Bonuses paid as dividends were not taxable as employment income, but were subject to national insurance contributions

Practical Law UK Legal Update 3-386-4668 (Approx. 7 pages)

Bonuses paid as dividends were not taxable as employment income, but were subject to national insurance contributions

by PLC Share Schemes & Incentives

Background

Cash bonuses paid to employees are treated as employment income, and are subject to income tax and employee and employer national insurance contributions (NICs), both payable through PAYE. If the recipient is a higher rate taxpayer, and is over the upper earnings limit for NICs, he will currently pay income tax on the bonus at 40%, and primary class 1 (employee) NICs at 1%. The employer will also be liable for secondary class 1 (employer) NICs, currently at 12.8% (although the employer will be entitled to deduct the cost of providing the bonus from its taxable profits). (Employer NICs on a cash payment cannot be reimbursed by or transferred to the employee, unless the payment is for the release of a right to convert a security, or the release of a securities option.)

By contrast, an individual receiving a dividend or other distribution from a UK company:

Receives a 10% tax credit on the grossed-up amount of the dividend.
If he is a higher rate taxpayer, pays tax on the grossed-up dividend at 32.5%.

Accordingly, with the 10% tax credit, the effective rate of tax on dividends for higher rate taxpayers is 25%. If the individual is not a higher rate taxpayer (and is not pushed over the basic rate threshold (£37,400 for 2009-10) by the dividend), there is no tax to pay on the dividend. There is generally no liability to NICs on dividends. However, dividend payments cannot be deducted from a company's taxable profits.

The difference between the tax rates for employment income and dividends means that companies have long sought to convert employment income into income taxable only as dividends. In the recent case of PA Holdings Ltd & Anor v Revenue & Customs [2009] UKFTT 95 (TC), the Tax Chamber of the First-tier Tribunal (Tribunal) (the successor to the Special Commissioners) considered whether these types of arrangements are successful.

Facts

PA Holdings Limited (PA), a multi-national, employee-owned consulting business, operated a discretionary bonus arrangement for its staff and for some years paid out cash bonuses through an offshore employee benefit trust (EBT). In 1999, with the assistance of Ernst & Young, PA put in place a bonus planning arrangement to re-route bonuses so that they were paid as dividends of a UK resident company and taxed as distributions. The steps involved for bonuses for the calendar year 1999 (also PA's accounting period), paid in the tax year 2000/01, were as follows:

PA established a new offshore EBT in December 1999.
PA paid £24,600,050 to the trustee of the EBT in December 1999. The payment represented amounts to be used to pay staff bonuses for the 1999 accounting year.
The trustee established a "restricted share plan" for the purpose of making awards to employees of PA in January 2000.
The trustee incorporated a company, Ellastone Limited (Ellastone), which was registered in Jersey.
Ellastone then became UK resident, when UK resident directors (senior employees of PA) were appointed to the board.
PA then gave its employees a choice as to whether to receive discretionary bonuses for 1999 through the normal route (cash from the earlier EBT) or from the new EBT.
In February 2000, the trustee transferred most of the funds provided by PA to Ellastone as a capital contribution and was allotted 24 million 1p redeemable preference shares in Ellastone.
In March 2000, the trustee directed that the redeemable preference shares should be registered to another company, Juris Limited (Juris), also established by the trustee and resident in Jersey, as nominee for the trustee.
On 13 March 2000, the trustee granted awards to employees of PA over shares in Ellastone under the restricted share plan, and directed that the nominee, Juris, now held the shares as nominee for the relevant employees.
On 24 March 2000, Ellastone declared a dividend of 99p per preference share, funded from the capital contribution by the trustee. The total dividend was therefore £23,760,000. The company and trustee expected this to be taxable as a dividend rather than a cash bonus and held back 25% of the dividend payments on that basis (although there is no withholding requirement for dividends, the trustee presumably wanted to help employees budget for the tax that would become due).
The dividend was paid to the nominee, Juris, on 28 April 2000. Juris then transferred the dividend payments to the employee award holders.
In 2001, Ellastone redeemed the preference shares. The redemption monies were paid to Juris, which distributed them to the relevant employee award holders in proportion to their awards, through the payroll of PA. These amounts were subject to income tax and NICs as employment income.

The same process was used for the 2000 and 2001 bonus arrangements (making use of the 1999 EBT, Ellastone and Juris).

The planned income tax and NICs savings were substantial

Assuming the employees were all higher rate taxpayers and over the NICs upper earnings limit, if the dividend payments had been subject to income tax and NICs as cash bonuses instead (as HMRC argued should be the case), the extra tax and NICs for 2000/01 alone would have amounted to:

Income tax of £23, 760,000 x (0.4 - 0.25) = £3,564,000.
Employer NICs of £23, 760,000 x 0.122 = £2,898,720 (the rate of employer NICs was 12.2% in 2000/01, rather than 12.8%, as now).
Employee NICs of £23, 760,000 x 0.01 = £237,600.

So the total tax and NICs saving in 2000/01 if the scheme had been completely effective can be estimated at £6,700,320.

Decision

The Tribunal found that:

The income tax charging provisions for distributions take precedence over the taxing provisions for employment income.
The arrangements could not be treated as a pre-ordained tax avoidance structure and so taxed differently under anti-avoidance case law.
However, there is nothing to prevent NICs from being due on a payment which is both a distribution and made by reason of the recipient's employment.

