Tax avoidance: using rules on tax relief for employee liabilities to create artificial deductions

12 January 2009

Introduction

1. On 12 January 2009 the government announced that it is taking action to prevent tax deductions being allowed where liabilities relating to an employment are incurred by employees and former employees with a main purpose of the avoidance of tax.

2. The specific avoidance arrangements of which the government is aware aim to exploit the provisions of sections 346 to 348 and 555 to 559 Income Tax (Earnings and Pensions) Act 2003, (ITEPA).

3. These provisions provide deductions respectively for employees and for former employees for:

1. insurance (whether taken out by the employer or employee) to indemnify employees against employment related liabilities such as damages relating to their jobs or legal costs to defend against such damages
2. payments (whether made by employer or employee) for such liabilities in circumstances where they are uninsured

4. Where the insurance premiums or payments in respect of employment-related liabilities are paid by the employer, the effect of the relief is to set a deduction against the taxable earnings generated by the payment by the employer, so that there is no net tax charge on the employee (or former employee). This relatively common scenario is one that is not connected to the avoidance arrangements of which the government is aware. Similarly, it is not affected by the proposed legislation.

5. The specific tax avoidance arrangements of which the government is aware involve the use of a number of entities including both companies and trusts, some of which may be located offshore. A key element of the structure is the creation of a contrived employment, the duties of which include entering into financial arrangements (which may take the form of stock lending) with another party.

6. During the course of the employment the individual will deliberately default with regard to one or more aspects of the financial arrangements. Under the terms of the arrangement, this will trigger automatic damages payable by the individual to the counterparty to the lending. The individual concerned will have borrowed the money to pay the damages from another entity in the structure. Given the nature of the structure, the individual will not in reality repay the borrowings and as a result the individual suffers no genuine loss of money in paying the sum designated as damages.

7. HMRC understands that the individuals who participate in these arrangements will claim that under section 346 or section 555 of ITEPA they are entitled to deduct the amount of the damages from their income on the grounds that the damages rank as a liability that was incurred when acting in his or her capacity as employee.

8. The government does not accept that these highly contrived arrangements have the effect that is sought, but will remove the uncertainty that would be caused by any litigation to establish that by including appropriate countering legislation in Finance Bill 2009. This legislation will take effect from 12 January 2009.

The legislation

9. The specific avoidance arrangements being countered are outlined above but the government is aware that it might be possible to use different structures to achieve a similar outcome. As a result the proposed legislation will deny any deduction under section 346 or section 555 ITEPA where the liability in respect of which the deduction would otherwise be due has been paid in connection with arrangements the main purpose, or one of the main purposes, of which is the avoidance of tax.

10. This new rule will apply to payments made on or after 12 January 2009, whether the arrangements that resulted in the payments were entered into before, on or after that date.

11. The new rule will not apply to payments made before 12 January 2009.

12. The tax deductions provided by sections 346 and 555 ITEPA will continue to apply as before where there is no main purpose of avoidance of tax. So those who are not engaged in tax avoidance arrangements will not be affected by the change.

13. Example 1 below illustrates circumstances where the new rule will prohibit a deduction.

14. The new rule will not prevent a deduction being set off against the cost of insurance premiums paid for by the employer in circumstances where the employer routinely takes out insurance policies whose sole purpose is to indemnify employees against employment related liabilities such as damages or legal costs relating to their jobs.

15. The new rules will not prevent a deduction where the employer meets the cost of an uninsured employment-related liability incurred by an employee, so that all that the relief does is offset the tax charge that would otherwise have applied. This is of course subject to there being no arrangements that have a main purpose of avoiding tax.

16. In both instances, the relief remains subject to the conditions that are already laid down in the legislation.

17. The new rule will not have any application where an employee or former employee personally meets the cost of a liability that qualifies for relief under the terms of the existing legislation, provided that the payment, or the surrounding arrangements, does not have a main purpose of securing such a deduction in order to reduce general income or gains. The mere fact that the employee is aware a deduction is available will not bring the legislation into play if it is not a main purpose for making the payment (or for any other part of the arrangements).

18. Examples 2 and 3 illustrate circumstances where the new rule will not come into play and relief will continue to apply as before.

Example 1

Individual M expects to have substantial income for 2008-09 and wishes to shelter it from tax. M therefore enters into arrangements that have been marketed by a tax adviser that promotes avoidance schemes that are designed to create a deduction of £200,000 under section 555 ITEPA. M plans to set the sum of £200,000 against general income of 2008-09 in order to reduce the amount of tax on which M expects to pay tax from £220,000 to £20,000.

Example 2

An individual (X) holds a directorship with company, A.

X is the subject of a work liability claim in respect of her job with company A. The claim is made by a customer who is dissatisfied with products that he purchased from the company and the way in which the products were marketed to him by X. There are no criminal charges involved.

All directors of that company are covered by an indemnity policy that only covers them against acts or omissions carried out in their capacity as directors of company A or in any other capacity in which they acted in the performance of the duties of their directorship. The premiums are paid for by company A.

The insurance premiums paid for by the employer count as taxable earnings but are fully offset by deductions under section 346 ITEPA.

In this particular case, part of the claim against X is met by a payment of £10,000 made by company A because the indemnity policy claims limit for that year has been reached.

This sum, whether paid direct to the claimant or passed to the X for onward payment to meet the liability, constitutes taxable earnings of X from her office with A. However, under s346 ITEPA, she will have an offsetting deduction for the full amount of £10,000.

Example 3

X is the subject of another claim later in the tax year by a customer for £20,000 in respect of products that she sold on behalf of company A. By then the company has ceased trading and is insolvent with the result that it is no longer able to meet the claim against X out of its own resources and X must pay this herself. She funds this partly out of her own savings and partly by increasing her mortgage with a High Street Bank.

The customer is not connected with X in any way and there are no arrangements in place for X to take actions to trigger a claim from the customer or that would have lead X to anticipate that the customer would make a claim.

If the claim was settled after the cessation of X's directorship with company A there will be no relief under Section 346 ITEPA. But as the payment is not made as part of any arrangements that have a main purpose of avoiding tax, the £20,000 can be relieved under Section 555 ITEPA against X's other income of the year. Section 555 and 556 ITEPA provide for relief for payments made up to 6 years after the employment in respect of which the payment arises has ceased.