The new legislation on 'Disguised Remuneration' and what it means for offshore trustees

On 9 December 2010, the UK Government released new draft legislation aimed at tackling arrangements involving trusts and other vehicles to avoid, reduce or defer liabilities to income tax on rewards of an employment or to avoid restrictions on pensions tax relief.
The draft legislation was subject to a consultation period which closed on 9 February and the new legislation will take effect from 6 April 2011. There are also anti-forestalling measures in effect from 9 December 2010.

On 21 February 2011, HMRC published a list of Frequently Asked Questions (FAQs) following comments received during the consultation period. The FAQs can be found at
www.hmrc.gov.uk/budget-updates/disguised-remuneration-faqs.pdf.
This note sets out a short summary of the new legislation and highlights the areas of concern for trustees and scheme administrators.
1. Employment income through third parties – draft legislation
1.1 Application
The proposed new legislation inserts a new Part 7A into the Income Tax (Earnings & Pensions) Act 2003 (ITEPA).
New section 554A of ITEPA sets out the requirements that must be satisfied in order for Part 7A to apply to an 'arrangement'. The new legislation can apply if:
a. a person is an employee, or a former or prospective employee, of another person (the employer);
b. there is an arrangement (the relevant arrangement) to which the employee is a party or which otherwise relates to the employee;
c. it is reasonable to suppose that in essence the relevant arrangement is wholly or partly a means of providing rewards or recognition or loans in connection with the employee's employment (or former or prospective employment) with the employer;
d. a relevant step is taken by a relevant third person; and
e. it is reasonable to suppose that, in essence, the relevant step is taken (wholly or partly) in pursuance of the relevant arrangement or there is some other connection (direct or indirect) between the relevant step and the relevant arrangement.
The definition of relevant third person is extremely wide and includes either the employee or the employer acting as trustee of an arrangement or any person other than the employer or employee (ie a third party trustee or other intermediary). HMRC have indicated in the FAQs that they intend to narrow the definition of relevant third person so as to exclude the application of the rules to group companies and to circumstances where the relevant arrangement is directly between the employee and employer.
1.2 Relevant steps
There are three broad categories of relevant steps which can give rise to a tax charge under Part 7A:
The earmarking of a sum of money or an asset:
A tax charge can arise if a person earmarks (however informally) any sum of money or asset held by him or on his behalf with a view to a later relevant step being taken in relation to a sum or asset by him or any other person.
HMRC have expressed their view (in Spotlights 5 and 6) that at the time that funds in an EBT are allocated to an employee or to the employee's family members, those funds become earnings on which income tax and national insurance contributions are due and should be accounted for by the employer.

FEBRUARY 2011
Whilst practitioners have expressed scepticism at this in the past, the introduction of the concept of 'earmarking' now puts the position beyond doubt.
It was originally understood that HMRC took the view that income or capital gains realised on earmarked funds should be treated as further earmarking of funds for the beneficiary. However, in the FAQs HMRC have confirmed that the administrative difficulties that this would create would be disproportionate and have confirmed their intention to amend the legislation so that the accrual of income and gains will not, in itself, be further earmarking. However, should such funds be the subject of a 'relevant step', a tax charge will arise at that stage.
The payment of a sum or money or the transfer of an asset:
A tax charge can arise if a person:
a. pays a sum of money to a relevant person;
b. transfers the property in an asset to another person;
c. takes a step by which a relevant person acquires securities, interests in securities or a securities options;
d. makes available a sum of money or asset for use as security for a loan made to a relevant person; or
e. grants to a relevant person a lease of any premises the effective duration of which is likely to exceed 21 years.
References to a relevant person include the employee, any one linked with the employee, any person or class of people chosen by the employee and, if the person taking the step does so on the employee's behalf or at their direction, any other person.
As such, the class of people to whom a distribution can trigger a tax charge on the employee is extremely wide.
The making of an asset available to a person:
A tax charge can arise if a person, without transferring the property in an asset to a relevant person, makes the asset available for the relevant person to benefit from in a way which is substantially similar to the way in which the relevant person would have been able to benefit from the asset had the asset been transferred to the relevant person or makes the asset available for the relevant person to benefit from at or after the period of two years starting with the day on which the employee's employment ceases.
References to making an asset available include making it available in any way, however informal, and it does not matter if the relevant person either has no legal right to benefit from the asset or does not actually benefit from the asset.
In both Macdonald v Dextra Accessories Ltd [2003] and Sempra Metals Ltd v HMRC [2008], HMRC were unable to establish that payments into EBTs which were subsequently loaned to employees should be treated as emoluments. With the introduction of the new legislation, the position of such loans has now been put beyond doubt.
1.3 Pay As You Earn (PAYE)
Where Chapter 1 of Part 7A applies to a relevant step, the value of the relevant step counts as employment income of the employee in respect of their employment with the employer.
A new section 687A applies PAYE provisions to income taxable under Part 7A where the relevant step is the payment of a sum of money. Where this section applies, for the purposes of the PAYE regulations the employer is treated as making a payment of PAYE income to the employee of an amount which, on the basis of the best estimate which can reasonably be made, is the amount of the employment income.
There is a similar provision (new section 695A) for employment income where the relevant step is not the payment of a sum of money (ie where the relevant step is either the transfer of an asset or the making of an asset available).
Any payments are treated as made on the latest of the day on which the relevant step is taken, the day on which the employee's employment with the employer starts and the day 30 days after the day on which the Finance Act 2011 is passed. Should the employee not 'make good' the income tax accounted for by the employer within a 90 day period, there can also be an income tax charge on the benefit of the employer having paid the tax (ie a so-called 'tax-on-tax' charge).
However, there is no PAYE obligation on the employer if the person who takes the relevant step (whether or not a person to whom PAYE regulations apply) deducts income tax from the payment and accounts for it in accordance with PAYE regulations. It will be appreciated that whether or not a trustee has the power to make such a payment will depend on the terms of the trust instrument.

