A remuneration arrangement known as a family benefit trust has become more popular in recent years as a way of rewarding key executives by enabling a lump sum to be invested on behalf of them and their families in an extremely tax efficient manner. A recent decision (Sempra Metals) has considered some aspects of the tax treatment of these trusts.
This article discusses the decision and also looks at other issues which employers and employees may want to consider before establishing family benefit trusts. Some of these points have emerged in transactions where these arrangements had been put in place.
Background
Sempra Metals is a trading house based in the City of London. Over the years, it had shown consistent interest in rewarding its employees tax efficiently.
In recent years, it had offered some of them the choice of either receiving a cash bonus at the end of the year (which would be fully subject to income tax and National Insurance contributions ("NICs")) or making a payment to employee trusts where the resulting funds would be "reserved" for the employee's family. As the payment to trust alternative was made without deduction of tax and was increased to take account of the employer's NICs saved by paying the employee in this way, it was significantly larger than the cash bonus alternative.
Based offshore to avoid a liability to pay UK tax on trust gains and income, the trusts either invested the payments tax-free or made loans to employees and their families, charging a relatively favourable rate of interest. Even if no interest had been charged, the employee would only have suffered a tax charge on the loan each year equivalent to approximately 2% (which should be exceeded by any reasonable investment return) compared with a 41% up-front charge if an outright payment were made.
Although these arrangements have not been popular for that long, they can be continued indefinitely. In practice they would be brought to an end when payments or benefits up to the full value of the invested trust funds are made to families without tax consequences and so both in the short-term and the long-term are extremely tax efficient vehicles. Generally, benefits provided to employees after they have left employment can be provided tax-free and so the trusts can provide holiday homes or simply loans (treated in tax terms as benefits) on very favourable terms. When an employees dies, there should be no inheritance tax on the value of the family benefit trust and the value of his taxable estate is reduced by the loan made to the employee.
Issues considered by the Special Commissioners
In the Sempra case, HM Revenue & Customs (the "Revenue") challenged two aspects of the tax treatment of the Sempra trust arrangements and the relevant issues were heard before two Special Commissioners.
Tax deductibility
While the Special Commissioners held that the payments to the trusts were deductible under general principles, this is now of historic interest only as crucially they held that various anti-avoidance measures which the Revenue have introduced were effective to deny a tax deduction (at least until taxable payments were made out of the trusts).
Tax treatment of the individuals
Although the Revenue's main aim seems to have been to block tax relief for the payments (on which they were successful), they also challenged the tax free nature of the payments into the trusts. The Revenue argued that they were de facto payments of earnings which the employees were entitled to receive. It said that if paid as earnings direct to the employees, the payments would undoubtedly have been subject to PAYE and NICs and it made little difference that they were paid to trusts. The Special Commissioners accepted that the employees controlled whether payment was made to them or to the trust, had effective control over what happened to the monies once in the trust and that there was very little expectation that the loans from the trust would ever have to be repaid except in exceptional circumstances.
However, the Special Commissioners held that this was not enough to make them earnings. The payments did not vest unconditionally in the employees. The employees and their families were not free to do what they liked with the allocated funds: they could apply for loans and for discretion to be exercised in their favour, but the final decision remained with the trustee.
Comment
Further consideration of family benefit trusts and other points relevant to them but not raised in the decision is set out below.
What are family benefit trusts?
Introduction
Family benefit trusts are employee trusts set up as remuneration arrangements by employers normally for the benefit of a select group of employees and their families. Usually, there is one employee trust and then various sub-trusts within the employee trust for the benefit of a particular employee and his family. The trustee is given a lump sum by the company which it then allocates to the particular sub-trusts either at the time of receipt or in due course.
Sometimes the sub-trusts are formal arrangements, with the sub-trusts being separate trusts: in other cases, as with Sempra, they were just notional allocations within the main trust. Where there are formal sub-trust arrangements, unless the trusts are revocable, the monies will belong to the employees and the family and so care should be exercised in drawing up a wide range of potential beneficiaries.
