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Tax must be deducted from investors’ bonuses

The upper tribunal has decided that a loyalty bonus paid to an investor is an “annual payment” for income tax purposes and so must have tax deducted. Andy Keates explains why.

6th Sep 2019
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Last April, I wrote about a case in which Hargreaves Lansdown Asset Management Ltd (HL) persuaded the first tier tribunal (FTT) that the loyalty bonus wasn’t an annual payment.

HMRC appealed this decision and the upper tribunal (UT) disagreed with the FTT (2019 UKUT 0246).

Why does it matter?

Companies that are not a ‘deposit takers’ (banks, building societies, NS&I etc) must withhold basic rate tax from any annual payments. The recipient may be able to recover this tax if the income falls within their personal savings allowance or savings rate band.

What is an annual payment?

Both the FTT and UT agree that to be an annual payment it must:

  1. be payable under a legal obligation;
  2. recur or be capable of recurrence;
  3. constitute income (not capital) in the hands of the recipient; and
  4. represent “pure income profit” to the recipient.

It was accepted by all parties that conditions 1 and 3 were satisfied.

FTT decision

The FTT decided that condition 2 was also fully satisfied. The loyalty bonus was capable of recurring, as long as some funds remained under Hargreaves Lansdown’s management.

However, in the view of the FTT, condition 4 was not satisfied. Judge Scott’s analysis was that the loyalty bonus was not income, let alone pure profit. Instead, he categorised it as a “mechanism for reducing net cost, nothing more and nothing less”.

UT decision

HMRC appealed on the ground that the FTT had decided wrongly on condition 4: the judge’s decision that the bonus was merely a cost reduction was wrong in law.

Hargreaves Lansdown (HL) counter-appealed, arguing the FTT was wrong on condition 2 and that the bonus payment was not capable of recurrence.

Recurrence

HL ingeniously suggested that each month’s loyalty bonus was in effect a “one-off” payment for these reasons:

  • it could be revoked at any time;
  • the investor must ensure that sufficient funds remain invested under HL’s management every month in order to qualify;
  • the investor could completely disinvest at any time; and
  • the amount of bonus was derived from the balance under management for each separate month.

The UT was not convinced. The loyalty bonus was paid monthly subject to a single contractual arrangement, whose terms apply on a continuing basis. This did not amount to a fresh contract each month.

The UT upheld the decision of the FTT on condition 2.

Pure income profit

The conclusion that the bonus was a means of reducing the annual management charge (AMC) was shown to arise during the FTT hearing from a misunderstanding of how funds are managed, both in law and practice. The UT judges applied their own specialised knowledge of investment management to fill this gap.

In legal terms, the AMC is paid by the fund to its authorised fund manager to remunerate them for their management skills. The investor has no legal obligation to pay the AMC.

In practice, the AMC is paid out of the fund’s income prior to distribution to investors. If income is insufficient, capital will be applied to pay the AMC.

EU regulatory provisions require the direct and indirect costs of investing in a fund to be disclosed by the fund manager to the investor in the form of a “reduction in yield”. This is the case whether the investment is direct or via a platform manager such as HL.

A rebate agreed between fund managers and introducers such as HL, does not reduce the AMC, which remains the same whether such a rebate exists or not. It is a bilateral agreement between fund and introducer, and the fund manager had no right or obligation to ensure that all or any part of the sums received by HL was passed on to its clients.

Because there is no contractual link relating to the loyalty bonus between the investor and the fund, it is wrong to regard the bonus as reducing the AMC. It is, in substance, a commission paid by the fund manager in consideration for HL’s ongoing promotion of the fund to its clients.

The operation of the AMC runs independently from the arrangements, whereby a rebate is paid by the fund manager to HL and then by HL to an investor. They are not a single composite transaction of which it might be said that one payment reduces another cost.

The suggestion “that the industry at large largely regarded the investors as paying the AMC” is without evidential foundation. How HL chooses to market an arrangement to its clients is not determinative of the actual substance of those arrangements.

The UT concluded that the investor receives a further income distribution as a result of their continuing investment in the fund. “The term loyalty bonus is, therefore, a correct description; the payment does what it says on the tin – it rewards loyalty”.

Conclusion

The UT found the loyalty bonus is an annual payment, and basic rate income tax should be withheld and accounted for.

The FTT’s decision was not unreasonable in the light of the limited evidence (primarily HL’s own marketing material) which had access to. However, this was seen to be wrong in law once the full legal analysis was made available.

This case is yet another example of HMRC’s lack of adequate preparation when taking cases before the FTT. If sufficient expert evidence had been presented at the FTT this second UT hearing might have been avoided.

Replies (1)

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By Kathryn15
09th Sep 2019 14:32

"The recipient may be able to recover this tax if the income falls within their personal savings allowance or savings rate band."

Are the personal savings allowance and savings rate band definitely available against this income? I thought not, as I have followed instructions advising it should be entered it as "Other Income" on the tax return, not as "Taxed Interest".

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