Disguise revealed

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KEY POINTS

• The reason HMRC decided to challenge disguised remuneration schemes.
• Concerns, consultation and legislative change.
• The three-step process for ITEPA 2003, Part 7A to apply.
• Examples of the charge on loans from EBTs.
• Exemptions for qualifying pensions and pre-6 April 2011 rights.

The legislation dealing with employment income provided through third parties was probably the most talked about measure in Finance Bill 2011.

It was the first major piece of anti-avoidance legislation that has been developed under the new policy-making process and was HMRC’s first exercise in developing anti-avoidance legislation in a transparent way in partnership with advisers and businesses without compromising the integrity of the policy.

This article covers some of the background that led to the government introducing this legislation, explains why it adopted the solution now in the legislation, discusses some of its innovative language, and aims to lay to rest some of the myths and scare stories about its scope. It gives an overview of how the legislation works for rewards and pensions.

There is more technical detail in the guidance that HMRC have published in draft.

Why disguised remuneration?

As we came to the end of the ‘noughties’, both HMRC and HM Treasury had become very concerned at the proliferation and spread of schemes that sought to delay or avoid income tax on employees’ wages.

These schemes had first surfaced in the 1990s as planners responded to the comprehensive legislation which dealt with readily convertible assets which had been used for National Insurance contributions (NICs) avoidance in particular.

The new schemes generally involved funds provided by an employer to an employee benefit trust (EBT). The EBT then made loans to employees that were either repayable in the far future, or had a shorter term but were repaid and then re-advanced regularly.

Some EBTs charged interest on these loans at a commercial rate which was paid by the employees. Where this happened, the making of the loan did not give rise to a tax charge under the legislation on benefits in kind.

But often, in practice, the loan interest merely accrued and the balance was rolled up in the loan outstanding, leaving a small taxable benefit compared with the true value delivered to employees.

Employers claimed a deduction against their profits for the amount they paid in to the EBT. But the employees who received the loans from the EBTs had no or little income tax to pay on the value they received.

Unsurprisingly, the Inland Revenue (as it was then) was not persuaded of this line of argument, and acted against the schemes both in litigation and in legislation.

Its first line of defence in litigation was to argue that there was no deduction against business profits as the sums were not paid as emoluments, and that the provision could not be deducted until paid.

This argument finally prevailed in the Dextra case (Dextra Accessories Ltd & Others v MacDonald [2005] STC 1111), but in the time taken for that case to proceed to the House of Lords the structures of the schemes were becoming ever more complex and the lack of corporation tax deduction was not always a disincentive, particularly as the avoided PAYE and NIC liabilities outweighed the diminishing corporation tax rate.

The Inland Revenue therefore returned to litigation with the Sempra case (CIR v Sempra Metals Ltd [2007] STC 1559), arguing that there was a PAYE charge at the point of allocation of funds by the EBT to the employee.

While there were good grounds for this argument, the Special Commissioners did not accept it and followed the case of Dextra in deciding that the corporation tax deduction claim was not allowable.

The Sempra case was not pursued further in the courts so there was no opportunity to set a legal precedent on the correct tax treatment of these types of arrangements.

The journey to legislation

This set the stage for the disguised remuneration legislation. In early 2010, HMRC set out their position on these types of arrangement through one of their regular internet communications on avoidance matters, Spotlight 5.

In Spotlight 5, HMRC made it clear that they did not agree that these schemes achieved the outcome promised when they were being marketed.

The article indicated that HMRC were challenging schemes, litigating where necessary and, at the same time, considering the scope for legislative action. As part of this work HMRC analysed their data on schemes being used and the speed with which they were proliferating.

The department assessed the existing threat to the tax base and considered how the arrangements might spread further.

A particular concern was the risk that they might be used by employers to provide retirement funds for staff that would not be subject to the reduced allowances restricting tax relief for registered pension schemes from April 2011.

The analysis pointed to a substantial threat to the UK tax base. This was quantified as £500m per annum, a figure agreed with the Office of Budget Responsibility. The analysis also indicated that the tax at risk could be expected to grow.

The individuals using these schemes ranged from highly paid employees in financial services, to UK-resident individuals providing services to UK businesses via offshore service companies.

The wide-scale use of these schemes not only posed a threat to the UK tax base, it also distorted competitiveness between employers and was unfair to the majority of ordinary employees who pay income tax and National Insurance contributions on their full wages.

Design and process

The legislation is designed to look through arrangements between an employer, third parties and employees and their beneficiaries and take account of the effect on the employee.

