Employee ownership: paying tax-free qualifying bonuses

This article examines how qualifying employee-owned companies can pay compliant tax-free bonuses. Focus is often on the attraction of a sale of a business to an employee ownership trust (EOT), but less has been written about the conditions and pay regime for qualifying tax-free bonuses. If they are to deliver efficient profit-share, some employers adopting the employee ownership (EO) model need additional help to navigate bonus compliance as they grow into this further phase of EO.

When a qualifying EOT controls a company, tax-free ‘qualifying bonus payments’ can be paid, capped at £3,600 per eligible employee each UK tax year. National insurance contributions (and in due course the health and social care levy) still apply.

‘Control’ for this purpose is not as used for other tax purposes (eg, s995, Income Tax Act 2007, regarding control at board level or s450, Corporation Tax Act 2010 (CTA 2010), regarding control at shareholder level). Instead, it has its own requirements as set out in s236M, Taxation of Chargeable Gains Act 1992 (TCGA 1992), as follows.

The EOT will meet the controlling interest requirement if the trustees:

• hold more than 50% of the ordinary share capital of the company;
• have powers of voting on all questions affecting the company, which if exercised would equal a majority of the votes in the company;
• are entitled to more than 50% of the profits available for distribution by the company;
• are entitled on a winding up to more than 50% of the assets of the company available for distribution; and
• there must be no provision in any document that would reduce the trustee’s entitlement as set out above without their consent.

It is important to therefore note that control needs to be assessed across a range of tests, not just voting control. Compliance will be more onerous where a company has multiple classes of shares, each with differing voting, income and capital rights.

Qualifying bonus payments

To qualify, the employing company and not the EOT trustee must pay the bonus and, in addition to the trading requirement (s312D, Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003)), both the ‘participation requirement’ and the ‘equality requirement’ (s312C, ITEPA 2003) must be met; see more on these below. Note that the income tax legislative requirements (set out in Chapter 10A, Part 4, ITEPA 2003) applying to such bonus payments are slightly different to the capital gains tax legislation (s236H–236U, TCGA 1992) ‘equality and participation’ requirements applying to transactions involving EOT benefit distributions (eg, a participator would be excluded from EOT benefit, but an employed participator must be included in any qualifying bonus).

The employer must also meet the ‘office-holder requirement’ (s312F, ITEPA 2003). This prevents the exemption applying where the ratio of directors and other office-holders (and connected employees) to all employees and office-holders is greater than two-fifths. Each group company needs to be assessed as part of the participation compliance check each time a bonus is contemplated.

Employers are expected to demonstrate, should HMRC enquire, that the payment meets all the conditions. In the event of any other corporate event, such compliance could also be subject to tax due diligence.

Participation requirement

Awards must be made to all the group’s eligible employees globally (‘group’ being interpreted in accordance with s170 and s236U(2), TCGA 1992, and thus including companies incorporated under the laws of a country or territory outside the UK).

The basic rule is that the principal company of the group (ie, the company for which the EOT is the direct controlling shareholder) and all its 75% subsidiaries form a group, together with the 75% subsidiaries below and so on. Section 1154(3), CTA 2010, determines that a company is a 75% subsidiary of another if at least 75% of its ordinary share capital is beneficially owned, directly or indirectly, by that other company.

A ‘group’ does not include any subsidiary company that is not an effective 51% subsidiary of the principal company.

A minimum qualifying probation period is possible and employees may be excluded in certain disciplinary circumstances.

Unlike the requirements for the all-employee statutory Share Incentive Plan (SIP), which allow a principal company to decide which other group companies will join the plan, the legislation here mandates that employees of group companies globally must participate. Bonus allocations can’t be adjusted to address any cost-of-living differential in overseas territories. The tax exemption applies to UK income tax only.

Equality requirement

Eligible employees must participate ‘on the same terms’. However, this requirement will not be infringed if an award is determined by reference to:

• remuneration;
• length of service; or
• hours worked – although in practice this metric is best avoided as it can easily cause a breach (eg, regarding employees on zero-hours contracts).

If other factors are used, the bonus is taxable.

If using more than one factor, each factor must give rise to a separate entitlement and the total entitlement must be the sum of those entitlements and not the product.

HMRC has not yet addressed all these matters in detail in its published guidance (at EIM03050). For now, therefore, we apply additional interpretative support from the analogous guidance relating to the ‘same terms’ requirement for SIP (at ETASSUM24140).

It is best practice to adopt a formal set of plan rules along with guidance notes to aid compliant operation. Any selective top-up can be paid under a separate, taxable, discretionary bonus plan.

Remuneration

If using a remuneration allocation factor, the calculation terms may be, for example, that eligible employees receive £100 bonus per £1,000 of salary (rounded up to the nearest £1,000). An employee earning £15,000 will be allocated a £1,500 bonus. An employee earning £25,000 will be allocated £2,500.

If using a percentage, the same percentage must apply to all. Alternatively, awards may be calculated by reference to pay bands, provided the bands are of equal width.

Employers with clear job grade structures and pay banding across their organisation will find this process easier and will have a more robust framework in place to aid decision making.

Remuneration and length of service

If a multiplication formula covers multiple factors (eg, 3% of salary multiplied by the total number of years worked), an infringement occurs. The scheme then produces a single result using more than one of the permitted factors.

If, alternatively, the scheme allocates a bonus as 3% of salary plus £100 per year of employment, there are two separate entitlements. This would produce a compliant award equal to the sum of those two entitlements.

Overarching requirement not to skew bonus

The scheme must not enable weighting of benefit to:

• directors or former directors;
• highest-paid employees;
• those employed in a particular part of the company or group; or
• those undertaking particular activities.

It is non-compliant if a group operates bonus pots based on the profits of different parts of the group.

For this reason, some businesses pay a flat equal sum to all employees (even if this is lower than the maximum £3,600 and therefore wastes some of the tax relief potential) as it eases the administrative burden and minimises PAYE compliance risk.

A combination of remuneration and length of service helps ensure that the bonus is not skewed only to highest paid. Advice on what constitutes ‘remuneration’ and ‘length of service’ should be taken. Acquisitive companies should consider how length of service is defined in the plan rules and then applied to employees who join the group under Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE).

The exempt amount

Such a bonus may be paid more than once a year, but the aggregate amount that qualifies for the exemption is restricted to £3,600 per employee, per tax year. The exempt amount is set against the payments in chronological order and any excess is taxable.

If, for any reason, an employer makes two separate bonus payments, each purporting to be qualifying, to an employee on the same day that results in the aggregate tax-free limit being exceeded, then a proportion of each bonus payment is tax-free and the excess is taxable, applying the formula set out in s312A(7), ITEPA 2003.   

About the author

Liz Hunter, Director of Equity Reward, People Services, Tax, KPMG in the UK

This article has been adapted from an article originally published in KMPG’s Tax Matters Digest.