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Employee Reward Structures by Aidan Langley

Aidan Langley considers the implications when a company lends money, or procures a loan by a third party, to its employees, particularly to acquire its own shares.

Loans to a Corporate Trustee

It is illegal for a company to make a loan to a director in his capacity as a trustee of an EBT (CA 1985, s 330). It is, however, legal to make a loan to an EBT trustee or a pension scheme, even if directors are potential beneficiaries of the Trust (CA 1985, s 346(3)(b)).

Tax on Cheap Loans to Directors and Employees

Affected Employees

The rules on the taxation of cheap loans are contained in ITEPA 2003, Part 3, Chapter 7. The rules apply to all directors, and to employees earning more than £8,500 per annum. The rules apply to employees who are resident in the UK, whether or not ordinarily resident (ITEPA 2003, s 216).

The term “loan” includes an alternative finance arrangement to which FA 2005, s 47 or s 47A applies, or would do if one of the parties were a financial institution (FA 2006, s 97).

Loans obtained by reason of employment

To determine whether a loan is made by reason of employment, it is necessary first to determine who is making the loan. Making the loan includes arranging,
guaranteeing or in any way facilitating the loan (ITEPA 2003, s 174(4)(b))

The person who makes the loan must be:

(a) the employer (ITEPA 2003, s 174(2)A);

(b) a company or partnership which the employer controls (ITEPA 2003, s 174(2)B);

(c) a company or partnership that controls the employer (ITEPA 2003, s 174(2)C);

(d) a company or partnership which is controlled by a person that controls the employer (ITEPA 2003, s 174(2)D); or

(e) a person who has a material interest in a close company, which is either the employer, controls the employer, or is controlled by the employer, or who has a material interest in a company that controls such a close company (ITEPA 2003, s 174(2)E).

The legislation also applies to a loan that was originally made to the employee by a third party, and then assumed or taken over, or continued by any such person (ITEPA 2003, s 174(4)(a)). References to the employer include references to a prospective employer (ITEPA 2003, s 174(3)).

How is the benefit calculated?

There are example calculations in the HMRC Manual at EIM26300204. Note that there is an exemption for loans up to £5,000 (ITEPA 2003, s 180). Note that “interest” includes alternative finance return from an alternative finance arrangement (FA 2006, s 97(2)).

Position where interest is not actually paid during the tax year

The borrower must actually pay interest during the tax year at at least the official rate. If, instead, the interest is accumulated and added to the principal, it will not be treated as having been paid (HMRC Manual EIM 26250).

If the borrower actually pays the interest in a subsequent tax year, he can make a claim to have his tax returns for previous years adjusted and the tax repaid to him (ITEPA 2003, s 191(2)). However, any such claim must be made within six years of the end of the year of assessment in question (HMRC Manual EIM 26255).

Loans denominated in Foreign Currency

The official rate of interest is applied to loans in foreign currency as if they were denominated in sterling. The only two exceptions are for loans in Swiss Francs and Japanese Yen, for which separate official rates apply (HMRC Manual EIM 26106).

Loans to relatives

A loan that is made to a “relative” of the employee will be taxable in the same way as if the loan has been made to the employee (HMRC Manual EIM 26112). However, the employee can escape taxation if he can show that he actually derives no benefit from the loan (ITEPA 2003, s 174(5) and HMRC Manual EIM 26150).

Fixed rate loans made for a fixed period

If a loan is made for a fixed period of time at a fixed rate of interest, it is the official rate at the time the loan is made that is relevant in determining whether there is any taxable benefit. Even if the official rate is subsequently increased, this will not increase the taxable benefit for subsequent years. It is essential to be able to show that neither the term of the loan nor the interest rate can be altered under any circumstances (ITEPA 2003, s 177 and HMRC Manual EIM 26152).

Interaction between Employment Income and Dividend Income where loan is written off

If any part of the loan is released or written off, that amount will be taxable as earnings (ITEPA 2003, s 188). But if the loan was made by a close company and the employee was a participator, the amount written off will also be taxable under ITTOIA 2005, s 415. This charge has priority over the employment income charge (ITEPA 2003, s 189 and HMRC Manual EIM 21746).

Death of Borrower

The employment income liability ends if the employee dies. There is no notional loan interest charge for periods following the death. There is no earnings charge if the loan is released or written off (ITEPA 2003, s 190).

NIC

The notional loan interest charge is subject to Class 1A NIC. However, any release or write-off that is taxable as earnings is subject to Class 1 NIC (HMRC Booklet CWG5).

Position where loan qualifies for interest relief

Interest relief on a “qualifying loan”, e.g. to acquire shares in a close company, or an employee-controlled company, is offset against the notional interest charge (ITEPA 2003, s 178).

