Disguised remuneration – overview
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HMRC has, for many years, sought to ensure that the rewards gained from employment are properly subject to income tax and national insurance contributions (NIC) deducted by employers through the pay as you earn (PAYE) system. By contrast, employers have sought to use increasingly innovative ways to structure remuneration by using employee benefit trusts (EBTs) and other vehicles to avoid, defer or reduce income tax liabilities.
The disguised remuneration (DR) legislation introduced in the Finance Act 2011 was a warning to employers and promoters of tax avoidance schemes that the use of EBTs and other contrived remuneration structures to avoid, defer or reduce income tax liabilities would be strongly challenged. Publication of the draft legislation in December 2010 was met with extensive criticism in light of its wide-ranging nature and its potential for catching innocent arrangements that did not involve tax avoidance. Following a series of amendments to the draft rules, ITEPA 2003, ss 554A–554Z21 (Pt 7A) (containing legislation known as the 'DR rules') was enacted which aimed at curbing such planning. The rules targeted the provision of loans and other forms of benefits by third parties, as well as certain arrangements which provide pension rights in excess of the annual and lifetime allowances applicable to registered pension schemes.
Guidance on ITEPA 2003, ss 554A–554Z21 (Pt 7A) is contained in the Employment Income Manual starting at EIM45000.
However, the Government confirmed at Budget 2016 that a further package of measures would be introduced to tackle the ongoing use of DR avoidance schemes. These were the subject of a technical consultation (which closed on 5 October 2016) on provisions to be introduced in the Finance Bill 2017. However, as a result of the Finance Act 2017 being fast-tracked through Parliament in advance of the 8 June general election, a number of the measures were dropped but were introduced in Finance (No 2) Act 2017.
Finance Act 2018 includes a number of further measures, including a new close company gateway. This measure was announced in 2016 but its implementation had previously been delayed.
The Act also includes provisions for a new DR charge where arrangements are funded as a result of an employee's 'redirected earnings' following the decision in the Supreme Court in the Rangers case (RFC 2012 plc (in liquidation) (formerly Rangers Football Club plc) v Advocate General for Scotland  UKSC45,  4 All ER 654).
In its final report on unapproved employee share schemes published in January 2013, the Office of Tax Simplification recognised the challenges for companies operating EBTs in light of the rules. It recommended (see para 6.38) a detailed review of ITEPA 2003, ss 554A–554Z21 (Pt 7A) to simplify its language, reduce its length and make it more accessible, although now seems unlikely given the further changes to the rules, which have resulted in an even more complex piece of legislation.
When do the rules apply?
The legislation applies where:
- there is an arrangement which relates to an existing, former or prospective employee or a 'relevant person' linked to the employee. Employee for these purposes covers non-executive directors and office holders. The definition of a person linked with the employee is broad, and covers any person who is, or has been, connected with the employee (this includes spouses and co-habitees) as well as family members and any company controlled by the employee (ITEPA 2003, s 554A(1)(a)–(b); ITA 2007, s 993);
- the arrangement is, 'in essence', wholly or partly a means of providing rewards, recognition or loans in connection with employment. The use of terminology such as 'rewards' and 'recognition' are new to tax legislation and are not defined in ITEPA 2003, ss 554A–554Z21 (Pt 7A), so their meaning currently remains untested (ITEPA 2003, s 554A(1)(c));
- the 'relevant third party' operating the arrangement takes a 'relevant step' (ITEPA 2003, s 554A(1)(d));
- it is reasonable to suppose that, in essence, the step is taken pursuant to the arrangement or there is some other connection (direct or indirect) between them (ITEPA 2003, s 554(1)(e)). The definition of 'arrangement' is extremely wide and covers an 'agreement, scheme, settlement, transaction, trust or understanding'. Informal arrangements which are not legally binding are also caught, including those that the employee may not have agreed to, or even been made aware of. (ITEPA 2003, s 554Z(3).)
