the formula works properly, no shares would need to be bought until exercise. The pay-as-you-earn obligation on exercise would now fall on the contractual employer. If the parent is not listed, this idea is probably not practical. – English Rose.
As yet, there is no contract. Might it be feasible for the client to make a wager with each employee as to the level of earnout he will obtain? Any wager is unenforceable at law, but betting winnings are free of tax and National Insurance. For example, a professional golfer escaped tax on the proceeds of bets on the results of holes played with novices (see Down v Compston 21 TC 60).
This suggestion seems practical because the employees will provide no services to the client, which might otherwise cause any 'bonuses' to be treated as made for consideration. The employees are already bound by their contracts of employment to devote their whole available energies to their employer. Indeed, it is for consideration whether the proposed agreements might be challenged as potentially harmful to the company, since the employees could be induced to promote short term manoeuvres favourable to targets set by the earnout agreement but possibly deleterious in the longer future. However, readers answering Query T15,684 in Taxation, 5 October 2000 at pages 20 and 22, seemed fairly relaxed about inducements.
Third parties providing cash incentives to employees have to operate pay-as-you-earn, including responsibility for National Insurance contributions (for non-cash benefits, see the Inland Revenue Tax Bulletin for April 2000 at page 747). Of course, the expression 'employer' in the Income Tax (Employments) Regulations 1993 (SI 1993 No 744) means any person paying emoluments, so it is the client who has to shoulder responsibilities for real bonuses. – M.C.N.
