Disguised Remuneration - Disappointing Revised Legislation
06 April 2011
Introduction
On 31 March 2011, the latest version of the "disguised remuneration" legislation was published as part of the Finance Bill and it takes effect on 6 April 2011. The legislation creates an income tax charge for an individual who is a UK taxpayer where trusts or other third parties earmark an asset, or provide a benefit, which relates to that individual's employment.
The revised legislation contains extensive exemptions for the use of trusts in association with deferred remuneration and conventional share plans. The main purpose of these exemptions is to prevent an individual having an up-front tax charge where a trust is used to hedge specific awards or options. However, these exemptions only apply to unapproved awards and options which cannot last for more than five years, which does not help 10 year options that are commonly granted.
However, updated guidance issued by HM Revenue & Customs (HMRC) says that if shares are put into an employee benefit trust to meet future requirements of a share plan, but are not earmarked in relation to specific employees, then the legislation does not apply – this is consistent with HMRC's previous guidance (see our earlier briefing). This potentially creates a way for companies to hedge 10 year options and avoid up-front tax charges for UK optionholders.
We are aware that HM Treasury is still open to changing the legislation so that conventional share plans which do not have a tax avoidance motive are not caught by the legislation. It is hoped that the various lobbying efforts, including our own, will result in getting 10 year options specifically excluded in the legislation, rather than companies having to rely on the HMRC guidance. In the meantime, we have to work with the current form of the legislation and this briefing focuses on how this legislation affects the operation of conventional incentive plans.
Actions
We have listed below some practical steps you could take with the aim of avoiding the tax charges introduced by the new legislation.
- For the grant of future incentive awards (including HMRC unapproved options), until such time as the legislation may be changed, it would be prudent for companies which wish to hedge those awards to grant them with a life of five years or less. If the legislation is relaxed then it should normally be possible under most share plan rules to extend the life of those awards beyond five years.
- Alternatively, for future incentive awards, companies may wish to rely on the HMRC guidance which states that if shares are not specifically earmarked for named individuals then the tax charges applying to the hedging of awards does not apply. So, by adopting a hedging strategy which does not connect a particular purchase of 1 shares with a particular award or option, the new tax charge can be avoided. However, this approach relies on HMRC guidance which could change as the legislation, and its implementation, evolves.
- For awards and options already granted and whose potential life is longer than five years, if those awards are already hedged then that would appear to avoid the legislation, because it only comes into effect on 6 April 2011. However, changing the basis on which the hedged shares are held, such as from being generally available to satisfy awards to being available only to satisfy a particular award, could trigger a tax charge under the legislation. Where existing awards and options have not yet been hedged then it would appear that either their life must be shortened to five years in order to hedge them specifically, or, by relying on HMRC guidance, they are hedged in a non-specific manner. Given that the legislation may change, it might be better for companies to delay hedging existing awards which can last longer than five years, where they can, until the legislation is finalised. The Finance Bill is expected to receive Royal Assent in July 2011 but should be in final form before the end of June 2011.
- If the trustee of your employee benefit trust (EBT) usually grants unapproved awards and you want to take advantage of the specific share plan exemptions, consider changing the arrangement so that a group company grants the awards instead. This is because the share plan exemptions are not drafted to include trustee grants.
- Consider using new issue or Treasury shares to satisfy awards if the share plan allows the use of those shares and it is commercially practical to do so. This avoids the legislation completely.
- Consider using market purchase shares acquired at the time of exercise so that there is no hedging. However, this approach may turn out more expensive than adopting a hedging strategy.
Background
The intention of the disguised remuneration legislation is to impose a tax charge on an individual who is a UK taxpayer if a trust or similar vehicle takes any one of a number of steps which relates to providing a reward, recognition or loan in connection with that individual's employment. In brief, those steps are: the earmarking of an asset for the individual; payment of a sum or asset to the individual; providing a loan, or security for a loan, to the individual; or making an asset available to the individual in a way as if that individual owned it.
The scope of the original legislation was very wide and could have caught the use of trusts with conventional share plans, as well as sub-trust and loan arrangements at which the legislation was targeted. One of the problems with the original draft legislation was that it could create an up-front income tax charge for UK participants in conventional unapproved share plans. This tax charge would arise if and when an EBT was funded, or purchased shares, to satisfy specific awards or options and those funds or shares could be said to be "earmarked" for a particular individual. The revised legislation has extended this provision so that it also applies where money, shares or other assets are being held specifically with a view to satisfy share awards. However, as described below, a number of exemptions for incentive plans and deferred remuneration have been introduced. In addition, as mentioned above, HMRC guidance has stated that if shares are put into an EBT to meet the future requirements of a share plan but are not earmarked in relation to specific employees then the legislation does not apply.
