Are You Preparing For Higher UK Tax Rates?

This year's Budget announced the following key changes to tax and national insurance rules for high earners: 
:

• From next tax year (ie 6 April 2010), a rise to 50% in the income tax rate for those with income of more than £150,000 (and a disappearance of the personal tax-free allowance for those with income of £100,000 or more)

• From 6 April 2011, an increase in the NIC rate for higher earners to 1.5% with an increase in the NIC rate for all employer contributions to 13.3%

From 6 April 2011, pension contributions by those with income of more than £150,000 will only receive basic tax relief (although those with income of up to £180,000 will still receive some higher rate relief benefit). Payments by employers or increases in benefits under final salary schemes for those with income of more than £150,000 may give rise to up-front tax charges, even if benefits are not ultimately taken. Anti-avoidance measures have also been introduced which have already taken effect. These stop larger contributions than normal made by affected taxpayers before 2011 from receiving higher rate relief.

At the same time, no change is proposed to the rate of capital gains tax (18%). 

Nor is it proposed to restrict the availability of the annual allowance, currently £10,100, or the ability to transfer capital gains tax-free to spouses/civil partners.


How may the impact these changes be reduced?


There are three areas you might consider.

Capital Gains

At 18%, capital returns are subject to a very favourable rate of tax compared to income.
Other benefits from achieving capital returns are :

• no NICs, 
• payment through the tax return rather than PAYE (thus improving cashflow), an annual exemption, currently £10,100 (which is not restricted for higher rate taxpayers), 
• and in some cases corporation tax relief for the gains made by employees will still be preserved. 

Achieving a capital rather than an income gain is therefore highly desirable. 


Common ways of achieving this are to use Revenue-approved share schemes such as:

Enterprise Management Incentives (EMI), 

EMIs enable small and medium sized companies to offer their employees options over shares worth up to £120,000. Whilst any gain in share value is usually subject to income tax and national insurance, EMI exempts both the business and employee from this liability.


SAYE


A savings-related, or save as you earn option scheme is an all-employee share scheme under which a company grants options over shares to its employees. The SAYE nbsp;schemeis linked to a formal savings contract. At the end of the savings period, typically three or five years,employees have sufficient capital to fund the exercise of the options and thus acquire the underlying shares.Normally, when an employee exercises a shareoption, a charge to income tax will arise based onthe excess of the value of the shares over the option price. The tax charge arises at the time of exercise even when the employee retains the shares. However, favourable tax treatment is available,


Share Incentive Plans (SIP)


This is the most tax efficient scheme but it must be open to all eligible employees. There are three main types of plan:

• employers can give staff up to £3,000 worth of free shares a year
• each year, employees can buy a further £1,500 worth of partnership shares from their gross salary, or up to 10 per cent of gross salary, whichever is less
• employers can give up to two matching shares for every share the employee buys

All shares are held in a trust. Share dividends can also be held in the trust. Dividends worth up to £1,500 in any given tax year can be invested in new shares, provided these are held for a minimum of three years.


No income tax or National Insurance contributions (NICs) are payable if the shares are held in the SIP for five years. Shares are free of Capital Gains Tax (CGT) when they are taken out of the trust. If you take shares out of the trust after 5 years and then sell them at a later date, CGT may be payable on any increase in value in the period from when the shares were taken out of the trust to the date of sale.

Company Share Option Plan (CSOP)

 This is a scheme under which an employee is granted a right (known as an 'option') to buy a fixed number of shares at a fixed price in a set period of time.

There would normally be an income tax liability upon the exercise of a share option. However, if the scheme is approved then there is income tax and NIC relief available for employees.

Eligibility

Discretion is given to the company as to which employees are eligible to participate and are granted options.

Limits

The total value of shares subject to an employee's options held under the CSOP or other approved discretionary scheme must not exceed £30,000 (at option price).

The price of the options is fixed at the time of grant. It must not be less than the market value of the shares and is valid for 10 years from the date of grant, but cannot be exercised in the first 3 years.

Options granted in excess of £30,000 can be held as unapproved options. Unapproved options are not subject to income tax or NIC relief.

Exercise of Option

Specific conditions can be set which must be met for an individual to be entitled to exercise his/her options. These are normally more relevant to listed, rather than private, companies. If conditions are included, they must be clearly stated at the time the option is granted. The most common conditions imposed include total shareholder return (TSR), adjusted earnings per share (EPS), pre-tax profits or turnover.

The company may sometimes arrange a loan and sale facility so that the participants can finance the exercise of options, perhaps subsequently selling sufficient shares to repay the loan.

Cessation of Employment

Since the intention of many CSOPs is to encourage an executive to stay with the company, it may often be provided in the rules of the scheme that the option would lapse if the employee left the company.

Special requirements may be included in the case of death so that the personal representative(s) can still exercise the option. They would normally have to do so within 12 months of death.

If any employee leaves through redundancy, ill health or retirement then the scheme may be set so that the employee can exercise the option within three years of grant without being liable for income tax or NIC. Employees leaving within three years as bad leavers - resignation or dismissal - may exercise if the option rules allow, but will pay income tax and NIC on their option gains.