When the legislation applies (referred to by HMRC as 'passing through the gateway'), the value of the cash or assets that are the subject of the 'relevant step' is treated as employment income and is subject to income tax and NIC under PAYE. This is the case even where the assets are not 'readily convertible' for the purposes of the PAYE rules. The value is broadly the amount of the sum of money or the market value of the assets, or in certain circumstances, the cost of the step if higher. (ITEPA 2003, ss 687A, 695A; SI 2003/2682, regs 62, 69.)
The employer is responsible for operating PAYE in respect of the best estimate of the value of the relevant step unless the third party operating the arrangement has already done so. The time scales for withholding are short. The tax is payable within 17 days of the end of the tax month in which the relevant step occurs if the employer accounts for tax electronically and 14 days in other cases.
See EIM11813 for HMRC's guidance on the PAYE implications of the DR rules.
In many cases, the employer will be unable to recover the tax and NIC from the employee by deduction. Unless the employee makes good to the employer, the amount of tax withheld on his behalf within 90 days of the end of the relevant tax year, there is a further tax charge on the employee with the tax paid on their behalf being treated as earnings. (ITEPA 2003, s 222.)
However, Finance Act 2017 introduced provisions which permit the payment of tax from funds held in an ITEPA 2003, ss 554A–554Z21 (Pt 7A) arrangement. The payment of the tax (which includes income tax, NIC, inheritance tax and corporation tax) is not treated as a relevant step if made subject to an agreement with HMRC. (ITEPA 2003, s 554XA.)
The NIC liability on the value of the relevant step only applies to steps made on or after 6 December 2011, as this was the effective date of the relevant amendment to the NIC rules. (SI 2001/1004, reg 22B.)
The extension of the rules to include a new gateway for close company arrangements where the main purpose is the avoidance of income tax, NIC, corporation tax or the charges under the loans to participator rules is intended to operate in a similar way to the existing gateway and applies where the individual has a 'material interest' in a close company which enters into a 'relevant transaction'. Relevant transactions are similar to 'relevant steps' – such as the payment of a sum or asset, the making or release of a loan and the making of an asset available.
In many cases DR arrangements implemented by close companies would already have been within the scope of the DR rules, so this extension does not widen the scope of the legislation as much as it might first appear. Its main purpose is to prevent owner directors of close companies arguing that they received DR-type benefits from their companies in their capacity as shareholders rather than employees.
Provisions are included to exclude transactions which could fall within both ITEPA 2003, ss 554A–554Z21 (Pt 7A) and the loans to participator rules in CTA 2010, ss 455–464B (Pt 10, Ch 3, Ch 3A) to avoid instances of double taxation. There are also draft amendments to deal with the interaction of the 2019 Loan Charge provisions (see below).
In general terms, contributions to employee trusts do not qualify for corporation tax relief until 'qualifying benefits' are paid in a form that gives rise to employment income and NIC (subject to a number of exceptions). The definition of 'employee benefit scheme' in CTA 2009, s 1291 includes 'relevant arrangements' in ITEPA 2003, s 554A and the definition of 'qualifying benefits' in CTA 2009, s 1292(6A) includes 'relevant steps' under ITEPA 2003, ss 554A–554Z21 (Pt 7A). This means that a corporation tax deduction potentially becomes available when and to the extent that there is a charge under the DR rules. However, to create a further disincentive for DR schemes, Finance (No 2) Bill 2017 amended CTA 2009, s 1290 to restrict deductions for contributions made on or after 6 April 2017 in two ways:
- a deduction for an employee benefit contribution will be permanently disallowed if qualifying benefits are not provided out of the contribution within five years of the end of the period of account in which the contribution was made; and
- no deduction is available unless income tax and national insurance contribution liabilities in respect of benefits provided from the contribution are accounted for within 12 months of the end of the period of account. (CTA 2009, ss 1290–1296.)