Complex bonus arrangements struck down by Tax Tribunal
11 January 2011
The First-tier Tax Tribunal recently considered whether a tax avoidance scheme designed to reduce or eliminate tax on bonuses was effective or not.
The scheme was designed to take advantage of the "restricted securities" legislation contained in Chapter 2 of Part 7 of the Income Tax (Earnings and Pensions) Act 2003. The analysis of this legislation is of historic interest, because anti-avoidance provisions subsequently introduced would now make the scheme ineffective. However, the decision also contains obiter comments on tax avoidance which may be of more general relevance.
In broad terms, the scheme involved sums which would otherwise have been paid as cash bonuses being received through allocations of shares which could be sold or redeemed for cash. Cash bonuses would have been subject to income tax at 40%, employee NICs and 1% and employer's NICs at 12.8%. By contrast, if the scheme had been successful, a capital gain realised on sale or redemption of the shares would have been subject to tax at 10% and would not have been subject to tax at all for certain employees who had become non-resident by the time of disposal.
Normally, an allocation of valuable shares to an employee would give rise to income tax and NICs on the value of the shares. As a general rule, however, there is no charge on acquisition if the shares are "restricted securities" (broadly, securities whose value is reduced by restrictions, such as good/ bad leaver provisions) and the restrictions will fall away within five years. Such securities are usually subject to income tax on disposal, although there are exemptions.
The scheme sought to rely on these provisions to avoid the charge to income tax. The shares were held on terms that they would be forfeited for 90 per cent of their market value if within three weeks of allocation the FTSE 100 index rose by more than 6.5%. It was argued on behalf of the company that:
- The forfeiture condition made the shares restricted securities. The definition of "restricted securities" specifically includes securities which are held on terms that they will be forfeited for less than market value if certain circumstances arise. The forfeiture condition was a realistic possibility (it had been deliberately set at this level to give a 5-10% probability of occurring).
- Since the restriction would fall away within five years, there was no charge to income tax or NICs on acquisition of the shares.
- On disposal of the shares, one of the exemptions from the charge to income tax applied. Broadly speaking, there is an exemption for shares in employee-controlled companies. The shares were shares in a special purpose vehicle (SPV) – i.e. a company specially set up just for these purposes – which was controlled by employees.
- In consequence, any profits realised by the employees were not subject to income tax and NICs: the profits were subject to tax (if at all) at the lower capital gains tax rates.
In parallel, the company entered into hedging arrangements for the employees’ benefit to prevent them suffering excessive loss if the forfeiture condition was triggered.
The First-tier Tax Tribunal held that:
- The shares were not "restricted securities," because although they would be forfeited if certain circumstances arose, the amount payable to the employees on forfeiture would not be less than their market value. While there was a modest chance that the shares could be forfeited for 90% of their market value, the court also took into account the parallel hedging arrangements, which had the effect that the employees would receive (almost) a full price either way.
- Since the shares were not restricted securities, a liability to income tax and NICs on the shares’ full value arose when they were acquired.
- Had the shares been restricted securities, the scheme would still have failed. Under anti-avoidance case law, the court was entitled to construe the legislation purposively and to take a realistic view of the facts. On a realistic view of the facts, the employees were receiving cash bonuses, and so should be subject to income tax and NICs on those bonuses in the normal way.
Clearly, the Tribunal’s verdict will be welcomed by HMRC and accords with the current public mood of hostility towards tax avoidance and resentment of large bonuses.
In strict legal terms, the decision appears to be muddled in places. In particular, the Tribunal’s interpretation of judicial anti-avoidance principles seems to go beyond the authority of previous judgments. With this in mind, and given the substantial sums of money at stake, the decision may well be appealed. In the current political climate, however, it is likely that the taxpayers will struggle to persuade a higher court to overturn the decision.