Tax Matters: Robust refusals

Peter Vaines looks at the Revenue's new hard line on EBTs and a brief loophole in IHT
Employee benefit trusts

The growing popularity of employee benefit trusts (EBTs) as vehicles for rewarding employees has encouraged the Inland Revenue to take an increasingly robust approach in refusing a tax deduction for contributions to an EBT. However, the Revenue has quite an argument on its hands because contributions to an EBT are generally allowable expenditure.

In Heather v PE Consulting Group 48 TC 293, contributions to an employee trust to enable employees to acquire shares in the company were an allowable expense on the grounds that they were a payment of a revenue nature for the benefit of the company's trade. This principle has been confirmed a number of times in later cases. The special commissioners have subsequently come up with a different view in Mawsley Machinery Limited v Robinson SpC 170. In this case, it was held that the expenditure was disallowable on the grounds that it was not for the purposes of the trade but to build up a capital fund for the purchase of shares of the major shareholder. However, the general principle is still regarded as being intact.

Accountancy evidence is an important feature and UITFs 13, 17 and now 32 are assuming increasing importance. The effect of UITF 32, Employee Benefit Trusts and Other Intermediate Payment Arrangements, is to disallow revenue treatment by causing the assets of the EBT to be treated as the assets of the company until such time as they vest in the employees. Its application is a matter of considerable debate, and so is the strength of Mawsley Machinery in the light of the earlier authorities, but these are arguments that are gaining ground within the Revenue. Another argument is based on s43, Finance Act 1989, which provides that payments of emoluments by an employer are only deductible if they are paid in the accounting period or within nine months thereafter. (Emoluments for this purpose include 'potential emoluments', which are amounts held by an intermediary with a view to their becoming emoluments.) Again, there are serious difficulties for the Revenue in sustaining a challenge on this basis.

I think we are going to hear a lot more about all this, particularly as I understand there are two cases on the subject about to be reported.

Inheritance tax: s 102(5), Finance Act 1986

The decision in Executors of Somerset (Deceased) v CIR SpC 296 has now been heard by the High Court under its proper name of IRC v Eversden [2002] EWHC 1360 (Ch). The Revenue lost comprehensively before the special commissioners and has now done so in the High Court as well. This is an extremely important decision and the opportunity to which it gives rise can only be short-lived.

A wife settled 95% of the matrimonial home on her husband for life with remainder to a discretionary trust of which she was one of the beneficiaries. Her husband died, the discretionary trust came into effect and on her death the question arose whether or not the matrimonial home formed part of her estate by reason of a reservation of benefit from the gift.

Superficially it looks as though there was a reservation of benefit; the wife created the settlement, she was a beneficiary and she continued to benefit from the settled property. But this overlooks the terms of s102(5)(a), Finance Act 1986, which provides that the gift with reservation provisions do not apply if the gift is an exempt transfer by virtue of the spouse exemption.

The executors said that she made a gift into the settlement that was fully covered by the spouse exemption and therefore s102 and the whole of the reservation of benefit rules simply did not apply. The discretionary trust was deemed to be created by the husband when his interest in possession came to an end on his death; it was not a transfer by his wife. The special commissioners agreed and so has the High Court.

It is necessary to look at the disposal at the time when it was made, and its character has to be determinedat that date. If the gift was exempt as a transfer between spouses, the provisions relating to property subject to a reservation have no application.

Tax equalisation

The Revenue has published a lengthy statement on the tax treatment of employees working in the UK where their employers adopt a tax equalisation policy. This means that the employer undertakes to pay any additional tax arising in the UK compared with the tax the employee would have paid if he had remained in his home country. Such payments are treated as earnings, but there has been some uncertainty about whether they are taxable under Case II or Case III of Sch E. This is important because, in these circumstances, the remittance basis will only apply to earnings taxable under Case III.

The Revenue argues that where tax equalisation payments are made referable to duties performed in the UK, they are equally taxable under Case II. This view was recently confirmed by the special commissioners in the case of Perro v Mansworth SpC 286. The case did not consider tax equalisation payments in respect of other UK income, capital gains or foreign tax liabilities paid on the employee's behalf. But following the reasoning in Perro v Mansworth, the Revenue proposes to attribute such earnings to the UK on a time-apportionment basis.

As far as payments of foreign tax are concerned, if the foreign tax relates wholly to overseas duties then the payments will be regarded as earnings within Case III and chargeable only on the remittance basis. If the employer meets the Case III Sch E liability, the payment of tax to the Revenue will be regarded as a remittance and further tax will arise on that payment; and it will be grossed up.

This seems to be entirely unnecessary. There is no need for the employer to make a direct payment of tax for the employee. The taxpayer could meet any Case III liability out of his own separate funds and receive reimbursement outside the UK.

Peter Vaines is a partner in Haarmann Hemmelrath

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