The scheme concerned is currently held out by the providers to be a successful strategy for the avoidance of the consequences imposed by Paragraph 3 of Schedule 12 to the Finance Act 2000 (commonly known as “IR35”). This analysis examines what the arrangement is attempting to achieve, highlights the ways in which it may fail to meet these objectives and gives an assessment of the potential impact on a company of involvement with this structure.
How the structure purports to work
The suggested structure is as follows:
1. The contractor ceases using his service company, and becomes an employee of a composite company but the individual has no shares in this composite company and is not in partnership with it.
2. The client company or the agent no longer pay fees to the service company owned by the contractor, but, instead, pay fees to the composite company who, presumably, would account for VAT on the fees received.
3. The composite company charges a percentage fee of the amounts received under the contract, and appears, in addition, to be able to provide group life, health and sickness insurance, and group pension arrangements.
4. The individual is be paid a salary that, at the very least, covers the minimum wage, and PAYE and NIC would be applied to this salary.
5. The composite company then makes a contribution to an employee benefit trust ("EBT") located in the Isle of Man. This contribution would comprise the balance of the fee received from the client company or agency net of the composite company’s own fee, and amounts paid by way of salary and associated NIC costs.
6. The trustees of the EBT would then make a loan, interest free, to the individual, which represents the balance of the net fee received. This means that the entire fund held by the trustees would be passed out by way of loan to the individual concerned.
7. There would be no terms for the repayment of this loan which, in practice, would be written off when the employee leaves the company. An income tax liability would arise each year based on the benefit of the interest free loan which, under current rates, would give rise to an annual income tax liability based on 5% of the loan. This tax liability would accumulate each year as the loan increases. It would appear that it is argued that no income tax liability would accrue when the loan is ultimately written off.
Analysis of why the structure may fail
In the view of the author, the structure is flawed in several respects, although it would be true to say that the provisions emanating from IR35 would not seem to apply.
A number of issues need to be considered.
Commerciality of the structure
It is difficult to see a bona fide commercial rationale for the structure. This is important as the Inland Revenue can ‘look through’ any arrangement the primary purpose of which is the avoidance of tax.
The trustees of the EBT have no discretion as to the application of the funds contributed to the trust by the composite company. Each of the individuals employed by the composite company is entitled to a very specific sum which must be paid out (or ‘loaned’) to them by the trustees, presumably very soon after the contribution has been made.
It could be argued, therefore, that the loans are not discretionary payments from a wholly independent settlement, but instead that the trustees are acting as no more than a conduit for the composite company, such that PAYE and NIC should be applied to the whole of the amount paid to the individual contractors. This would mean that the contractors would be in exactly the same position as they would have been in have they been treated as straight-forward employees of the company (assuming the composite company forgoes their percentage fee).
Assuming that the trustees are able to make loans to the employee that are not caught by PAYE, there remains an annual benefit-in-kind charge to be applied to the outstanding loan as described above.
Income tax on write-off of the loan
Assuming that the trustees are able to make loans to the employee that are not caught by PAYE, the write-off of the loan must be considered.
When the write-off happens, there would be an income tax charge and also a Class 1 NIC liability (as this would be an emolument under s19 ICTA on general principles). This is in addition to the annual income tax liability and also a Class 1B NIC liability on the annual benefit-in-kind on the interest free loan.
Even if the write-off happens after the individual ceases employment with the composite company an income tax charge may arise under s148 ICTA 1988. This legislative provision imposes a charge to tax where payments and other benefits are made in connection with the termination of employment, even if received at a later date.
Potential implications for the composite company
The composite company would have to make a contribution to the EBT of almost the whole of its profits, as the only amount not paid out by way of salary, NIC or other benefits is the fee charged by them on the contract value. This, presumably, would be reduced by internal administrative costs.
This level of contribution is significantly greater than a level of contribution that would, ordinarily, be acceptable by the Inland Revenue as a reasonable contribution. Our experience is that the Inland Revenue argues that any contribution in excess of 50% of profits is not commercial and could not be regarded as being incurred wholly and exclusively for the purposes of the company's trade. As a result, it is likely that the contribution to the EBT would not be allowable as a deduction for corporation tax purposes.
If the composite company has a corporation tax liability on its profits (profits which fund the contribution to the trust) and the contribution to the EBT is disallowed for corporation tax purposes by the Inland Revenue, how would that corporation tax liability be paid? Presumably this would need to come from profits in future years – though this is the same money that would otherwise be expected to flow to the beneficiaries of the trust.
Furthermore, if the trustees are liable to account for a PAYE and NIC liability on the amounts paid to the beneficiaries (on the basis that they are acting as no more than a conduit), how will those liabilities be paid? What rights do the individual contractors have over the amounts paid to the composite company by the composite company’s clients?
Potential Implications of using this arrangement
If the Inland Revenue were to investigate the composite company, the responsibility for meeting any consequent liabilities (in respect of unpaid PAYE, for example) would rest with the composite company. That company has limited liability, however, and would in all likelihood be wound up before the outstanding payments were made. In these circumstances the Inland Revenue would seek to recover the shortfall from the individual contractors.
In essence, there is the potential for contractors not only to lose entirely ‘contributions’ made to the EBT but not yet distributed – and to face substantial liabilities for sums previously received.
The type of arrangement set out above is, in the author’s view, ineffective for corporation tax, income tax and NIC purposes, and has the potential to result in financial losses for participants and equally has the capacity to generate a great deal of ill-will for individuals to whom the scheme is promoted.
WJB Chiltern Group PLC has specialist EBT and Reward Consultancy teams who provide expert advice to corporate clients on all aspects relating to Employee Benefit Trusts and efficient executive remuneration strategies.
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