The tax consequences of being generous

It is heart-warming to see the number of business owners who want to reward loyal staff on significant events, such as the sale of the business, transition to employee ownership or an IPO. Owners who receive a return on their hard work over many years often want to share that with their employees. They think it's a gift. HMRC sees it as potential tax avoidance.

These gifts are therefore taxable under one of the harshest and most complex of employment tax provisions, sometimes known as the ‘disguised remuneration rules’ but officially as ‘employment income provided through third parties’ and found in part 7A of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA).

Broadly speaking, the tax works like this:

The business owner disposes of some shares and makes a capital gain, let's say £10m. The owner may pay capital gains tax at 20 per cent, leaving £8m. A generous gift is then made to, say, 250 employees, totalling £1m. That is a very healthy bonus, but it is fully subject to PAYE with income tax at the relevant rates and employee’s National Insurance, and it’s the employer, not the business owner, who has the task of operating PAYE plus paying the employer’s National Insurance contributions at 15.05 per cent.

The tax implications of this generosity are often misunderstood. The logic behind the tax is that these individual employees will be getting a reward derived from their employment, and so it should be taxable. The problem is that this £1m has been taxed twice – once as a capital gain, and then as income.

By contrast, if it was the company that had made the gift instead of the previous owner, tax on the employees would be the same, but the company might be able to gain relief from corporation tax purposes meaning the gift is taxed just once.

The unfairness of this is made worse if the former business owner decides to give an employee a loan instead of an outright gift. For example, they might want to help them to buy shares in the company or to buy a house. Even though that loan might be repayable, and might in fact be repaid, the full amount of the loan is still treated as a fully taxable amount and the tax is not repayable if the loan is repaid.

Whether this is right or wrong is for Parliament to decide, but it is a little-known trap that can bring some very nasty tax consequences.

If you have questions or concerns about how this might affect your business, please contact Fiona Bell.