Capital Gains Tax

After exercise there may be a liability to Capital Gains Tax (CGT) on the gain between the sale price and the exercise price. If the employee makes a profit on shares when he/she sells them, the employee may have to pay CGT on part of that profit. In general terms, the employee is liable to pay CGT on any Capital gains made in the course of a year.

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Corporation tax relief should also be available for the employing company using any of these schemes. However, not all companies can use them and each plan has relatively low limits.


Other share based schemes

• Another scheme which gives option-like returns but capital gains treatment is the joint share ownership plan,
• Partly-paid shares (where subsequent growth in the value of the share is subject to capital gains treatment, but the employee does not pay for the share until he is just about to sell it) may also be attractive.

However, in the case of both the joint share ownership and partly-paid shares the company will not receive tax relief for gains made by employees.

While there are fairly complicated measures proposed to prevent income being shifted between spouses/civil partners, nothing is so far proposed to prevent capital gains being shifted between spouses/civil partners to ensure maximum tax efficiency. Moreover, there is generally more flexibility to roll-over capital gains rather than suffer tax immediately, so that the gains can be realised in later tax years (possibly tax-free).

The downside of many of these schemes is that, while they give optimal treatment for the employee, capital gains treatment for the employee will not, unless one of the Revenue approved schemes is used, mean that there is tax relief for the employer. The loss of this benefit (which is normally available if the employee paid income tax) can be difficult for companies to balance against a scheme wholly for the employee's benefit, but if the company is loss-making, wants to avoid employer's NICs, has large accumulated losses already or is never going to get value from any corporation tax relief, then the company's tax relief for employee gains may be easy to sacrifice.


Of course, one of the concerns here is that the Government may change the law to prevent capital gains tax treatment applying to these arrangements when they come to vest, or simply increase the tax rate from 18%.

Accelerating (Or Delaying) Bonus Or Other Payments

It may be sensible to accelerate bonus payments/share vesting so that these occur before the start of the relevant tax year when a higher tax or NIC charge would then arise.


For quoted companies, this may require consideration of whether shareholder approval is needed, but the saving of 10% tax or NICs is likely to be a valuable benefit which may sway answers. Claw-back could be imposed so that benefits are not obtained early and the employee then leaves.


Going forward, large bonuses or share vestings may suddenly push employees into a higher rate bracket and lead to extra tax being payable either because of the 50% tax rate or the withdrawal of the personal allowance, or even (see below) tax being payable on pension contributions or lower than anticipated tax relief on pension contributions. 


Employees may going forward want flexibility on the timing of vestings or part vestings so that they can fall into tax years which best suit their personal position. 


Year end tax planning of a new kind is therefore likely to arise. 


Companies will need to think in good time about whether they want to offer this facility to employees with the extra administration that it will involve, all inevitably coming at the end of the tax year, when some March year end companies could even be in a close period restricting share dealings for directors and senior employees.


So far, there is no anti-forestalling legislation planned to impose additional tax charges for those who bring forward or delay employment income, but whether this emerges may only be a matter of time.

Pension Payment – Using A Sub-Fund Within An Employee Trust Instead?

The proposed pension changes are likely significantly to affect the operation of pension arrangements for higher earners with over £150,000 in income. 


This is because contributions or increases in pension benefits could 

• (a) lead to higher rate tax relief not being available or clawed back or 
• (b) (where a contribution is made by an employer) even to tax being payable because employer contributions and/or increases in benefits can no longer be made tax free for these employees. Employers are unlikely to gross up these payments or benefit accruals for tax.

Since 2006, employers and employees have grown used to new lifetime and annual limits for Revenue approved plans but those were not unduly restrictive for most employees and employers. However, because the new changes affect all employees with more than £150,000 total income per year (NB not just those with £150,000 employment income), and the anti-forestalling changes apply to suddenly increased payments or benefits this year in advance of the actual changes in 2011, the proposed changes are likely to be more wide-ranging than in 2006.


Thoughts are inevitably going to turn to unregistered pension schemes which do not have the tax benefits of registered (ie Revenue approved) schemes, but importantly do not have any financial limits on them either. However, pension and lump sum provision from those arrangements will be subject to income tax when they pay out, although they should be free of NICs.


What some companies may therefore prefer are arrangements where money is placed into an employee trust and the money is notionally allocated to an employee and his family in a sub-trust. This is not a watertight reservation for the employee, but in most cases employees will be satisfied that the money is not going to be used for anyone other than their family. In due course, benefits (including loans) can be advanced tax-free and the value of the sub-trust will not, unlike with employee pension arrangements, form part of the estate for inheritance tax purposes. These therefore can be very tax-efficient vehicles for future wealth accretion, even though they are not formally pension vehicles.


Industry practice is still to emerge here with the actuarial and consulting firms just starting to draw up comparisons between all the various arrangements.


However, companies would be well-advised to look into these alternative arrangements as higher-paid employees, who have been used to receiving tax-free contributions into their pension schemes or earning pension accrual on a tax-free basis until payment of a pension, may receive a rude shock when they are suddenly visited with tax to pay on this benefit-in-kind.