The actual transfer of shares by an EBT to satisfy awards and options will not generate a tax charge under the new legislation because normal tax rules impose a tax charge at that time anyway and these will apply instead. A similar approach is taken with the provision of forfeitable shares and other employment-related securities which are covered by long-standing specific tax rules.
The incentive plan exemptions
HM Treasury has tried to respond to many of the criticisms of its original legislation by introducing exemptions relating to incentive plans into the revised legislation. These are summarised below.
Hedging of unapproved share awards
An exemption from a tax charge on the earmarking of money or shares for an unapproved share award applies if the awards and the earmarking of shares satisfy various conditions, the main ones of which are as follows:
- under the terms of the award, the shares are to be received by an individual on a specified date (the vesting date) which is not more than five years after the award date – HMRC guidance indicates that early delivery of shares, such as in the case of "good leavers" and takeovers, is acceptable;
- the vesting of the award must be subject to conditions and there must be a reasonable chance, as at the award date, that the conditions will not be met and, consequently, the award will lapse (in whole or in part) – HMRC guidance indicates that "good/bad leaver" rules will satisfy this requirement;
- vesting on or before the end of the vesting date must result in an income tax charge for the individual;
- the number of shares earmarked must not exceed the maximum number of shares which might reasonably be expected to be needed for satisfying the award; and
- there is no connection between the earmarking and a tax avoidance arrangement.
This exemption also applies to the hedging of phantom awards where cash is paid on vesting, based on the value of the shares at that time, and to earmarking within 3 months before the grant of an award.
Hedging of deferred remuneration
There is an exemption for the earmarking of money or shares for an award of deferred remuneration. This has similar requirements to those described above for share awards. The main additional requirements are:
- if the remuneration was provided to an individual on the award date, instead of deferred, then it would be subject to income tax; and
- the earmarked money or assets must represent the deferred remuneration and nothing else.
Hedging of unapproved options
The exemption from a tax charge on the earmarking of money or shares for an unapproved share option has similar requirements to those described above for a share award but with some additional requirements to reflect the option structure. The main requirements of the exemption are as follows:
- under the terms of the option, the option must not become exercisable until a specified date (the vesting date) which must not be more than five years after the grant date – HMRC guidance indicates that early exercise and delivery of shares, such as in the case of "good leavers" and takeovers, is acceptable;
- the vesting of the option must be subject to conditions and there must be a reasonable chance, as at the grant date, that the conditions will not be met and, consequently, the option will lapse (in whole or in part) – HMRC guidance indicates that "good/bad leaver" rules will satisfy this requirement;
- the option must be exercised before five years have elapsed from the date of grant and the exercise must result in an income tax charge for the individual;
- the number of shares earmarked must not exceed the maximum number of shares which might reasonably be expected to be needed for satisfying the option; and
- there is no connection between the earmarking and a tax avoidance arrangement.
Again, this exemption also applies to the hedging of phantom options where cash is paid on exercise, based on the value of the shares at that time, and to earmarking within 3 months before the grant of an option.
Hedging of phantom awards in non-listed companies
There is another exemption from a tax charge on hedging which is similar to those above but applies where a non-listed company hedges phantom awards by placing some of its shares in an EBT. While there is no time limit on the vesting of these awards, the vesting can only occur on an IPO or a sale of the company. The fact that this exemption is limited to phantom awards and requires them to be cashed out on an IPO limits the usefulness of this exemption.
Approved share plans
The original legislation exempted steps taken under HMRC approved plans, including EMI options, from the legislation. The revised legislation has extended the scope of this exemption by specifically exempting arrangements involving the holding and delivery of shares by EBTs for the purposes of an approved share plan. However, the number of shares which can held by the EBT for this purpose must not exceed the maximum number of shares which might reasonably be expected to be required for that purpose over the following five years.
Cashless exercise
The legislation creates a tax charge for many types of employee loans. However, the revised legislation contains an exemption for short-term loans made to facilitate the exercise of share options. The loan must be repaid by the sixth day of the month following the month in which the loan is made.
Acquisition of shares from a trustee
The revised legislation corrects a limitation in the original draft legislation by allowing the value of any consideration given by an individual to a trustee in return for shares or other assets to reduce the size of the tax charge applied under the new legislation. In addition, the consideration paid by the individual can be in cash or in other assets, such as shares in a share for share exchange.
Further updates
We will keep you updated with any changes to the legislation and any further clarifications from HMRC as to how they are going to interpret the legislation in relation to incentive plans.
Please contact your usual Hewitt New Bridge Street adviser if you would like to discuss the points raised in this briefing.
This update is intended to highlight issues and not be comprehensive, nor provide specific advice. Aon Hewitt Limited does not accept nor assume any responsibility for any consequences arising for any person as a result of them using or relying on the information contained in this briefing.
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