Avoiding 50% tax: Cheap loans and EBTs
Will cheap loans save you tax? Nichola Ross Martin explores the whys and wherefores of HMRC’s latest business briefing on close company EBTs.
With a 50% ‘super tax’ fast approaching, the idea of taking cheap company loans instead of cash remuneration is looking increasingly attractive for many higher paid directors and employees. However, you cannot take a long term loan from your company without the company incurring a tax charge under section 419 of the 1988 Income Tax Act (ICTA 1988).
One way to get around this problem is to set up an Employee Benefit Trust (EBT). This allows you to transfer funds into your trust, which then advances them to you and your family and employees. So far, so good - cheap loans all round. However, HMRC seems to have finally had enough with EBTs. It has just published a briefing to illustrate its ‘new’ view that if your company is a close company, and you are one of its participators, any loan back to you from your EBT will incur an inheritance tax charge. It is an interesting approach and HMRC has to jump through several hurdles to get there.
EBTs in a nutshell
An EBT is a special sort of trust which is set up to benefit ‘all or most of the persons employed by or holding office with the body concerned’.
They were a tax planner’s dream for a while. Up until 2002 a company could make a contribution into an EBT and receive corresponding corporation tax deduction for the payment. The trustees of the EBT would then use these funds to confer benefits to the company’s employees, and some companies used them to make large loans (sometimes millions of pounds) to employees, but normally it went to the directors and their families, who benefited from the tax free cash, often using a web of sub-trusts. Incidentally, if you happened to die in service, this sort of loan can be written off tax-free too.
Following the case of MacDonald (HMIT) v Dextra Accessories, the government changed the rules. From 27 November 2002 a company is no longer entitled to tax deduction on its contribution to the EBT unless the EBT applies the funds within nine months of the company’s year end as some form of remuneration which is subject to PAYE and NICs.
The result has made EBTs less attractive, but they remain a useful tool when it comes to tax planning as they can still be used to make cheap loans to employees, distribute profits and fund share ownership trusts. They are also handy when income tax is so high in comparison to corporation tax.
The close company trap
A close company is basically a UK registered company with five or less participants/directors - see section 102(1) of the 1994 Inheritance Tax Act (IHTA 1984) though for a full description.
When a company is close there are special rules to ensure that it cannot use its funds (which are, after all, its participator’s funds), to avoid inheritance tax. Therefore, when a close company transfers its funds into a trust which is set up for the benefit of the company’s participators, this can become a taxable event under IHT transfer of value provisions, according to HMRC. These rules create a tax charge on the funds transferred proportionately according to each participator’s interests, subject to their available annual IHT exemption.
Not every transfer of funds, or ‘disposition’ as it is known in IHTA speak, is only treated as transfers of value (i.e. taxable). There are exemptions which are found in sections 10 to 13 of IHTA 1984. These cover dispositions that are:
- Section 10: Not intended to confer gratuitous benefit.
- Section 11: For the maintenance of family (not relevant here).
- Section 12: Allowable for income tax or corporation tax, or if it provides retirement benefits to employees and their dependants under an approved pension arrangement.
- Section 13: Into a trust not designed to benefit a close company’s participators.
EBTs and transfers of value
When a close company makes a contribution into an EBT, the EBT’s trust deed is drafted so that the trustees have to use the funds to reward employees for their past services. This means that there is not normally any intention to confer any gratuitous benefit and therefore the section 10 exemption applies. HMRC disagrees with this and argues that there must be a gratuitous benefit, particularly when the scheme is set up to provide unlimited loans to the controlling director.
Industry insightsView more
If the EBT does not use the company’s contribution within nine months of the company’s year end to make payment which is subject to tax, the contribution is effectively held in ‘corporation tax limbo’. It is an asset for tax (and on the company’s balance sheet) and it is only when the EBT converts the payment into taxable earnings in a later period that the contribution becomes allowable for corporation tax for the company. As the payment is not allowed for corporation tax, this means that it must be a transfer of value of this point, so this rules out the exemption in section 12 too.
There is no relief under section 13 as the loan is made to participators.
HMRC is going to be homing in on close company EBTs and if it is correct in its analysis, IHT is payable by the company. It 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. If the company does not pay, HMRC will collect it from its participators (see paragraph 30124 of its inheritance tax manual, ‘Liability in Special Cases: Transfers by a Close Company’).
Is HRMC right?
The application of the transfer of value rules is just HMRC’s view of how things stand. It looks reasonable, especially if the loans are being made to one person of their family on a semi-permanent basis. Then again, can the creation of an asset in the company’s balance sheet really be defined as a transfer of value, particularly when any employee loan is capable of it or will be repaid, and tax will be paid on the funds at a later date?
I put these questions to David Heaton, who is Baker Tilley’s top man when it comes to employment taxes. He says that the guidance is ‘contentious’, and notes that whoever wrote HMRC’s guidance has not noticed that we have a new Corporation Tax Act. (It’s quite cheery to see that tax is evidently so taxing that even HMRC can’t keep up with it!).
David thinks that a properly drafted EBT will probably scupper this interpretation, and believes that the gratuitous benefit part is going to be difficult for HMRC to argue. “Only time will tell whether the tribunals agree”, he says.
As with all these things, the devil is in the detail. If you have an EBT set up, you may want to have your paperwork reviewed in the light of HMRC’s new approach.
HMRC says: “Pending the resolution of any legal challenge to this view, existing cases will be pursued by HMRC on this basis”.
Links: HMRC’s Business Brief 49/09
Nichola Ross Martin FCA, heads up www.rossmartin.co.uk a unique practical tax database with Virtual Tax Partner support for accountants.