Employee bonus schemes involving forfeitable shares
The first tier tax Tribunal has recently ruled in favour of HM Revenue & Customs (“HMRC”) on the tax treatment of an employee bonus scheme involving forfeitable shares. The bonus scheme followed a structure which was relatively common before anti-avoidance legislation was introduced in 2004.
Under this bonus scheme, rather than paying cash, the employer awarded shares in a special purpose vehicle (“SPV”) to its employees which could be sold for cash very shortly afterwards under arrangements funded by the employer. As a result, employees effectively received their annual bonus but with much more favourable tax treatment than an outright cash payment from the employer.
The scheme sought to take advantage of a number of gaps which were at that time perceived to exist in the system for taxing employee receipts as employment income.
In this and other cases:
•Payments made by the employer into the scheme (including, for example, to an employee trust) did not give rise to a tax charge on any particular individual so long as they were not allocated to any particular employee, although an earlier tax charge could arise in the case of guaranteed bonuses;
•The payments into the scheme were used by the employer (sometimes via an employee trust) to acquire shares in an SPV;
•The employer then awarded those shares to employees subject to forfeiture restrictions. Providing the shares were “forfeitable” there was no tax charge on the employees receiving these shares;
•The schemes then differed in how they enabled employees to receive value from the shares in a way which did not incur income tax. In some schemes, employees received high dividends on the shares which were then cancelled for a nominal sum. However, in this particular scheme, shares could be sold by employees for an amount which was effectively equal to the bonus it was intended they should receive. It was argued that the gain was not subject to income tax because, as the employees were not employed by the SPV and the SPV was not controlled by their employer, they could rely on an exemption contained in the legislation. Any proceeds would instead be taxed as a capital gain. For certain employees who were non-UK ordinarily resident or domiciled, the proceeds would possibly be free of UK tax altogether because the SPV was incorporated outside the UK.
However, one of the difficulties with this type of scheme was that if any of the steps gave rise to an income tax charge on the value of the shares, the whole scheme failed.
Decision – were the shares forfeitable?
This case principally addressed whether the shares awarded by the employer were “forfeitable” so that no income tax charge arose when the shares were awarded by the employer. In tax terms, “forfeitable” means the employee can be required to sell his shares at less than market value if certain circumstances do or do not arise.
In many schemes the forfeiture provision required employees to sell their shares for considerably less than their market value if they left in say a two week period after the award was granted but before the shares were sold. However, in this scheme such a provision was not possible for commercial reasons, which may in retrospect have been regrettable. The forfeiture provision in this scheme required that employees must sell their shares if the FTSE 100 index rose above a certain level at any time during a three-week period but would only receive 90% of the market value of the shares in consideration.
On the particular facts of the case, the Tribunal appears to have held that on its own this feature would indeed have made the shares forfeitable and so avoided an upfront income tax charge on the employees being awarded the shares. The Tribunal noted that the legislation does not require the restriction to be employment-related – so it was acceptable for the restriction to relate to the movement in the FTSE 100 index – and that the short period of time over which the restriction applied did not of itself prevent it being treated as a restriction.
However, the scheme was structured so that the SPV hedged the difference with commercial options so that, if the forfeiture provisions were triggered, the employee could be compensated for the remaining 10% of value that they had not received for their shares. The Tribunal found that this was a central part of the scheme and that even though employees could receive less than market value for their shares if the forfeiture provision was triggered, this was not the only amount they could receive. In practice they would always receive an amount equal to the market value of their shares albeit from an alternative arrangement. As a result, the shares were not forfeitable within the meaning of the legislation and an income tax charge arose when the shares were awarded to employees.
However, more worrying is that the Tribunal held that even if the scheme had worked technically, it would have ruled that the Ramsay doctrine, which sees through artificial steps, would have allowed HMRC to tax the awards of shares as cash payments anyway. This part of the judgment will be of concern to all advisers who have put in place elaborate remuneration schemes for employers, although real commercial features (such as leavers losing shares) may well be a distinguishing feature from this case.
In practice, schemes like this one were mostly blocked by anti-avoidance legislation announced in 2004 as part of a tougher tax environment, although there are still a large number of bonus schemes like this whose tax treatment is outstanding, where HMRC’s resolve will no doubt be fortified by this judgment.
This article first appeared in Law-Now, CMS Cameron McKenna's free online information service, and has been reproduced with their permission. For more information about Law-Now, please go to www.law-now.com.