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HM Revenue and Customs Brief 18/11

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HM Revenue and Customs -Tax Authorities

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Issued on Issued 4 April 2011

Employee Benefit Trusts: Inheritance Tax and Income Tax issues

Introduction

Employment Benefit Trusts are discretionary trusts which seek to reward employees by making payments that favour employees or their families.

This brief sets out HM Revenue & Customs' (HMRC's) current view on Inheritance Tax issues associated with Employee Benefit Trusts. It supersedes and amplifies Revenue & Customs Brief 61/09.

It also includes material on various matters not previously addressed including ongoing Inheritance Tax liabilities of the trust and any sub-trusts it created and the taxation of income arising in offshore Employee Benefit Trusts.

This brief is aimed at agents advising on the Inheritance Tax and trust taxation liabilities of Employee Benefit Trusts.

Existing cases will be taken forward by HMRC on the basis of the views set out in this brief.

All statutory references are to Inheritance Tax Act 1984 unless otherwise stated.

Contents

  1. Entry charges payable by a Close Company when it makes a contribution to a s86 Employee Benefit Trust
  2. Flat rate exit charge (s72) when property leaves a s86 Employee Benefit Trust
  3. Ten year and exit charges in respect of any sub-trusts
  4. Payment of ongoing Inheritance Tax liabilities
  5. Income Tax assessable under the transfer of asset legislation on income arising in offshore Employee Benefit Trusts
  6. Income Tax in relation to UK source income of offshore Employee Benefit Trusts
  7. Payment of ongoing trust Income Tax liabilities
  8. Contact details and legal references

Part 1 - Entry charges payable by a Close Company when it makes a contribution to a s86 Employee Benefit Trust

1.1 Employee Benefit Trust

This part of the brief assumes that the Employee Benefit Trust qualifies as a s86 Employee Benefit Trust in that it is a trust where the funds are held at the trustees' discretion to be applied for the benefit of 'all or most of the persons employed or holding office with the body concerned' (s86(3)(a)).

1.2 Charge on participators (s94)

Where a Close Company (s102(1)) makes a transfer of value (s3) to an Employee Benefit Trust an Inheritance Tax charge arises under s94 unless, broadly, the disposition:

  • is not a transfer of value under sections 10, 12 or 13
  • is eligible for relief

1.3 Transfers of value

Where there is a transfer of value it is apportioned between the individual participators according to their respective rights and interest in the company immediately before the contribution to the Employee Benefit Trust is made. There is an immediate charge of 20 per cent on the value transferred (the contribution) in excess of the participator's unused nil rate band.

The liability for the charge to Inheritance Tax that arises under s94 is the company's or, so far as the tax remains unpaid, the participator's (s202).

Inheritance Tax arising under s94 is due six months after the end of the month in which the contribution is made or at the end of April in the year following a contribution made between 6 April and 30 September inclusive. Interest is charged on any unpaid tax from the due date.

1.3.1 Dispositions not intended to confer gratuitous benefit (s10)

A disposition is not a transfer of value when the terms of s10 are met. There is both a subjective test and an objective test; and both tests must be met to satisfy section 10.

1.3.1.1 Subjective test - no intention to confer gratuitous intent

The test is not met if there is the slightest possibility of gratuitous intent at the date the contribution is made.

1.3.1.2 Objective test - arm's length transaction

To meet the terms of s10 the transaction must either:

  • have been made at arm's length between persons not connected with each other (as defined in s270)
  • was such as might be expected to be made in a transaction at arm's length between persons not connected with each other

An Employee Benefit Trust is a discretionary trust and to satisfy the conditions of s86 the trustees' discretion must remain unfettered. Given that the potential beneficiaries under an Employee Benefit Trust normally include the participators themselves; the employees or former employees; and/or the wives, husbands, civil partners, widows, widowers, surviving civil partners and children and step children under the age of 18 of such employees and former employees; it will normally be difficult to show that the conditions of s10 are met.

1.3.2 Dispositions allowable in computing profits for Corporation Tax (s12)

1.3.2.1 Overview

A disposition by a person is not a transfer of value when the terms of s12 are met: broadly, that the disposition is allowable for the purposes of calculating that person's Corporation Tax.

The relieving effect cannot be given provisionally while waiting to see whether the contribution will become allowable for Corporation Tax purposes; and is only available to the extent that a deduction is allowable to the company for the tax year in which the contribution is made.