2. Considerations for trustees

2.1 First steps
Trustees of employee benefit trusts, employer financed retirement benefit schemes and other unapproved incentive plans will need to carefully consider the new legislation and to take appropriate tax and legal advice. It is anticipated that this will generally be lead by the sponsoring company.
However, trustees have overarching fiduciary duties to beneficiaries under both Jersey and Guernsey law which cannot be excluded in the terms of the trust instrument. As such, trustees will need to be pro-active when considering the necessary steps to take.
There may also be potential conflicts of interest with the sponsoring company, for instance, the sponsoring company may prefer for any tax liability to be borne by the Trust Fund as opposed to by the company itself whilst the trustees will be mindful of their duties to the beneficiaries.

2.2 Breadth of draft legislation
At present, the draft legislation is extremely widely drawn and will catch many inadvertent steps by trustees. Some of these steps were not intended to be caught and it is anticipated that the legislation will be subject to a number of amendments.
For instance, as currently drafted, a step as small as agreeing to a request from a beneficiary to invest a part of the trust fund in a specific investment could potentially be a 'relevant step'. The FAQs note that this was an unintended consequence and that the draft legislation will be amended to only apply where value leaves an arrangement in favour of an employee.
As currently drafted the legislation would also catch the use of trusts to warehouse shares for incentive schemes and the genuine deferral of remuneration (for instance, in line with the requirements of the FSA Remuneration Code). However, the FAQs confirm that the Government intends to amend the draft legislation to take such arrangements outside of the new Part 7A. It is proposed that, in order to fall outside of Part 7A, deferred awards must:
a. be subject to conditions which, if not met, will mean that there will be no possibility of the employee (or a person linked with or chosen by the employee) receiving the full reward or retaining a future entitlement to the reward;
b. specify a date for vesting of the reward which must be at most five years from the date of grant (and, if vesting does not take place within that time period, a tax charge will arise unless there is no possibility of the employee receiving the reward);
c. be such that if it is provided on or before the vesting date, it will be chargeable to tax as employment income; and
d. the deferral or avoidance of tax must not be the main purpose, or one of the main purposes, of entering into the arrangement.
At present registered pension schemes, approved SIP, SAYE and CSOP schemes and EMI option schemes are excluded from the ambit of Part 7A and it is anticipated that there will be further carve-outs to exempt other genuine incentive arrangements. It is also expected that there will be regulations introduced to exempt QROPS from the new legislation.

2.3 Contents of the trust deed
There will usually be provisions in the trust deed providing a mechanism for accounting for any income tax and national insurance contributions due on distributions to beneficiaries.
There will also invariably be indemnities included in the trust deed between the trustee and the employer company in relation to any employee and employer tax liabilities.
However, as these were provisions were drafted on the basis of the 'old law', the interpretation of such clauses will be crucial to the continued operation of such schemes. For instance, it is now expressly provided that a tax charge can arise even after the employment has terminated whereas previously such distributions may not have been taxable (depending on the relevant facts and circumstances).

Furthermore, there may also be powers for either the trustees or the sponsoring company to amend the terms of the trust deed. If the power is expressed to be only exercisable with the trustees consent, consideration should be given to whether or not it would be in the interests of the beneficiaries to exercise the power. It may prove necessary to amend certain arrangements to ensure that they fall within some of the exemptions from Part 7A, for instance, for genuine deferral arrangements.

2.4 Window of opportunity
Lastly, there is a small window between the publication of the draft legislation and it taking effect on 6 April 2011. During this period, the anti-forestalling legislation contained in paragraphs 47 to 52 of Schedule 1 to the Finance Bill 2011 will apply.
However, the anti-forestalling provisions (as currently drafted) are less extensive than the new legislation which will take effect from 6 April 2011 and there may be opportunities for employers, trustees and beneficiaries to restructure arrangements in this period.