Business owners in the UK will be familiar with the conventional methods of extracting profits from the company, such as bonuses, dividends and directors loans.

A more tax-efficient method could be via an Employee Benefit Trust (EBT). In this issue of Tax Matters, Friend LLP’s specialist tax advisers explain how EBTs work and identify where they may be of benefit to business-owners.

Key features of Employee Benefit Trusts

Employee Benefit Trusts are discretionary settlements created by a company to benefit family members of past and present directors or employees. They allow a company to share its profits with employees and directors without triggering an immediate PAYE and National Insurance (NIC) liability. This makes them a relatively tax-efficient way of incentivising employees and paying bonuses.

The trustees of the EBT are typically an overseas trust corporation, who can invest in a variety of assets, lend money to beneficiaries and apply capital or income for the benefit of the beneficiaries as they (the trustees) see fit.

Nominations are made for which family members are to benefit and the trustees may allocate part of the trust fund accordingly. A nominated beneficiary might then choose to have a loan from the trustees or amounts invested by the trustees.

Typically, any loans would be for an indefinite term and vary from being interest-free to a rate of interest equal at least to the rate prescribed by HMRC for ‘cheap loans’. Further loans would be made to fund any interest payments and the trustees have discretion as to if any loan should be repaid, and how to deal with it following the death of a beneficiary.

Although interest-free loans may be taxed as a “benefit in kind”, the effective rate of income tax would currently be only 1.9% per annum for a 40% taxpayer. This is compared with a “normal” bonus payment to a 40% taxpayer, which would be liable to a total of 41% in PAYE and NIC charges.

Example

A company wishes to distribute £100,000 of its profits to its directors. This example shows how a loan from an EBT is more cost-efficient than a bonus payment:

Option 1: bonus payment
The £100,000 will have a net cost of £81,216 to the company, once National Insurance Contributions and tax reliefs are taken into account. The bonus payment will then be liable to 41% tax (a mixture of PAYE and NIC) leaving the directors with a total of £59,000.

Option 2: loan via an EBT
The company pays the £81,216 into an EBT, which is then loaned – interest-free – by the EBT Trustees to the directors’ families for their benefit. The directors will receive the £81,216 in full.

Opportunities

The principle objective of the EBT must be to benefit the company’s employees. However, subject to this overriding principle, opportunities do arise:

Tax Planning

EBTs may provide a capital gains tax free environment, income tax and national insurance mitigation plus the ability to roll up income in a tax-free environment.  Loans outstanding at the date of death of a beneficiary should be deductible for IHT purposes.

Property acquisitions

A beneficiary can use an EBT to buy properties at home and abroad, whilst avoiding a large initial income tax and national insurance liability although any private use is likely to attract a taxable benefit.

Tax-free roll-up – an alternative to an approved pension

An EBT can also be used to provide an alternative method of providing a retirement fund, and without the restrictions of an approved scheme.

Market for company shares

An EBT can provide a fund that can be used to acquire shares in a private company. This will allow the provision of equity to key employees on a tax-efficient basis or possibly as an exit route for a retiring shareholder. Shares acquired by an EBT can be ‘recycled’ in conjunction with a company share scheme.

A note of caution

Employee Benefit Trusts can be viewed as an aggressive form of tax planning. In this respect, they do not compare with approved pension arrangements, where there are statutory tax reliefs. EBTs take advantage of the current tax regime, which may change. Also, if an EBT is used inappropriately, it can be liable to attack from the Inland Revenue.

By sticking to the following principles the position can be improved:

• Ensure the business does not control the Trustees.
• Observe practical limits on contributions.
• Make regular rather than one-off contributions.
• Ensure that the widest class of employees actually benefit from the EBT.
• Make it clear that the rationale for establishing the EBT is to benefit employees, not to fund a capital project nor to only benefit shareholders.

Summary

EBTs can bring significant benefits from a tax planning point of view, particularly for cash-rich businesses.

Careful planning and execution is required however to ensure that the EBT does not attract the wrong kind of attention from HMRC.

To discuss whether or not an EBT might be suitable for your business, please contact Frank Upton or Iain Wright