A deduction in the Corporation Tax accounts can be permanently disallowed by the following:

  • capital expenditure disallowed by s74(1)(f) ICTA 1988/s53 CTA 2009
  • expenditure not wholly and exclusively incurred under s74(1)(a) ICTA 1988/s54 CTA 2009

Also the timing of a deduction can be deferred to a later period by the following:

  • generally accepted accounting practice (UITF32) which capitalises Employee Benefit Trust contributions by showing them as an asset on the company's balance sheet until and to the extent that the assets transferred to the intermediary vest unconditionally in identified beneficiaries
  • expenditure subject to s43 FA 1989 (the Dextra decision) - see below
  • post 27 November 2002 expenditure subject to Sch24 FA 2003/s1290(2)(3) CTA 2009 - see below

If expenditure is not allowable for any of these reasons then s12 does not apply.

1.3.2.2 Impact of MacDonald (HMIT) v Dextra (2005) UKHL 47 ('Dextra')

The Dextra decision applies to contributions made before 27 November 2002.

In that case, the trust deed gave the trustee wide discretion to pay money and other benefits to beneficiaries and power to lend them money. The potential beneficiaries of the trust included past, present and future employees and officers of the participating companies in the Dextra group and their close relatives and dependants. The trustee did not make payments of emoluments out of the funds in the Employee Benefit Trust during the periods concerned. Instead the trustee made loans to various individuals who were beneficiaries under the terms of the Employee Benefit Trust.

The point at issue was whether the company's contributions to the Employee Benefit Trust were 'potential emoluments' within the meaning of s43(11)(a) FA 1989, being amounts 'held by an intermediary with a view to their becoming relevant emoluments'.

The House of Lords held that the contributions by the company to the Employee Benefit Trust were potential emoluments as there was a 'realistic possibility' that the trustee would use the trust funds to pay emoluments. This meant that the company's deductions were restricted. The company could only have a deduction for the amount of emoluments paid by the trustee within nine months of the end of the period of account for which the deduction would otherwise be due. Relief for the amount disallowed would be given in the period of accounting in which emoluments were paid.

1.3.2.3 Restriction of deductions for employee benefit contributions (Sch24 FA 2003)

Section 143 and Schedule 24 to the Finance Act 2003 applies to contributions made after 27 November 2002 and prevents a deduction for Corporation Tax purposes until the contribution made for employee benefits is spent by a payment that has been subjected to both PAYE and National Insurance contributions. The position already established in Dextra is therefore effectively formalised by legislation for events on or after 27 November 2002.

1.3.3 Dispositions by Close Companies for benefit of employees (s13)

A disposition is not a transfer of value when the terms of s13 are met.

However, this exclusion does not apply where (amongst other things):

  • the contributions by the Close Company are made to an Employee Benefit Trust that does not satisfy s86
  • the participators (s102(1)) in the company and any person connected with them are not excluded from benefit under the terms of the Employee Benefit Trust and so s13(2) applies

1.4 Relief from Inheritance Tax - business property relief (s104)

Usually, sections 10, 12 or 13 will not be met and the contribution by the Close Company will be a transfer of value as a result of a reduction in the value of its estate - the aggregate of the property beneficially owned by the company.

Relief from Inheritance Tax may, however, be available where the value transferred is attributable to relevant business property (s105).

The company's estate is capable of being relevant business property if it is 'property consisting of a business' (s105(1)(a)). However, the availability of business property relief is conditional on whether the transfer meets all the other requirements in Part V, Chapter 1. This means, in particular that:

  • the business is not an excluded one, for example a company the business of which consists wholly or mainly of making or holding investments (s105(3))
  • the value of the relevant business property transferred is not attributable to any excepted assets (s112)

Business property relief will, therefore, not apply on a transfer of value made by a Close Company that is an investment company.

Part 2 - Flat rate exit charge (s72) when property leaves a s86 Employee Benefit Trust

This part describes charges to Inheritance Tax that can arise in any s86 Employee Benefit Trust; even where the original disposition into the trust was not made by a Close Company or individual.

The charge arises where a payment is made from the Employee Benefit Trust into a sub-trust that is not itself a qualifying s86 Employee Benefit Trust (as outlined at 1.1 above). The charge is a flat rate charge and is dependant on the length of time the property was held subject to the terms of the s86 Employee Benefit Trust. Business property relief will not apply to the flat rate exit charge in these circumstances.