Broadly speaking, if third-party arrangements are used to provide what is in substance a reward or recognition, or a loan, in connection with the employee’s current, former, or future employment, then an income tax charge arises.

The legislation is drawn widely because of the range of intermediaries and the arrangements it needed to tackle. It provides exclusions or ‘carve-outs’ for particular sets of arrangements that are not designed to avoid income tax and National Insurance.

The draft legislation was published in December 2010 and included various carve-outs covering, for example, tax-advantaged employee share schemes and registered pension schemes.

It is fair to say that the publication of the draft legislation generated a lot of comment and debate. Some of the more heated initial reactions were based on a misinterpretation of the legislation which was, perhaps, understandable given some of the novel language it used.

The rules on ‘earmarking’ prompted some of the strongest reaction. Some commentators felt that the legislation was rewriting the rules on the tax treatment of employment income and comments were made about an attempt to ‘tax thin air’.

In fact, earmarking, although not a term previously used in income tax legislation, is not a new concept.

The term refers to the allocation of funds by third parties for the benefit of employees or their families under arrangements entered into by employers and employees in an attempt to avoid tax and NICs – the type of arrangements HMRC had referred to in their earlier Spotlight 5 publication.

Much of the reaction to the draft legislation focused on its wide scope. Commentators identified a number of existing arrangements between employers and employees which were already subject to tax under other provisions in the Taxes Acts, but which would also be caught by the draft legislation.

They argued strongly that the exclusions in the draft legislation were insufficient.

Consultation and changes

Another area of concern was that the draft legislation did not provide an exclusion from the charges imposed by ITEPA 2003, Part 7A for existing pension funds built up under regimes such as employer financed retirement benefits schemes (EFRBS).

HMRC worked with advisers and employers during the consultation period to understand their concerns and consider how the draft legislation could be refined to take account of legitimate concerns, without undermining its purpose.

In February 2011, HMRC published a set of frequently asked questions which covered the most common areas of concern and set out the aspects of the draft legislation that would be changed in response to points raised during the consultation.

The revised version of the proposed legislation was published as part of the 2011 Finance (No 3) Bill on 31 March 2011.

The main changes to the legislation as a result of the consultation were made to:

• improve the drafting of the exclusions to remove benefits in kind already charged to income tax;
• retain the existing tax treatment of payments made out of funds put into EFRBS before 6 April 2011;
• better align the legislation with the Financial Services Authority’s guidelines on deferred rewards in the financial services sector;
• introduce exclusions for unapproved share schemes to remove arrangements with no tax avoidance motive;
• ensure there was no double charge to tax where an employer had already accepted that funds held by a third party were subject to PAYE and had accounted for the income tax and NICs in reaching an agreed settlement with HMRC; and
• ensure that, as far as possible, venture capital funding structures were not disadvantaged.

The publication of the Finance Bill did not end the debate about the legislation and HMRC continued to work with advisers and employers while the legislation was passing through its Parliamentary stages.

As a result of these ongoing discussions, further amendments were made to the legislation to address concerns without undermining its purpose.

The income tax legislation is in ITEPA 2003, Part 7A and became law from 19 July 2011 when F (No 3) A 2011 received Royal Assent.

Draft NICs regulations were published for consultation on 25 August, with consultation closing on 25 September 2011. The regulations (amended if necessary) will be laid before Parliament as soon as possible after the close of consultation and will come into force 21 days later, expected to be in late October 2011.

How the legislation works

HMRC published comprehensive guidance, for use by advisers and HMRC staff, in document form on 18 August 2011. This will be fully web-enabled in the Employment Income Manual in the early autumn.

This guidance sets out how the legislation works and includes examples of when charges will arise and how the exclusions work. The legislation works by a series of tests or steps to identify transactions that will be deemed to be employment income in the hands of the employee and income subject to the operation of PAYE in the hands of the employer.

Step 1. Is there a third party?

For the legislation to apply there needs to be a provision by a third party. Part 7A will not apply in a case where the employer is providing something directly to the employee, and there is no third party involved.

There are two exceptions to this general rule. First, Part 7A can apply where the employer is acting as a trustee. Second, Part 7A can also apply where certain steps are taken by an employer and there is an undertaking to pay contributions to a relevant third person that are not subject to the annual and lifetime restrictions on pensions tax relief.

Step 2. Are the s 554A conditions met?

Step 2 involves answering three fundamental questions.

