Crack down on tax avoidance schemes relating to employment income

As part of the pre-budget report on 2 December 2004 the Chancellor announced a crackdown on tax avoidance schemes relating to employment income. Finance Act 2005 will amend the infamous "Schedule 22 legislation" (as contained in Part 7 of the Income Tax (Earnings and Pensions) Act 2003). The Schedule 22 legislation was introduced in 2003 and relates to employment income paid in the form of shares or other non-cash means.

Earlier this year a new disclosure regime was introduced pursuant to which accountants, lawyers and other advisers are obliged to notify the Inland Revenue of certain tax planning schemes involving employment arrangements. As a result of these disclosures, the Inland Revenue has concluded that tax avoidance in relation to non-cash remuneration remains rife. The Inland Revenue has therefore announced some detailed changes to block specific schemes, such as setting up a cash box company and paying a bonus to an employee in the form of dividends. The detailed changes will take effect from 2 December 2004.

More interesting perhaps in the longer term is the general announcement indicating that schemes to deliver disguised employment bonuses in a non-cash form free of income tax and national insurance will no longer be tolerated; as and when the Inland Revenue becomes aware of a specific scheme, new legislation will be introduced to block it, but with effect from 2 December 2004 when necessary. A further law-now on retrospective legislation will be issued shortly.

Essentially, we are now in a situation where, every time an individual acquires a valuable non-cash asset or the value of a non-cash asset increases (separate from normal commercial growth), we need to ask whether or not there is an employment connection. If there is an employment connection then it seems clear that the Inland Revenue will seek income tax and national insurance. Given the complexity and detail and raft of changes to the Schedule 22 legislation, it seems odd to find ourselves in a position where, as far as the Inland Revenue is concerned, it is only necessary to apply a simple test of: has the individual received value in his capacity as an employee?

The pre-budget announcement on 2 December 2004 is, however, the culmination of a hardening Inland Revenue approach that has been emerging ever since the publication of the Schedule 22 legislation. Both the published guidance and the informal guidance obtained by this firm reveal that the Inland Revenue attitude is: if you fall outside the detail of a particular part of the Schedule 22 legislation such as the restricted securities regime but we believe you have engaged in unacceptable tax planning, we will simply tax you under a different part of the legislation (such as the vaguely worded provision that gives rise to income tax where a relevant person "receives a benefit" in connection with employment-related securities). The fact that employment arrangements are one of the two areas targeted by the recent Inland Revenue disclosure regime is also telling. As is the fact that many of the detailed changes announced involve amending various provisions to state that they only operate in a particular way where there is no avoidance motive – a general anti avoidance provision for share schemes?

This firm believes that the Inland Revenue could struggle to enforce this "purposive" approach to the detailed Schedule 22 legislation if it went to court. Unless and until the Inland Revenue are successfully challenged in court, however, any scheme purporting to deliver employment income without attracting income tax or national insurance must be approached with caution and in the knowledge that an Inland Revenue attack is likely.

For more information on Schedule 22 issues or other tax issues relating to employee incentive arrangements please contact Mark Nichols ([email protected], 020 7367 2051), Alison Hughes ([email protected], 020 7367 2862), Toby Locke ([email protected], 020 7367 2411) or Anika Chandra ([email protected], 020 7367 3798).