Those involved in administering employee benefit trusts and employee share plans have had a roller-coaster ride over the last few months due to the publication of complex draft tax legislation containing the disguised remuneration rules on 9 December 2010. Even though a broadly satisfactory position has now been reached, some concerns remain. It is hoped that these will be relieved by the publication of further guidance by HMRC.
Those involved in administering employee benefit trusts (EBTs) and employee share plans have had a roller-coaster ride over the last few months considering "disguised remuneration". This was due to the publication of complex draft tax legislation on 9 December 2010 (the original draft), which prevented remuneration and loans channelled through third parties, such as EBTs, avoiding income tax and National Insurance contributions (NICs).
Concern increased when the tax charging regime took effect on 6 April 2011. The draft legislation (to be a new Part 7A of the Income Tax (Earnings and Pensions) Act 2003) had been substantially revised (the March redraft) when it became part of the formal legislative process in the Finance (No 3) Bill 2011 (the Bill), but the exemptions and HM Revenue & Customs (HMRC) FAQs were still unclear, and the evolving position left companies extremely exposed. Companies were at risk of PAYE (pay-as-you-earn) charges if they did not comply with whatever the final terms of the legislation turned out to be.
The resulting confusion finally culminated in 88 amendments to the Bill being agreed on 19 May 2011 (the May amendments). Even though a broadly satisfactory position has now been reached, some concerns remain. It is hoped that these will be relieved by the publication of further guidance by HMRC, although this is not expected until some point in July 2011.
The key concern for quoted companies has been the targeting by the disguised remuneration legislation (the legislation) of "earmarking". This is where an EBT earmarks, however informally, a sum of money or an asset for an employee with a view to paying that money or transferring the asset at a later stage, even if the details have not been worked out (for more information, see Briefing "Disguised remuneration: is there still a future for employee benefit trusts?", www.practicallaw.com/0-504-8803).
While the legislation is primarily meant to target tax avoidance schemes used in private companies, the mere possibility of an employee receiving shares from an EBT under any employee share plan award may be enough to trigger an earmarking charge, unless a specific exemption applies. Any charge would normally be on the full value of the shares an employee might receive, with penalties arising for non-compliance.
This is irrespective of other income tax legislation, which prevents an upfront tax charge on the grant of an award, and generally only imposes a tax charge as and when there is an actual receipt of shares.
Attention has therefore focused on exemptions from the earmarking charge. Following the May amendments, it is hoped that the final legislative position on the main exemptions from earmarking, supplemented by expected HMRC guidance, will be as follows:
Who has to make the award? In the original draft, there was only an exemption if the employing company made the relevant award. In practice, most awards are made by a parent company in a group or by an EBT itself, not by the employing company. Following the May amendments, the award can now be made by any person.
Length of award. Both the original draft and the March redraft limited non-HMRC approved share awards to five years in most cases (although market value options could also benefit from relief under another exemption). This contrasts with general employee share plan practice which, for some time, has been to have ten-year awards.
The May amendments now allow ten-year awards, other than for cash, and so no changes to general practice are now needed.
Terms of award. Under the legislation, an award must be made before, or within three months after, the earmarking. The employee must also generally only receive the shares on a stated date if predetermined conditions have been met. However, in earlier drafts, there was no express provision for common terms in share schemes that allow shares to be received earlier on the employee leaving as a "good leaver", for example, or on a change of control, and also for conditions to be waived in other cases.
In a quoted company context, these terms would only be drafted within the framework of corporate governance guidelines and, in any event, any shares received early would be subject to income tax and NICs (unless specifically provided for under various HMRC-approved schemes), and so should have been of little concern to HMRC.
While the May amendments and informal HMRC guidance now appear to allow companies the ability to draft leaver and other early vesting terms flexibly, much still awaits HMRC's revised public interpretation of what is a "reasonable chance that the conditions will not be revoked" when the award is made.
