FOI release

Section 6 - Interaction with other taxes

Published 23 April 2020

There are several interactions between DR, and the loan charge, and taxes other than Income Tax and National Insurance contributions (NICs). We do not think there is any interaction with Capital Gains Tax, and have set out in more detail the interaction with:

• Beneficial loans;
• Inheritance Tax; and
• Corporation Tax

The interaction with beneficial loans and Corporation Tax only apply to employment DR schemes. Inheritance Tax applies to both employment and self-employment DR schemes.

Beneficial loans

Loans made from an employer to an employee that are interest free, or attract a very low rate of interest, can give rise to a benefit in kind (BiK) charge. The charge is Income Tax and Class 1 secondary NICs on the benefit of having a lower rate of interest than would be available from a lender other than the employer. Such loans are often referred to as ‘beneficial loans’. The beneficial loans BiK charge applies whether the employer makes the loan directly, or indirectly via a third party.

It has been claimed that some individuals paid a BiK tax charge based on the beneficial loan provided through the DR scheme. Any BiK tax charge would be small, as it would only arise on the difference between the interest rate charged and a government set rate equivalent to a commercial rate (the official rate of interest).

Some commentators have claimed that because individuals paid a BiK tax charge they thought they were fully compliant. Tax enquiries opened by HMRC would have made clear that Income Tax was due on the amount of the loan, and individuals declaring a BiK are likely to have done so to make the arrangement seem less like avoidance and reduce the risk of challenge.

HMRC’s position is that DR schemes give rise to an employment income charge at, or around, the time the loan is made on an amount roughly similar to the loan balance. An employment income charge would be on a much larger amount and takes precedence over a BiK charge so HMRC’s view is there is no BiK tax charge. Anyone who paid a BiK charge can reclaim it through the overpayment relief claims process subject to the normal time limits.

The DR rules, including the loan charge, make clear that once an employment income charge has arisen a loan can no longer be treated as a beneficial loan, and so no further BiK charge will arise on the loan after that point.

There is no double taxation, as the BiK charge is on the benefit of the loan being a beneficial loan rather than on the amount of the loan itself, and HMRC would not seek a BiK charge for any year where the same loan was taxed as employment income.

Inheritance Tax

Generally, Inheritance Tax (IHT) can arise on a person’s estate (their money and possessions) when they die. IHT can also arise when a person is alive if they transfer some of their estate into a trust. Many DR schemes use a trust as the third party, and therefore IHT charges can arise.

Broadly, an IHT charge can arise when there is a payment, or disposition, resulting in a loss of value to a trust. This includes outright payments, or distributions, to beneficiaries, and occasions when settled property is no longer held in a section 86 Inheritance Tax Act 1984 (IHTA84) compliant trust. It also includes where a loan is released (written off), in certain circumstances where a loan is made (if the circumstances give rise to a loss of value at that time), as well as other charging occasions where payments and distributions are made to beneficiaries.

Where a particular transaction gives rise to both an Income Tax charge and an IHT charge, relief against the IHT charge is due where the same transaction is treated as income.

As the loan charge only arises where the loan remains outstanding at 5 April 2019, there is no loss of value to the trust at that time and no charge to IHT arises as a result. Given that the loan continues, there could be a charge to IHT at a later time, if, for example, the loan is released by the trustees giving rise to a loss of value.

In summary, the loan charge will not give rise to an IHT charge. However, IHT may still be due on the use of the DR scheme.

DR schemes that use trusts can give rise to IHT liabilities. In RFC Plc (in liquidation) (formerly The Rangers Football Club Plc) v The Advocate General For Scotland, Lord Drummond Young said in his judgment that there ‘…was an ordinary trust, and for tax purposes it would be subject to the ordinary tax regime that applies to trusts’.

Generally, assets within a discretionary trust will be ‘relevant property’.

A charge to IHT may arise on every tenth anniversary of the creation of the trust. The 10-year anniversary charge is a maximum of 6% of the value of the relevant property held in the trust at that date.

A charge to IHT can also arise where there is a loss of value, typically property leaving the trust. This includes situations where the trustee agrees to release loans or distribute the property held on trust. This IHT charge is proportionate to the amount of time elapsed since the last 10-year anniversary.

An Employee Benefit Trust (EBT) is specifically one meeting the requirements of section 86 IHT Act 1984. The beneficiaries must be defined by reference to employment and ‘all or most’ employees must be within the class of potential beneficiaries.

As property held in these trusts is not relevant property, the 10-year anniversary charge does not apply. However, a charge arising from loss of value can arise, and the amount of the IHT charge increases the longer the property has been held by the trustee.

DR schemes typically use EBTs, but often then set aside funds for a specific employee, and their family, within a sub-fund within the main trust. These sub-funds typically do not meet the ‘all or most’ requirement of section 86 IHT Act 1984, and therefore fall within the relevant property regime.