In addition, where there is a non-commercial loan to a participator then an exit charge may arise under s72(2)(b).

Part 3 - Ten year and exit charges in respect of any sub-trusts

In general, sub-trusts are not s86 Employee Benefit Trusts and are, therefore, relevant property trusts for Inheritance Tax purposes (s58). (Full details of 'relevant property trusts' can be found in the Inheritance Tax Manual at page IHTM 42001+.)

Relevant property trusts pay Inheritance Tax on two key occasions:

  • on the ten year anniversary of the commencement of the trust (s64) (and every subsequent ten year anniversary)
  • when property leaves the relevant property trust or when it ceases to be relevant property (s65)

For both of these occasions a calculation is required in order to establish the Inheritance Tax liability but this charge will not exceed 6 per cent of the value of the trust assets concerned.

For the purposes of the ten year anniversary charge, the anniversary is calculated from the date on which the property became settled (s81), that is, the date the s86 Employee Benefit Trust commenced. However, property can only be treated as relevant property when it leaves the qualifying Employee Benefit Trust.

Where the trustees of a sub-trust decide to bring the trust to an end an exit charge will arise under s65.

The basis of valuation for a charge arising under either s64 or s65 will be an open market value (s160) and will include the value of loans and any accrued interest.

Part 4 - Payment of ongoing Inheritance Tax liabilities

Section 201(1) (Settled Property) outlines the persons liable for Inheritance Tax on chargeable transfers arising in respect of trusts, including proportionate charges (s65) and ten year anniversary charges (s64) as well as the flat rate charge (s72) (property leaving employee trusts). Where the transfer is made during the life of the settlor and the trustees are not resident in the UK then the settlor is liable for the ongoing trust Inheritance Tax liabilities (s201(1)(d)).

The settlor of an Employee Benefit Trust will usually be the company, whether or not it is a Close Company.

In addition, where a participator has benefited then s201(1)(c) means that they are liable for the ongoing trust Inheritance Tax liabilities.

Part 5 - Income Tax assessable under the transfer of asset (ToA) legislation on income arising in offshore Employee Benefit Trusts

5.1 Overview

It is common for the trust vehicle used as the Employee Benefit Trust to be situated in an offshore jurisdiction and this will potentially give rise to additional liabilities where income arises within the trust.

The ToA legislation was amended by FA 2006 and the legislation applicable following this amendment can be found at s714 ITA 2007, onwards. It came into effect from 6 April 2007. The pre-FA 2006 legislation is contained in s739 ICTA 1988, onwards. There are two potential charges that arise under the ToA legislation - the so-called 'income charge' (s739 ICTA 1988/s720 ITA 2007) and the 'benefits charge' (s740 ICTA 1988/s732 ITA 2007). Each of these are considered in turn.

5.1.1 Income charge

The income charge provisions apply to prevent the avoidance of a liability to Income Tax by individuals who are ordinarily resident in the UK where the following conditions apply:

  • there is a transfer of assets by virtue or in consequence of which, either alone or in conjunction with associated operations, income becomes payable to a person abroad
  • the transferor has the power to enjoy the income

For the income charge provisions to apply the individual on whom the charge arises must be the person who transfers the assets or procures the transfer. If the offshore Employee Benefit Trust is a normal commercial arrangement by a company to reward its employees, the transferor is the employer company; and in such circumstances the income charge is unlikely to be applicable as the transferor and beneficiaries are different people. However, it may be that the employee has transferred a right to receive a bonus into the offshore Employee Benefit Trust and is therefore the transferor. If this is the case the ToA legislation may apply and the employee will be liable to tax on any income arising in the trust.

If the employer company is controlled by its shareholder/directors and the offshore Employee Benefit Trust was formed solely for their benefit, the director/shareholders may have procured the transfer into the offshore Employee Benefit Trust and could be considered transferors for the purposes of the income charge. Whether or not the ToA income charge is then applied will depend on the facts of each case.