Cashless exercise. The original draft caused a tax charge if employees exercising options did not pay their exercise price upfront, but most employees simply do not have access to ready cash to do this. The March redraft gave a very short-term exemption for loans from EBTs and others (for example, brokers) to meet exercise price liabilities (increased by the May amendments to 40 days). More importantly, it also allowed for payment to be made at or around the time of the receipt of shares, which means that employees can enter into simpler deferred funding arrangements with EBTs themselves without a tax charge.
The net result here has been helpful: most cashless exercise arrangements should not now need to change.
HMRC-approved plans. While the original draft purported to give exemptions for the operation of approved plans, these were narrowly drawn. In the March redraft, funding could only come from the company that set up the scheme, not another company in the group, as is often the case. The May amendments have addressed this point, but some others remain, including the "overstocking" issue (see below).
Overstocking. Various exemptions only apply to the extent that an EBT holds no more shares than it reasonably needs. This prevents EBTs having excess funds which can be used for anti-avoidance activity. The key problem is that the legislation still measures this on an award-by-award basis (or scheme-by-scheme basis in the case of HMRC-approved plans), whereas companies look at the overall number of shares they need.
HMRC has informally indicated that it will allow companies to assess these tests on a reasonable basis. It is hoped that companies will not have to conduct regular checks, for example, and that HMRC will only be concerned with cases of blatant tax avoidance.
Since the original draft was published, most companies have simply relied on the legislation being amended to allow them to operate as usual, although this was a slightly risky approach that did not appeal, or was not available, to all. Clients have often been incredulous that the legislation has given rise to these issues.
Other companies delayed asking their EBTs to take any action, some used employing companies rather than EBTs to make awards and satisfied those awards through issuing shares or using treasury shares (because no third party would be involved), and some even suspended making awards altogether.
Advisers were cautious of even sending letters of recommendation or wishes to EBTs, or notifying EBTs of awards that had been made. Some EBTs were concerned about taking any action without a specific indemnity from the company. Awards were also shortened to five years in an attempt to comply with the legislation.
For a number of companies, however, delay has not been possible. Definitive positions have had to be taken on transactions, with risks apportioned between buyer and seller.
Most of that caution now seems unnecessary following the May amendments, although much still hangs on the final HMRC guidance.
On a final note, the entire legislative history of this measure reveals serious defects in HMRC's ability to implement satisfactory anti-avoidance legislation in a wider commercial context. HMRC had been working on addressing abuse in this area for some time before the original draft. Since then, repeated descriptions of how employee share plans operated in practice were provided by various employer and practitioner groups. Given this, it is particularly disappointing that the exemptions drafted in response by specialists (supposedly familiar with employee share plans and purporting to cover industry and remuneration practice) have not reflected this input.
Also, the May amendments were provided just four days before they were due to be debated in Committee. The lack of time properly to assess reaction was noted in Committee, and there was also a general dissatisfaction with the length of the legislation and its scatter-gun approach. A more modern way of processing legislation would at least simultaneously provide a track-changes version to show amendments.
Even where the primary legislation remains inadequate, the Exchequer Secretary has said that no further amendments will be made. Instead, secondary legislation will be used to make necessary changes, which is unsatisfactory in itself. It is more likely that HMRC's guidance will be used to disclose the intended position, despite the Supreme Court's criticism of the use of guidance to compensate for poor drafting or fill gaps in the legislation in Gray's Timber v HMRC [2010] UKSC 4. Indeed, even with the May amendments and revised guidance, it is likely that disguised remuneration issues will still surface for some time to come.
All in all, the only benefit that can come out of this tortuous exercise is a conclusion that a better solution is badly needed to how such a wide-ranging piece of legislation can be properly drafted and implemented, yet not impede normal commercial activity in the interim.
Nicholas Stretch is a partner and head of employee incentives at CMS Cameron McKenna LLP.
The Explanatory notes to the relevant amendments made in May 2011 to the Finance (No 3) Bill 2011 are at www.hm-treasury.gov.uk/d/financebill2011_amendments_10_to_94_and_104.pdf.
PLC will be publishing an article by CMS Cameron McKenna on the impact of the disguised remuneration legislation on pension schemes in our September issue.