First, is there an ‘arrangement’ which meets the conditions set out in ITEPA 2003, s 554A? ‘Arrangement’ includes any agreement, scheme, settlement, transaction, trust or understanding, whether it is legally enforceable or not.

Second, if there is such an arrangement, has a ‘relevant third person’ taken a ‘relevant step’? A relevant third person takes a relevant step if the person:

• pays a sum of money, transfers an asset, or grants a lease which is likely to have an effective duration exceeding
• 21 years; and
• does so in favour of a ‘relevant person’.

Third, is that ‘relevant step’ connected with the arrangement in question? If the answer is no, then Part 7A does not apply.

Step 3. Do any of the exclusions apply?

If an arrangement has met the conditions in s 554A, that does not necessarily mean that it has given rise to a charge to income tax under ITEPA 2003, Part 7A.

Part 7A does not include a test based on the purpose of the arrangements. This means the charge under Part 7A is not limited to arrangements set up for the purpose of avoiding income tax.

Instead of a test based on the purpose of the arrangements, Part 7A has a number of specific exclusions. These exclusions cut down the scope of Part 7A considerably. For example, there is an exclusion whereby no step taken under a registered pension scheme can give rise to a charge to income tax under Part 7A.

Advisers will want to familiarise themselves with the guidance so that they can understand where a transaction or arrangement may give rise to a charge to income tax under Part 7A, but some examples are shown in EBT loan and Existing loan.

Pension considerations

Legislation in FA 2011 significantly reduced the annual and lifetime allowances on tax relief for pension contributions made to registered pension schemes and certain other pension schemes established outside the UK.

For pension benefits funded from 6 April 2011, the income tax charge imposed by Part 7A generally applies to pension schemes as to other third party intermediaries.

However, no income tax charge arises under Part 7A when the intermediary is a pension scheme subject to the annual and lifetime allowances. This maintains the effectiveness and coherence of the reforms to the pension tax regime.

However, the legislation recognises that employers using non-registered or unfunded schemes before 6 April 2011 were legitimately using existing reliefs.

It recognises also that before 6 April 2006 employers could provide retirement benefits through funded unapproved retirement benefit schemes (FURBS) or through non-UK schemes accepted by HMRC as corresponding to an approved pension scheme established in the UK.

As a result, the previous tax treatment of pensions and other retirement benefits paid out of rights dating from before 6 April 2011 is broadly being maintained. All pension income continues to be taxable under ITEPA 2003, Part 9 and not under Part 7A.

Lump sum retirement benefits paid out of rights built up before 6 April 2011 and not charged under Part 9 continue to be taxable as payments of PAYE employment income, but under ITEPA 2003, Part 6 Ch 2 and not under Part 7A. See the Pre-2011 lump sum rights example.

The legislation in Part 7A does not alter how double tax treaties apply to pension and other retirement income. Any payment to a non-resident individual that would previously have benefited from a double tax exemption from UK tax will continue to do so.

Part 7A Ch 3 deals with cases where an employer, instead of paying contributions straight into a pension scheme which is not subject to the annual and lifetime allowances, sets aside funds or assets to provide or secure payment of future contributions to such a scheme.

Chapter 3 does not give rise to an income tax charge unless there is an undertaking for contributions to be paid to a third party intermediary in order to fund the provision of retirement benefits by the intermediary. In these circumstances a relevant step is taken if:

• an employer earmarks assets with a view to the contributions that are the subject of the undertaking being paid; or
• an employer otherwise provides security for payment of those contributions.

An example of an employer providing security for the performance of a relevant undertaking is illustrated by Ruth’s EFRBS.

The future?

HMRC recognised that a piece of legislation that is as wide-ranging as Part 7A was likely to generate comment and debate. However, the scale of the threat to the UK tax base was significant and the schemes involved were complex and growing in number.

HMRC will continue to engage with advisers to understand any ongoing areas of concern, and will add to or revise the guidance as necessary to give as much clarity as possible.

The structure of the legislation substantially reduces the opportunities for tax avoidance in this area.

However, HMRC remain vigilant and will use the rules on the disclosure of tax avoidance schemes (DOTAS) to monitor developments and keep their assessment of the tax at risk in this area up to date. HMRC will also continue to challenge arrangements that they consider fall within Part 7A, or which attempt to escape a charge under Part 7A, but can be challenged under other areas of the Taxes Acts.

Val Hennelly is deputy director, HMRC central policy

Issue: 4322 / Categories: Comment & Analysis , Admin , Employees , Income Tax