5.1.2 Benefit charge

Where the company, not the employee is the transferor the benefit charge may apply. The benefit charge matches any income arising within the Employee Benefit Trust with any benefits received by the employee. The test is effectively the same as s739 ICTA 1988/s720 ITA 2007 in that where by virtue or in consequence of a transfer income becomes payable to a person abroad, s740(1)(b) ICTA 1988/s732(1)(d) ITA 2007 applies the charge to individuals not liable to tax under the income charge. If a person receives a benefit provided out of assets available for the purpose as a consequence of the transfer, and the trustees are in receipt of income, any benefit provided to a beneficiary is potentially chargeable. The amount of the benefit charged to tax is up to the maximum of either the income or benefit. The benefit charge could, therefore, catch any income arising in the offshore Employee Benefit Trust if it is not caught by the income charge and there are actual distributions by the trustees which are not otherwise chargeable to Income Tax.

Part 6 - Income Tax in relation to UK source income of offshore Employment Benefit Trusts

If an offshore Employment Benefit Trust receives UK source income then, subject to s811 ITA 2007, the income will be chargeable to tax in the UK and the trustees should make a return of this income to HMRC. Section 811 ITA 2007 limits the scope of the liability to Income Tax of a non-UK resident trust provided that none of the trust's beneficiaries are resident in the UK. As Employee Benefit Trusts are discretionary trusts the trustees will be chargeable to tax at the trust rate under s479 ITA 2007. If the trustees make a discretionary payment out of the trust income to a beneficiary this is treated as untaxed income of the UK resident beneficiary. It does not matter that the trustees have suffered tax on the trust income. The beneficiary returns the income received and can claim relief under Extra Statutory Concession B18.

The trustees of the offshore Employee Benefit Trust or sub-trusts may have advanced interest bearing loans to beneficiaries. If the beneficiaries are resident in the UK then depending on the particular circumstances of each beneficiary the interest will be UK source income in the hands of the trustees and should be reported as such. It is also likely that in such circumstances tax should be deducted at source by the beneficiary paying the interest under s874 ITA 2007.

Where it is contended that the interest is not UK source income, the circumstances surrounding the payment of interest will be closely examined by HMRC.

If the beneficiary does not pay the interest, but the interest is rolled up by the trustees, no immediate tax charge will arise; however, if the interest is subsequently paid or capitalised it is likely that an Income Tax charge will accrue on payment or capitalisation.

Part 7 - Payment of ongoing trust Income Tax liabilities

To the extent that income continues to arise within an offshore Employee Benefit Trust and is caught by the transfer of assets legislation the income charge and benefits charge will continue to apply. Likewise if the trustees continue to receive UK source income they will have an ongoing liability to Income Tax and should continue to complete Trust Returns.

Part 8 - Contact details and legal references

8.1 Contact details

If you wish to notify the Trusts and Estates business within HMRC of the existence of an Employee Benefit Trust; or, if you wish to discuss settlement of any Inheritance Tax and non-resident trust liabilities that have arisen in respect of an Employee Benefit Trust, then please contact HMRC Trusts & Estates via this link ebtiht.settlementmailbox@hmrc.gsi.gov.uk.

Further information can be obtained by contacting the Helpline on Tel 0845 30 20 900.

8.2 Legal references

Corporation Tax

For accounting periods ending on or after 1 April 2009:

  • references to Schedule 24 Finance Act 2003 should be taken to be references to Sections 1290 to 1297 Corporation Tax Act 2009
  • references to s74(1)(a) ICTA 1988 should be taken to be references to s54 Corporation Tax Act 2009
  • references to s74(1)(f) ICTA 1988 should be taken to be references to s53 Corporation Tax Act 2009

Income Tax

For tax years 2005-06 onwards:

  • references to Schedule 24 Finance Act 2003 should be taken to be references to Section 38 to 44 Income Tax (Trading and Other Income) Act 2005
  • references to s74(1)(a) ICTA 1988 should be taken to be references to s34 Income Tax (Trading and Other Income) Act 2005
  • references to s74(1)(f) ICTA 1988 should be taken to be references to s33 Income Tax (Trading and Other Income) Act 2005
  • reference to s739 ICTA 1988 should be taken to be references to s720 ITA 2007
  • reference to s740 ICTA 1988 should be taken to be references to s731 ITA 20

About the Author

Crown Copyright 2011.

A licence is needed to reproduce this article and has been republished for educational / informational purposes only. Article reproduced by permission of HM Revenue & Customs.



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Article Published/Sorted/Amended on Scopulus 2011-04-06 11:13:54 in Tax Articles

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