Clearly, the trustee has to operate with the confidence of both the employer and the employees as there are a wide range of beneficiaries and the employee and his family will have the expectation that they will receive cash or assets from the trust. In each case there will be different arrangements providing for consents to change trustees and to make payments/benefits/loans to beneficiaries and to provide for what happens if employees leave employment.
Who pays to run the trust?
Usually, the employer will pay to set up trust and sub-trust arrangements, but costs thereafter are a matter of agreement between the employer, trustee and employees. Clearly, the more of the cost the employer bears, the greater the return to the employee and his family. The expense of these arrangements should not, however, be underestimated. The need to demonstrate watertight paperwork means that administration can be expensive, and as the trust will usually be offshore to obtain other tax benefits, the trust will need to be run by professional trustees.
In Sempra, the Special Commissioners said: "We agree that the trustee was likely to comply with reasonable requests but that does not mean that the trustee was a cipher who did what it was told." This shows, yet again, the importance of trustees holding meetings properly to consider requests made by employers/beneficiaries and, in some cases, even challenging them properly to minute discussions made so as to demonstrate that independence is maintained, which is important for all trustees.
What does the trust do with the money received from the employer?
The trust can invest the sums received in any asset or simply hold the cash on trust. Some companies like to tie these arrangements into employee share schemes or require the trust to invest in company shares. In these arrangements, cash is therefore returned to the company and the employee's investment interests via the trust therefore coincide with the company, but in the longer term the employee is likely to want to diversify the trust’s investments.
Certain companies controlled by individuals should be very careful if they make payments into trusts which can benefit employees who are also shareholders. Unless these employees and their families are excluded, in addition to there being no corporation tax deductibility, the companies could be treated as individuals making a lifetime gift to the trust which has immediate inheritance tax consequences. Although this is not referred to in the Sempra decision, it is known that the Revenue is challenging arrangements made by some companies.
The trustee can also make payments and provide benefits (in any form and at any time) to an employee and his family. In Sempra, as in many family benefit trusts, the trust lent money to the employee or his family, charging a relatively favourable or low rate of interest. Even if no interest is charged, the employee would only have suffered a tax charge on the loan each year equivalent to approximately 2% (which should be exceeded by any reasonable investment return) compared with a 41% tax charge up-front if an outright payment were made. Even if interest is paid, it is in effect the employee paying himself as the interest received is added to the sub-trust fund and is available for future benefits. The employee may do what he likes with the loan, including paying down his mortgage, and can remain relatively relaxed that the loan will never be called, although this depends on each trust and its policy, and employers would need to be able to demonstrate to the Revenue that it was not an outright payment in disguise. Other benefits may include a holiday or second home.
Cash payments to an employee and his family while employment continues are fully taxable. Benefits are taxable too - although benefits in kind may be favourably taxed and the taxable amount may be much less than the perceived value of the benefit to the employee or his family.
Greatest tax efficiency is achieved if non-cash benefits (which would include loans) are made after employment has ceased when they can normally be made tax-free.
Who can receive benefits?
The employee and his family can receive benefits, although in practice the employee himself will almost always receive the benefits. The family is included to avoid the trust fund being treated for tax purposes as if it were the employee's own funds.
Monies can be ring-fenced for employees and their families either by notional reservations in the accounts of the trustee or in formal sub-trusts (either revocable or irrevocable). Where there are formal sub-trust arrangements, unless the trusts are revocable, the monies will belong to the employee and his family and therefore the list of potential beneficiaries should be carefully considered.
One argument which the Revenue did not raise in Sempra was whether the trust arrangements could be seen as leading to a benefit-in-kind charge. Employees are chargeable on their earnings and also on benefits which cannot be immediately turned into cash (eg insurance cover, cars, accommodation). There has long been a concern that family benefit trusts could be challenged under this head if there is a formal creation of a sub-trust in favour of one employee or his relatives within the trust. It is interesting that in the Sempra trust arrangements the sub-trusts were not created, which probably explains why this argument was not raised, but it is often relevant in other similar arrangements.