Consumer Credit Act 1974

Care must be taken in relation to a loan to an employee to make sure that it complies with the Consumer Credit Act 1974. In principle, the lender must obtain a consumer credit licence from the Director General of Fair Trading, unless an exemption is available.

In many cases, a loan to an employee to acquire shares will fall within the Consumer Credit (Exempt Agreements) Order 1989, reg 4(c). This covers loans with the following characteristics:

• the loan is made by an employer to an employee to be used to acquire shares from a third party (e.g. by purchasing shares from an EBT, or subscribing for shares in the employer’s parent company);

• the loan is made available only to employees;

• the interest rate cannot be increased; and

• the APR of the loan is no more than 1% above base rate.

Loans to Acquire Shares in Close Companies

If an individual borrows money to acquire ordinary shares in a close company, tax relief may be available under ICTA 1988, s 360 if all the following tests are met:

(a) the company must meet the requirements of ICTA 1988, s 13A(2). This means that it must be a trading company, the holding company of a trading group, or a company that invests in land, apart from land that is let to someone connected with that company, or a relative or spouse or civil partner); and either

(b) the borrower holds a material interest in the ordinary share capital of the company; or

(c) the borrower works for the greater part of his time in the “actual management or conduct” of the company or an associated company ‐ it is not sufficient just to be an employee.

The company must be close at the acquisition date. No relief is available if the company is not close at the acquisition date but subsequently becomes close.

On the other hand, the relief is not lost if the company is close when the shares are acquired, but subsequently ceases to be close (SP 3/78).

Loans to Acquire Shares in an Employee-controlled company

If an individual borrows money to acquire ordinary shares in an employee-controlled company, tax relief may be available under ICTA 1988, s 361 if all the following tests are met:

(a) full-time employees beneficially own more than 50% of both the issued ordinary share capital and the voting power in the company (ICTA 1988, s 361(5)). However, in applying this test, if any full-time employee holds more than 10% of the shares or voting power, it is necessary to ignore the excess over 10% (ICTA 1988, s 361(6)). This test must be satisfied either because the company became an employee-controlled company in the year in which the interest is paid, or for at least nine months in that year;

(b) the company must be a trading company or the holding company of a trading group (ICTA 1988, s 361(4)(a)(ii));

(c) the company must be resident in the UK and not resident elsewhere and its shares must not be listed on the London Stock Exchange (ICTA 1988, s 361(4)(a)(i));

(d) the borrower must be a full‐time employee throughout the period between borrowing the money and paying the interest. If the borrower terminates employment, the relief remains available for interest paid during the next 12 months (ICTA 1988, s 361(4)(d)).

Loans to Participators in Close Companies

If a close company makes a loan to a participator, or to an associate of a participator, there is a tax charge at 25% of the amount of the loan. This tax charge will be repaid when the loan is repaid.

What is an associate of a participator?

See ICTA 1988, s 417(3) and HMRC Manual CT 6115. If the borrower is an EBT, it will be an associate of any individual who is a settlor or a beneficiary.

When is the tax due for payment?

The tax becomes payable nine months after the end of the accounting period in which the loan is made. (ICTA 1988, s 419(3)).

Application to loan to EBT

This provision applies where the borrower is a corporate trustee (ICTA 1988, s 419(6)) and also, in HM Revenue & Customs’ view, to an individual trustee who
receives a loan (HMRC Manual CT 6650b).

Loan to an EBT that is not a Participator

If the borrower is an EBT that already holds shares in the close company, or has an option to acquire shares, the Trustee will be a participator so the loan will be within these provisions.

If the EBT does not hold shares at the time the loan is made, but later subscribes for new shares in the close company, the loan is not subject to ICTA 1988, s 419. If the EBT subsequently purchases shares from a participator, HM Revenue & Customs take the view is that this is a loan to that participator (ICTA 1988, s 419(5)).

Release or Write-off of the Loan

If the loan is released or written off, rather than being repaid, the borrower is treated as having received a distribution equal to the amount written off, grossed up at the dividend ordinary rate (ITTOIA 2005, s 416(2)).

The loan is repaid before the tax due date

The tax charge does not apply if the loan is repaid before the due date for payment of the tax. However, if the loan is repaid after the due date for payment of the tax, the company cannot claim repayment until nine months after the end of the accounting period in which the loan was repaid (ICTA 1988, s 419(4A)).

Aidan Langley

About ‘Employee Reward Structures

The above article is adapted from ‘Employee Reward Structures’, published by Spiramus Press Ltd. For further information and to order a copy of this title, click here.

About the author

Aidan Langley, has practised as a solicitor and now works for a Big Four accounting firm, advising smaller companies on the design and implementation of short and long‐term reward plans.