Where Now for Employee Trusts?

CHARLES SANDISON, NEIL MORGAN and JONATHAN LEVY of Ernst & Young discuss a recent Special Commissioners' decision.

THOSE ADVISERS WITH experience of employee benefit trusts will know that the increasing use of such trusts by companies has generated considerable controversy with the Inland Revenue in recent years. Concern about the tax advantages of these trusts has led the Revenue to scrutinise various aspects of them, in particular with a view to ensuring there is symmetry between the timing of the corporation tax deduction for the contributing company and resulting income tax and National Insurance liabilities when value is provided to beneficiaries of the trust.

Now an important recent Special Commissioners' decision, involving the Caudwell group of companies, has shed some light on this difficult area; the case is reported as  Dextra Accessories Ltd and others under Special Commissioners' reference SpC 331.

The Revenue approach

Prior to the Caudwell case, the Revenue took the view that, to the extent funds are accumulated in such trusts so that significant taxable value has not been provided to beneficiaries, no corporation tax deduction is available or at least that such a deduction is deferred until such time as funds are distributed by the trustees. The line generally taken by the Revenue in seeking to deny or defer a corporation tax deduction includes contesting one or more of the following points:

1. The accounting statements contained in Financial Reporting Standard 5/Urgent Issues Tax Force 13 (and recently UITF32) should be applied so that the employee benefit trusts assets should be treated as assets of the sponsoring entity.

2. Contributions should be reviewed to establish whether they are capital in nature as opposed to revenue.

3. If contributions are of a revenue nature, do they satisfy the wholly and exclusive tests, particularly if the employee benefit trust has been set up and funded by a close company?

4. And finally, even if all the above arguments fail, consider whether section 43, Finance Act 1989 applies to defer the timing of the corporation tax deduction until the accounting period in which funds are distributed by the trustees in a form that results in a Schedule E liability on the beneficiaries.

5. Additionally, in order to achieve symmetry, the Revenue has sought to accelerate the timing of income tax and National Insurance liabilities on beneficiaries if it considers taxable events have occurred prior to the actual distribution of funds to beneficiaries. Such events could include the creation and contribution of funds by the trustees to revocable sub-trusts in which the class of beneficiary is a specific employee and his family, or the 'allocation' of funds within the general fund by the trustees for such persons.

6. To top it all, depending upon the circumstances, if a close company is the sponsor and the Inland Revenue considers the trustees not to be independent, consider whether the Ramsay doctrine applies to defeat the tax advantages that may otherwise arise.

The appeals

There were twelve appeals before the Special Commissioners. The first six appeals relating to the deductibility of payments to an employee benefit trust made by six group companies. The second six appeals related to the taxability and liability to National Insurance contributions of allocations of funds within the trust on sub-trusts for the three director shareholders of the group, Mr John Caudwell, Mr Brian Caudwell and Mr Craig Bennett and their wives.

The facts

The Caudwell group sells mobile telephones and mobile airtime. It has been extremely successful, growing from thirty employees in 1989 to an international organisation with subsidiaries in six countries with a turnover of £1.4 billion, a profit of £22 million and a staff of 2,800. The group has its headquarters in Stoke on Trent.

There were many reasons why the Caudwell group wished to set up a flexible remuneration plan operated via an employee benefit trust to reward its key employees. Central to the group's thinking was the following:

• Employees did not value unapproved options in shares in an unquoted entity, so that when the taxpayer introduced such arrangements, the taxpayer considered it was giving significant benefit to employees, but this view was not reciprocated by the employees without there being a short-term route to market. The taxpayer was too large to operate enterprise management incentive arrangements.
• The workforce was generally relatively young and key employees needed an incentive to remain with the business in the medium to long term.
• To attract and retain key personnel to the group meant that the remuneration packages offered had to be sufficiently attractive to 'compensate' recruits who may be offered similar positions within organisations in major cities such as London.
• A flexible vehicle as a mechanism to provide benefits in a wide variety of forms was needed to be able to satisfy any requirements as the taxpayer enhanced and diversified its reward strategy over the medium and long term as market conditions necessitated.
• To foster employee support for any reward plans which were to be implemented, the fact that the taxpayer could pay monies to an independent entity free from the control of the employer persons was attractive for a company operating in a market which was extremely volatile. Monies held and invested by the trustees could not be repaid to the taxpayer and benefits had to be provided to employees even if there was a sharp downturn in trading conditions.
• To ensure the maximum motivation for the workforce the board of directors considered it vital to ensure that for any reward plan implemented, any shareholder/director benefited on the same terms as other employees.

The parent company settled a nominal sum on to discretionary trust in December 1998. The terms of the trust deed and powers of the trustees were wide, so that the trustees could invest funds and provide benefit in a variety of ways, including providing shares in any taxpayer group company and the making of loans.

On an annual basis, without there being any legal obligation, various United Kingdom and overseas subsidiary companies contributed funds to the trustees. There was no fixed formula used to decide the level of profits contributed.

