Special Commissioners give short lived victory to remuneration trusts

In the recent case of Dextra Accessories Limited and Others v HM Inspector of Taxes the Special Commissioners upheld the tax effectiveness of what is now quite a common tax avoidance device known as a "remuneration trust". This involves a company setting up an employee benefit trust for its employees which it then funds by contributions from itself or other companies in its group. The trustees then allocate these funds between beneficiaries (mainly senior management) and make distributions to them, usually through loans.

In this case, a mobile phone company set up an offshore employee benefit trust and its group made contributions to it totalling £2,750,000. Allocations were made into separate sub-trusts for six managers totalling just under £2,000,000, with another £275,000 for other employees and £500,000 remaining unallocated. Loans were made from these sub-trusts to the managers. The loans were repayable on demand, properly documented and subject to interest at the Inland Revenue’s "official rate" to avoid being treated as "beneficial loans" for tax purposes. Although these sub-trusts were revocable, a "protector" was appointed who was required to consent to any revocation in order to provide some protection to the employees. The relevant managers themselves were all substantial shareholders and effectively controlled the company.

The Commissioners accepted the documents at face value, finding that the managers were not free to do what they liked with their sub funds, the trustee retaining control over them and that the loans were genuine loans, not disguised contributions to the managers. It also was important that the trustee controlled the investment of the sub-fund and was not prepared to advance by way of loan the whole of an allocated fund. The mere fact that the trustee was likely to comply with a reasonable request from a beneficiary for a distribution was not in itself a problem.

The Revenue had argued that there was an asymmetry with the company obtaining an immediate tax deduction for its payment into the trust without any corresponding charge to tax on the employees, except in the case of a beneficial loan in their favour. In this case, as mentioned, none of the loans were beneficial and therefore no tax charge would ever arise. The Commissioners did not see this as a problem since the reason why the employees were not taxed on the funds was that they do not belong to them. Similarly, the fact that the managers controlled the company did not mean that they controlled the trustee, which as a professional trustee company was to be treated as independent. This independence was an important feature in establishing the trust's credibility.

The Commissioners did not consider that any overriding commercial objective or "Ramsay" type arguments would succeed; cash in the sub funds only being equivalent to cash in an individual's "money box" if the trustee was, in a commercial sense inevitably compelled to comply with that individual's wishes, which it was not. Nor was the fact that the company was strongly influenced by tax considerations in setting up the remuneration trust, prejudicial.

This case effectively gives the green light to tax and National Insurance Contributions ("NICs") efficient remuneration trusts. Provided the ground rules regarding the independence of the trustee and its control over the sub-fund are adhered to, a corporation tax deduction should be available on contributions to the remuneration trust and no income tax or NICs will be payable on "official rate loans" to employees. This could be described as a win win situation for the taxpayer.

However, the Chancellor's Pre-Budget Statement has meant that for accounting periods ending on or after 27 November 2002 the rules for obtaining a corporation tax deduction on a contribution to an employee benefit trust have been tightened.

In particular, the first draft of the legislation suggests that, in order for a corporation tax deduction to be available the trust must provide the employee with a "qualifying benefit" within the same accounting period in which the contribution is made or nine months thereafter. A "qualifying benefit" is defined as the payment of money or a transfer of assets (other than certain share-related benefits), which: (1) gives rise to both an income tax charge and NICs; or (2) is made in connection with the termination of the recipient's employment. Since loans to employees (whether at the official rate of interest or not), are expressly excluded from this definition, they will no longer entitle the employing company to a deduction.

This effectively means that although remuneration trusts can still be used, the "have your cake and eat it" scenario of there being both a corporation tax deduction for the company and no income tax or NICs on certain payments to the employees will no longer be available. Either a corporation tax deduction can be obtained if fully taxable payments to employees are made or, if official rate loans to employees are used (so as to avoid income tax and NICs) no corporation tax deduction will follow.

For more information about remuneration trusts generally please contact:

Kate Kelleher
London tax partner
kate.kelleher@cms-cmck.com
+44 (0)20 7367 2860

Mark Nichols
London tax partner
mark.nichols@cms-cmck.com
+44 (0) 20 7367 2051

Toby Locke
toby.locke@cms-cmck.com
+44 (0)20 7367 2411