In the recent case of PA Holdings Ltd and Kully Janjuah v HMRC, an employer argued that payments of dividends as part of an employee bonus scheme could only be taxed as such and so could not be subject to PAYE or NICs as employment income.

The Tax Tribunal (as the Special Commissioners are now known) agreed that the taxing provisions for dividends took precedence over the taxing provisions for employment income. However, there was no overriding provision for NICs and so it was possible for an NIC charge to arise on dividends.

The case will be of great interest to those who have used dividends as part of bonus planning schemes, and are still contesting liability with the Revenue, although, following anti-avoidance legislation introduced since 2003, the scope for using dividends as a tax-efficient way of paying bonuses has considerably diminished.

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In the recent case of PA Holdings Ltd and Kully Janjuah v HMRC, an employer argued that payments of dividends as part of an employee bonus scheme could only be taxed as such and so could not be subject to PAYE or NICs as employment income.

The Tax Tribunal (as the Special Commissioners are now known) agreed that the taxing provisions for dividends took precedence over the taxing provisions for employment income. However, there was no overriding provision for NICs and so it was possible for an NIC charge to arise on dividends.

The case will be of great interest to those who have used dividends as part of bonus planning schemes, and are still contesting liability with the Revenue, although, following anti-avoidance legislation introduced since 2003, the scope for using dividends as a tax-efficient way of paying bonuses has considerably diminished.

Background

The case concerned a tax avoidance scheme implemented by PA Holdings (the "Company") to replace the cash bonus arrangements the Company previously used to reward employees. Under the scheme, the Company established an offshore employee benefit trust (the "EBT") and made a payment of approximately £24.6 million to the EBT which represented the amount which would have been paid to employees as bonuses.

This money was then invested in shares in a special Jersey company, which were awarded to employees. The shares then paid a dividend to employees of £24.6 million.

At the relevant time a higher rate taxpayer in the normal course of events only had to pay 25% tax on dividends and no NICs, compared with 40% tax and NICs (both employer's and employee's (in some years)). The total annual tax and NICs savings were approximately £6.7 million.

Tax treatment of the dividend payments

The Revenue instead argued that the dividends should be taxed as employment income and so subject to PAYE and NICs on the basis that the arrangements were orchestrated between the parties and that the employees received the payments not because of their holding of shares but because of their employment with the Company. The payments were clearly linked to their employment. The Company was heavily involved in the arrangements: the acquisition of the shares in a special Jersey Company was funded by the Company, continued employment with the Company was a condition of receiving both the shares and the dividends and the Company was heavily involved in "selling" the arrangements to employees. The Company informed employees of the new arrangements, stating that they were "exciting proposed changes to the delivery of current bonus awards". Further the EBT's resolutions stated that arrangements were intended to motivate and encourage employees in the performance of their duties.

The Company maintained that whatever the background, the fact was that the payments were received as dividends in respect of the shares they held and should only be taxed as dividends. If reinforcement was needed, specific legislation restricted dividends from being taxed as anything other than dividends (Section 20(2) Income and Corporation Taxes Act 1988 ("Section 20(2)", now s366(3) Income Tax (Trading and Other Income) Act 2005 and s716A Income Tax (Earnings and Pensions) Act 2003).

The Special Commissioners held that:

  • it was possible for the payments to be characterised as both dividends and employment income and on the facts of the case it was appropriate to do so;
  • Section 20(2) was unambiguous in providing that the tax charge on distributions (such as dividends) took precedence over the employment income charge and accordingly the payments could not be taxed as employment income and could not be subject to PAYE; and
  • the payments would, however, be subject to NICs as the payments were earnings and there was no NIC statutory provision or case law equivalent of Section 20(2) in the context of NICs.

Application

The case is a partial victory for the Company as at least the scheme will have saved tax if not NICs. Many companies used this scheme to pay bonuses (it was particularly popular in the City) and (properly implemented) significant savings were offered and achieved. It is notable that Ernst & Young is reported in the case as having charged the Company a £335,000 fee for its intellectual property in this scheme, which gives some idea of what was at stake.

Those still tempted to take advantage of the tax planning opportunities apparently confirmed by the case should, however, be aware anti-avoidance provisions introduced in 2003 and 2004 are likely to curtail the scope for this. In particular:

  • Since 2003, companies have had had a statutory bar on corporation tax deductions for payments to employee trusts unless and until those monies are used to provide employment income. Not receiving tax relief for remuneration now severely reduces the attraction of the scheme (and in any event accounting changes and previous law may have denied a deduction anyway).
  • The success of the scheme was dependent in part on there being no upfront income tax charge when the employees acquired shares, which was possible under the legislation in place at the time even though they paid nothing for their shares.

    Under current legislation where an employee acquires shares for less than market value they can be made subject to an upfront income tax charge on the value of the shares if anti-avoidance activity is in play. Accordingly, in the PA Holdings case, the employees would have been taxed upfront on the value of their shares which would have taken into account the expected dividend and then the dividend itself - potential double taxation!
  • Finally, the Revenue has enacted legislation which purports to remove the automatic taxation of dividends as employment income (although some doubt the effectiveness of this). Specific legislation (if further legislation were needed) now allows an employee to be treated as receiving employment income where he receives a benefit in connection with shares he has acquired by reason of his employment. While in practice the Revenue had said that normal dividends would not be caught, dividends used as a way of avoiding tax on cash bonuses would probably be treated as a benefit.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 06/07/2009.