06 January 2011

HMRC and the Code

Paul McGrath
Partner | UK

Any firm that must apply the revised FSA Remuneration Code (and indeed, any firm which, while entitled to disapply Code rules, nevertheless chooses to implement some or all of them) will need to think carefully how to implement the provisions relating to the deferral of variable remuneration and the satisfaction of variable remuneration in shares or share-like instruments. Even before the Code was revised, it was not uncommon for some variable bonuses to be paid on deferred terms, such deferral providing a useful retention mechanism for key staff.

Where bonuses are deferred, employers have frequently used an employee benefit trust (‘EBT’) as the ultimate paying entity. Typically, the employer would contribute the full amount of annual bonus payments to the EBT, which would then hold such sums for a specified number of years, before paying them out to employees who remained with the company after the qualifying period. The advantage from the employee’s perspective is that, provided the employer was solvent at the time it made the contribution to the EBT, sums held within the EBT are relatively safe from attack by creditors if the fortunes of the company subsequently change for the worse. Also, to the extent that vesting of any portion of the deferred bonus is dependant upon the exercise of some person’s discretion, having an independent, professional trustee as the person exercising that discretion provides some comfort that the discretion will not be exercised unfairly against the employee should there be, for example, a change in management at the company itself.

It might be thought that the use of EBTs would increase as a result of the revisions to the Code. However, on 9 December 2010 the Government released draft clauses to be included in the 2011 Finance Bill which may put an end to the use of EBTs as vehicles for deferring remuneration.

In the past, deferred bonuses were generally only taxed when actually received by the employee, not when the employee was notified of the award or when the sums to satisfy bonuses were transferred to an EBT. If the new rules are enacted as announced, any allocation, reservation or earmarking of any sum of money or asset held by an EBT with a view to its later being paid to an employee will be taxable at the first moment of allocation, reservation or earmarking. In short, if an employer uses an EBT (or any other third party, eg a custodian or escrow agent) to warehouse deferred bonuses, it is likely that those bonuses will be taxed at or about the time the EBT receives the cash. This could be several years before the employee actually receives all or any part of the bonus. Indeed, if some or all of the bonus amount is forfeited because the employee fails to meet the vesting criteria, eg because he leaves or because the performance of the employer deteriorates, he will have paid tax on an amount he will not have received and will not be able to recover that tax from HMRC.

Unless the draft legislation is significantly amended before it is enacted, it would seem that employers would generally be ill advised to pay sums representing deferred remuneration to third parties but should instead keep these amounts within their own bank accounts. The new rules would also catch the employer acting as trustee. In fact, the rules are drafted so widely that they could be interpreted as catching any reservation of money by the employer for the purpose of paying bonuses, even if there is no actual trust created.

Another use to which EBTs have historically been put is to act as a warehouse for shares to be used to satisfy awards made by an employer under a share option scheme or long term incentive plan. Given the requirement under the Code to satisfy at least 50% of variable remuneration in shares or share-like instruments, it is likely that the use of share option and long term incentive plans will increase. That said, if the new rules on EBTs are enacted in their current form, care will need to be taken to ensure that income tax and national insurance contribution charges are not inadvertently triggered. The new rules will not catch the grant of a share option by the trustees of an EBT. However, many companies with share option plans grant the options themselves and have a separate arrangement with the EBT for it to reserve a number of shares held by it to satisfy those options. The reservation of shares by the EBT will trigger an income tax and NIC charge upon the relevant employees, even though there would have been no such charge had the grant been made directly by the EBT.

All this is unsettling as employers grapple with the implications of the Code. Withers LLP is currently liaising with HMRC in order to clarify the scope of the draft legislation and to press for changes to limit it.

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