Employers need to be very careful about effective salary sacrifice arrangements. The Special Commissioners did not seem too troubled about this but if the paperwork is not correct and the employee is just directing that his bonus is paid into the trust, that, in law, is the same as saying that it be paid into his or another person's bank account and the payment will still be taxable. We have seen a few examples of this potentially being a point of challenge for the Revenue.
Who controls the trust?
Strictly, the trustee must have complete discretion as to how the trust funds are allocated. However, in practice there are a number of checks imposed. The trustee can be removed from office and substituted by the company or the employee, depending on the nature of the arrangements. As such, there will normally be provisions governing these arrangements and who needs to consent to the exercise of the trustee’s discretion, any investment decisions, any allocation of benefits to beneficiaries and other relevant decisions. Sometimes beneficiaries have a "protector" to champion their cause/block detrimental decisions. For example, an employee may fall out with his employer, the ownership of his employer may change, or the chief executive may change, all of which could affect the beneficiary’s confidence in decisions likely to be taken by the trust unless he has some sort of control.
How long does the arrangement last?
Normally, there will be an 80 year long-stop date, but in practice the arrangements will be unwound long before then. There should be no inheritance tax when the employee dies on the value of the family benefit trust and any loan made to the employee/family member will reduce the value of his taxable estate on death too. However, it is fair to say that more attention is often focused on setting these arrangements up than to how to wind them up, where experience is more limited given their relatively recent origins.
What are the downsides?
We have come across a few negative aspects when considering trusts for our clients, aside from the cost and complexity of administering them.
In some cases, clients would have been better advised just to make loans out of the company itself rather than set up a trust to do it. They would have saved significant expense and maintained more control. Now that the restrictions in company law on loans to directors have been relaxed, this approach may become more common.
Now that several cases have confirmed that there can be no corporation tax deduction unless taxable payments come out of the trust (which is what the employee of course does not want), there can now be a tension between what is good for the company and good for the employee. This conflict of interest means that it is difficult for quoted companies to use these arrangements, as the company would be better off making a fully taxable payment, suffering the employers' NICs, yet getting the tax relief. However, in some cases, there may be good reasons, eg (a) if a company has no taxable profits or has large accumulated losses or (b) if a smaller payment is received by the employee through the trust than would have been paid as a bonus but which because of the favourable tax treatment for him and his family gives rise to a larger after-tax payment than he would have received with a bonus.
Some family benefit trusts are quite large. We have come across one company where the trust funds were around £20 million. If the trust provides a taxable benefit or makes a taxable payment, the employer has to bear employers’ NICs. The result is that the company had ongoing exposure over which it may have limited control. While the current owners of the company were prepared to live with the tax risks and costs, prospective private equity fund owners were not. If the trustee had decided to make taxable payments out to employees at once, the company would have been visited with an employers' NIC charge of around £3 million. As a matter of law, it may be difficult to make an employee trust bear this, and it is most unlikely that employees can be forced to bear it. Although it was unlikely that the trusts would ever want to distribute taxable cash benefits while the employees were in employment as employees want to free low tax or tax free benefits, that risk could not be ignored by the purchaser who would have become liable for the employers’ NIC liabilities, as well as residual PAYE liabilities if the employee trust does not discharge them. We have seen at least two deals put in jeopardy because of this.
There is an inherent pressure within these arrangements for the employee to cease working for the company as only then can the full tax benefits of the trust be unlocked for him and his family. Is this something that the company wants to encourage?
Change of law is a considerable risk (and this could even be a retrospective change in legislation or a retrospective interpretation of existing law) - and there are still uncertainties under current legislation about the tax treatment of post-employment benefits. Who bears the risk of these? Generally, the Revenue will go against the employer (or former employer) rather than the employee trust, and so when benefits are made in due course which the trustee and the employee think are tax-free, who will bear the risk of these being subsequently challenged? Should the company indefinitely take the risk of tax and NIC charges?
General knowledge of these types of arrangements is still low and there is not much experience of them. It is fair to say that not all of the endgames have been worked through - there has been a great deal of attention given to setting these up, but not so much focus on operating them long-term or how risks are allocated, particularly when the company is sold.