It is possible for there to be some property in the EBT within the relevant property regime and some property within the definition of section 86 IHT Act 1984. Only one of the 2 charging regimes can apply to the same property at any point in time.

The loan charge

Loans are assets of the trust and there is no loss of value charge where the debt remains. The loan charge does not discharge the loan so an IHT charge does not arise at the same time. The trust will remain and relevant property, or section 86, charges may arise in the future.

Nil Rate band

The nil rate band (NRB) for IHT, currently £325,000, can apply to reduce the value of relevant property.

The calculation of the charge applying to relevant property includes a deduction for the NRB applying at that time. This reduces the value of the property subject to IHT, and the IHT charge. Where the value of the relevant property is less than the NRB no IHT will be due.

Where there is a single person making the contributions to the trust, a single NRB will apply. Generally, one employer settled the funds within a trust forming part of a DR scheme, and so a single NRB applies.

In some schemes used by individuals, each individual made their own contribution so they will each benefit from their own NRB. The amount avoided through a DR scheme means most individuals will not surpass the NRB and no IHT will be due.

2006 changes

The major changes in the law relating to trusts and IHT in 2006 were to bring property held on most Interest in Possession trusts within the relevant property regime. This has no impact on DR schemes as the trusts used are discretionary trusts.

There was a change to the IHT exclusions in 2006. Where the trust qualified as a sponsored superannuation scheme, trust property was excluded from being relevant property. Where there are no further contributions to the trust after April 2006 the exemption continued to apply. Where a later contribution is made the existing property remains protected, but the additional property is subject to the IHT relevant property regime.

A number of early DR schemes included the necessary pension benefit provisions within the trust deed to benefit from this exemption. Some exempt trusts did receive later contributions on which IHT charges arise.

On death

One of the benefits used to promote DR schemes was that, on death, the liability (debt due to the trust) was deducted from the value of the deceased’s estate and therefore reduced any IHT due on death.

From 17 July 2013, legislation to neutralise other, non-DR, IHT avoidance involving the artificial creation of liabilities was introduced. This meant the liability is only deducted from the value of the estate to the extent that it is repaid. This has reduced the frequency of DR loans reducing IHT due on the beneficiary’s own estate, on death.

Corporation Tax

The starting point for computing Corporation Tax is the employer’s accounts prepared according to generally accepted accounting practice. In general, employers using DR schemes deducted the contribution to the DR scheme in their accounts for the year in which the contribution was made.

Payments made by an employer to reward employees, and that are incurred wholly and exclusively for trade purposes, are trading expenses which qualify as a deduction in calculating taxable profits. However, where the payment is made to a DR scheme from which employees may only benefit after some time has passed, specific anti-avoidance legislation enacted in 2004, defers this deduction, generally, until the employees receive an amount taxed as employment income derived from the payment. This treatment is often referred to as “fiscal symmetry”.

In the vast majority of DR schemes employers claim to avoid an employment income charge and receive Corporation Tax relief for the amount contributed to the scheme, breaking the fiscal symmetry. This is purportedly achieved by rewarding employees in a way that does not create an employment income charge while still claiming Corporation Tax relief on the employee reward at the point the scheme is used. HMRC’s view is that there is fiscal asymmetry because an employment income charge arises.

Where these employers are liable for the loan charge, it does not result in a further debit for the underlying contribution appearing in their accounts. Therefore, there is no further Corporation Tax deduction for the underlying contribution in the accounting period in which the loan charge arises.

There are some older cases where Corporation Tax relief was not given in the year the scheme was used. This could be as a result of a settlement agreement between HMRC and the employer, or the outcome of litigation deciding that the original contribution was not earnings and that the deduction in the earlier year’s accounts for the contribution was disallowed for Corporation Tax purposes. In such cases, relief for the underlying contribution is allowed when the loan charge arises, which maintains fiscal symmetry.

There are some employers who included the expense in their accounts but never claimed the Corporation Tax deduction at that time. These employers no longer have any statutory route to claim the Corporation Tax deduction. However, a concession was incorporated into the published settlement terms to enable the deduction to be given to those who settle.

In either case, the employer will be able to claim an expense in their accounts, and a Corporation Tax deduction, for any Income Tax and NICs they pay for the loan charge. This only applies where the Income Tax and NICs are greater than the original accounts expense.

To discourage employers from entering into DR schemes, the government changed the rules from April 2017 so that tax relief for employers’ contributions to DR schemes is denied rather than merely deferred until there is a corresponding employment income charge. It is not possible for the employer to obtain a tax deduction for such a contribution unless employment taxes and NICs are paid within 12 months of when the contribution is made, even where the contribution is subsequently agreed to be remuneration.

Go to section 7: Disclosure of Disguised Remuneration Schemes .