The group introduced two specific reward plans - one was a short-term scheme which provided benefit if performance criteria was achieved over a one-year period, the second was a longer term scheme which provided benefit if performance and service was achieved over a maximum twenty-year period. The short-term scheme operated in the year of dispute, 1998, whilst the long-term plan was introduced the following year.

Each year the board of directors would recommend to the trustees which employees it wished the trustees to benefit should performance criteria be met. For the director/shareholders such recommendations were only made provided an independent remuneration consultant had confirmed that the level of remuneration for each director/shareholder was not excessive. As the director/shareholders were traditionally paid in arrears, the independent remuneration consultants reported on the performance achieved by such individuals in the prior year. The taxpayer had prepared a policy document which detailed its objectives in setting up the two reward plans and these policy documents were provided to the trustees.

Shortly after receipt of the recommendations, the trustees, exercising their discretion and taking into account guidance provided in the policy document, appointed funds on to revocable sub-trust for the benefit of the specific employee and his immediate family.

The class of beneficiary of the sub-trust included individuals outside the scope of section 168, Taxes Act 1988 so that, for example, grandchildren of the individuals were included within the class. The employee for whose benefit a sub-trust had been created could make recommendations to the trustees as to the type of investment in which the funds should be held. Throughout, the trustees retained absolute discretion over the timing and form of benefit which could be ultimately provided, and over how the funds were invested. Beneficiaries for whom sub-trusts had been created also had the ability to write to the trustees and request that loans be made to them, and indeed a number of loans were made.

Revenue arguments

Before the Special Commissioners, the Revenue was represented by Timothy Brennan QC. The appellants were represented by Andrew Thornhill QC. On behalf of the Revenue, Mr Brennan put forward three arguments as follows:

Potential emoluments

Contributions made by group companies to the employee benefit trust were 'potential emoluments' within section 43(11), Finance Act 1989, since they were held by the trustees as intermediary with a view to their becoming 'relevant emoluments,' defined by section 43(10) as emoluments for a period after 5 April 1989 in respect of a particular office or employment. Section 43 provides symmetry between deductibility by the companies and the taxability of employees and provides that deductions against corporation tax profits of a company may not be made unless relevant emoluments are paid within nine months of the end its period of account.

Alternatively, it was mooted that allocations to a sub-fund constituted a 'benefit in kind' taxable under section 154, Taxes Act 1988.

Ramsay

In any event, the 'Ramsay' principle applied and the trust should be regarded as a pretence whose true purpose was not to remunerate employees but to allocate bonuses to the recipients and obtain a corporation tax deduction while trying to avoid any Schedule E charge on emoluments.

The Special Commissioners' decision

The Special Commissioners did not accept the Revenue's arguments. On the evidence heard by them from the director shareholders, Mr Bennett, Mr John Caudwell and Mr Brian Caudwell, one of the employees and the trustees they found that money contributed to the trustees of the employee benefit trust and allocated by them to sub-funds was not at the absolute disposal of the Caudwell group. The tribunal found instead that the trustees were truly independent of the settlor group.

Against the above findings of fact, the tribunal dismissed all three of the Revenue's arguments. On section 43(11), Finance Act 1989, the Special Commissioners held that the term 'with a view to becoming emoluments' meant that the contributing company's purpose in making the payments to the trustee, the intermediary, had to be the provision of emoluments and nothing else. This was not the case as the funds might be used in a variety of ways, such as the making of loans, which had actually happened. On section 154, Taxes Act 1988 the Commissioners accepted Mr Thornhill's contention that the specific charging sections referred to in section 154 require actual benefits rather than the potential benefits provided by the trust.

Finally, the tribunal held that the 'Ramsay' doctrine could not apply. The Special Commissioners agreed with Mr Brennan that a commercial approach should be adopted in construing the relevant legislation as set out by the House of Lords in MacNiven v Westmoreland Investments Limited [2001] STC 237.

However, on the facts of this case, the Commissioners held that:

The Commissioners concluded therefore that -

Other challenges?

The Special Commissioners' decision is important in clarifying the section 43(11) and section 154 arguments, but it is important to remember that their decision is based on the facts of the case before them. On the evidence presented to them, the tribunal held that the trust had been established for a bona fide commercial purpose with trustees who could not be said to be the ciphers of potential beneficiaries.

Each case, however, will have to be looked at on its own facts for this commercial test to be met, and challenges by the Revenue to other employee benefit trusts cannot be ruled out. In addition, the Revenue did not deploy other arguments available to them, such as those based on the application of accounting standards, or whether the deductions had been incurred 'wholly and exclusively' as part of the contributing company's trade. The application of accounting standards is likely to prove a particularly contentious area, despite the clarification provided by Urgent Issues Tax Force 32.

Charles Sandison is a partner in Ernst & Young's Private Client Services; Neil Morgan is a director at Ernst & Young's Private Client Services; and Jonathan Levy is an Assurance Senior Executive in Ernst & Young's Tax Risk Management Group.

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