The Tribunal asked itself:

Were the sums distributions from a UK resident company?
Were the sums paid as employment income (for income tax purposes) and/or earnings (for NICs purposes)?
If the sums were both distributions and employment income/earnings, were they to be taxed as distributions or as employment income?

In answering these questions, the Tribunal held that:

The employees received the restricted share awards from the EBT, and the dividend and redemption monies from Ellastone, by reason of their employment with PA. This was because continued employment was a crucial factor in being eligible to participate in the arrangement.
The dividends were "distributions" within section 20 of the Income and Corporation Taxes Act 1988 (ICTA 1988).

The Tribunal then considered which tax charge took precedence, because, as the Tribunal noted, "one of the most important unwritten rules of income tax is that income generally can be taxed only once". It decided that the charge on distributions (Schedule F under ICTA 1988) took precedence over the employment income charge (under Schedule E of ICTA 1988), because of the unambiguous precedence provisions set out in section 20(2) of ICTA 1988. Section 20(2) provided that "no distribution which is chargeable under Schedule F shall be chargeable under any other provisions of the Income Tax Acts". There was no ability for HMRC to choose which taxing provisions it preferred on the facts of each individual case - Parliament's instructions were absolutely clear as to which taxing provisions would apply in these circumstances.

The Tribunal then considered whether there was a similar provision (or case) in relation to NICs. It found that the payments were "earnings" for NICs purposes, as well as being distributions. However, there is no statute or case law which prevents a charge to NICs on any earnings which may be charged to income tax only as a company distribution. Therefore the Tribunal held that employer and employee class 1 NICs were due on the dividend payments.

Comment

This is the first time this issue has been considered by a Tribunal (or the Special Commissioners before the Tribunal was formed). Therefore, the decision is an important confirmation that HMRC cannot determine that the employment income taxing provisions take precedence in these circumstances.

Section 20 of ICTA 1988 has now been re-enacted, but the precedence provisions set out in section 20(2) have been preserved in section 366(3) of the Income Tax (Trading and Other Income) Act 2005 and section 716A of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). As a result, this feature of the income tax legislation remains available for tax planning.

However, it seems that arrangements of the type considered in this case will no longer work, because of anti-avoidance provisions introduced (with retrospective effect) in Finance (No 2) Act 2005 - see Anti-avoidance provisions will now block similar schemes.

The fact that the Tribunal has confirmed that NICs are due on these types of arrangements may put companies off attempting similar arrangements in future. The employer NICs savings alone represented 43% of the total savings PA had hoped to secure for itself and its employees (see The planned income tax and NICs savings were substantial).

It is also possible that, having failed to convince the Tribunal that the employment income charging provisions should take priority where employment income has been converted into dividend income in an avoidance scheme, HMRC will appeal the decision or introduce legislation to change the priority of the charging provisions in cases of avoidance.

We understand that schemes like this, or variants of it, were widely used before they were blocked by statutory amendments. This decision may therefore be important to other employers who are still in dispute with HMRC over their former use of similar schemes.

Anti-avoidance provisions would now block similar schemes

Despite the name of the restricted share plan, the shares were not "restricted securities" within Chapter 2 of Part 7 of ITEPA 2003, as this had not been enacted and amended at the time shares were acquired under the plan. Instead the shares were subject to the taxation regime for shares acquired on a conditional basis, introduced by the Finance Act 1998. (This was originally set out in sections 140A to 140C and 140G to 140H of ICTA 1988 and can now be found in sections 422 - 434 of ITEPA 2003, as originally enacted. It continues to apply to shares and interests in shares acquired before 16 April 2003.)

An important feature of the conditional shares regime is that no income tax charge (other than a notional loan charge or a charge on option exercise) could arise on acquisition of conditional shares if they would cease to be only conditional within five years of acquisition (see section 426 of ITEPA 2003, as originally enacted). The arrangements put in place for PA relied on this feature, as without it there would have been a charge to income tax on the value of the restricted interests in the Ellastone preference shares when awarded to the employees, before the bulk of the value of the shares could be paid out as a dividend.

The conditional shares regime was replaced by the restricted securities regime from 1 September 2003, for securities acquired on or after 16 April 2003 - see Practice note, Restricted securities. Like the conditional shares regime, the restricted securities regime includes a provision which prevents certain income tax charges arising on the acquisition of securities, if they are subject to a forfeiture restriction which will fall away within five years - see Practice note, Forfeiture restriction lasting five years or less: exclusion of general earnings charge. However, employees can elect jointly with their employers to override this provision, or to take securities out of the restricted securities regime altogether - see Practice note, Forfeiture restriction lasting five years or less: consider an election to pay a general earnings charge and Election to be taxed up-front on unrestricted market value (and take restricted securities out of the restricted securities regime).

If arrangements like those considered in this case were to be set up now, they would need tax charges on acquisition to be deferred until after dividends could be paid. However, section 431B of ITEPA 2003 would prevent this. This section applies to securities acquired on or after 2 December 2004 and has the effect of deeming a joint election to have been made if the securities are acquired under a tax or NICs avoidance scheme, triggering an income tax charge when restricted securities are acquired based on the unrestricted market value.

Case

PA Holdings Ltd & Anor v Revenue & Customs [2009] UKFTT 95 (TC).

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