Contractors face ruin to pay tax on loans
Andrew Robins provides an update on the legislation to impose tax and NIC charges on the value of contractor loans and ETB loans which remain outstanding at April 2019.
Last year Rebecca Cave discussed the Budget 2016 proposals to impose a retrospective tax charge on certain loans to contractors and employees, and the reasons why this charge was seen by many as both unfair and retrospective.
Many things have changed in the world since then, and both political and judicial decisions have been made that many observers feel would justify a review of the original plans. However, when the draft loan legislation was re-published on 13 July 2017, it looked virtually identical to the previous, much criticised, 2016 version.
At the heart of the proposals are the complicated and deliberately punitive ‘disguised remuneration’ (DR) rules. These rules began to take effect from 9 December 2010 and were specifically designed to discourage payments being routed through third parties to defer or eliminate employment taxes.
The DR rules were widely drafted and, in almost all cases, contractor loans and loans made by employee benefit trusts (EBTs) taken out on or after 9 December 2010 were subject to immediate income tax and national insurance (NIC) charges.
The Budget 2016 proposals took the existing DR rules and expanded them further, to cover pre-2010 loans that remain in existence on 5 April 2019. Under the proposals, unless the borrower agrees a settlement with HMRC prior to this date, most outstanding loans will be taxable as earnings on 5 April 2019, creating a typical combined tax and NIC liability of 61% of the loan value.
How to repay
The draft legislation includes a very wide definition of loan and a very narrow definition of repayment.
In particular, for repayments after 16 March 2016 only “payments in money by the relevant person” will be treated as effective, so the transfer of an asset to satisfy a repayment obligation after that date will be ignored. In cases where the expectation was that the borrower would die before the liability matures, the borrower’s estate will be worse off by both the repaid debt and the tax – a typical cash cost of 147% of the amount borrowed, with the possibility of the individual also picking up the employer’s NIC liability.
The terms of the HMRC settlement agreements for EBTs and contractor loans are not generous. Essentially, the taxpayer is required to accept that the full amount paid into the arrangement should have been taxed as earnings initially, and to settle the income tax and NIC that should have been paid. HMRC will request interest on this ‘late paid’ tax, although in some cases this can be challenged.
In the case of an EBT, if the value of the trust has increased since its creation (eg due to investment growth), any settlement will now only cover the original contributions into the EBT. The growth in value of the trust will be taxable as employment income when distributed.
HMRC is not willing to change its settlement terms, even where the tax at stake is enough to result in financial ruin for the taxpayer. HMRC’s attitude is heavily influenced by its view that loan arrangements are abusive tax avoidance, and cracking down hard on affected taxpayers is a way to send a signal discouraging anyone from undertaking similar ‘tax planning’ in future.
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The only way to avoid suffering a tax charge on most outstanding contractor or EBT loans is to repay them in cash by 5 April 2019. Failing that, the choice is between settling with HMRC now or waiting until 2019. This decision comes down to calculating the tax, interest and penalties payable for settling now, compared to the potential total tax charge in 2019.
Is it fair?
Ever since the proposed new charges were first made public they have been criticised. There is a widely-held view that the effect of the charge is retrospective and that its whole premise is unfair.
The counter-argument is that although it affects loans taken out before the legislation was introduced in 2010, the charge can be eliminated by repaying the debt, so the taxpayer can choose what to do. Successive governments have also considered that where tax planning is ‘abusive’, even the most draconian anti-avoidance rules are justified.
It is, in theory, possible to seek judicial review to request the courts to overturn tax charges on the basis that the taxpayer had a legitimate expectation that they would not apply. It is also possible to take a case to the European Court of Human Rights on the basis that the legislation is a breach of the right to peaceful enjoyment of personal property. In practice, even if successful, the cost of making such a challenge is likely to be prohibitive, and the chances of success are very small.
Unfortunately, the reality is that the new loan charges will be introduced, and they will need to be faced head on. The real question for affected borrowers is how to find the money to meet their obligations.
Andrew Robins is a partner in RSM’s London private client tax team, advising on all areas of UK personal taxation. He specialises particularly in advising high net worth individuals, non-UK domiciled individuals, non-UK trusts, and members of corporate remuneration plans such as employee benefit trusts and international pension plans.