Employee Ownership: Paying tax-free qualifying bonuses
For Employee Ownership Day 2022 we examine how qualifying employee-owned companies can pay tax-free bonuses.
For Employee Ownership Day 2022 we examine how qualifying employee-owned companies
To celebrate Employee Ownership Day 2022 we examine in this article how qualifying employee-owned companies can pay compliant tax-free bonuses. Focus is often on the attraction of a sale of a business to an Employee Ownership Trust (EOT) but less has been written about the conditions and pay regime for qualifying tax-free bonuses. To deliver efficient profit-share some employers adopting the employee ownership (EO) model need additional help to navigate bonus compliance as they grow into this further phase of EO.
When a qualifying EOT controls a company, tax-free ‘Qualifying Bonus payments’ can be paid, capped at £3,600 per eligible employee each UK tax year. National Insurance Contributions (NIC) (and in due course Health and Social Care Levy) still apply.
Qualifying Bonus payments
To qualify, the employing company and not the EOT trustee must pay the bonus and both the ‘participation requirement’ and the ‘equality requirement’ must be met – see more on these below. NB The income tax legislative requirements applying to such bonus payments are slightly different to the capital gains tax legislation ‘equality and participation’ requirements applying to transactions involving EOT benefit distributions - e.g. a participator would be excluded from EOT benefit but an employed participator must be included in any Qualifying Bonus.
The employer must also meet the 'office-holder requirement'. This prevents the exemption applying where the ratio of directors and other office-holders (and connected employees) to all employees and office-holders is greater than two-fifths. Each group company needs to be assessed as part of the participation compliance check each time a bonus is contemplated.
Employers are expected to demonstrate, should HMRC enquire, that the payment meets all the conditions. In the event of any other corporate event such compliance could also be subject to tax due diligence.
Awards must be made to all the group’s eligible employees globally. A minimum qualifying probation period is possible and employees may be excluded in certain disciplinary circumstances.
Unlike the requirements for the all-employee statutory Share Incentive Plan (SIP), which allow a principal company to decide which other group companies will join the plan, the legislation here mandates that employees of group companies globally must participate. Bonus allocations can’t be adjusted to address any cost of living differential in overseas territories. The tax exemption applies to UK income tax only.
Eligible employees must participate 'on the same terms’ however, this requirement will not be infringed if an award is determined by reference to:
- Length of service; or
- Hours worked (although in practice this metric is best avoided as it can easily cause a breach e.g. regarding employees on zero hours contracts).
If other factors are used the bonus is taxable.
If using more than one factor, each factor must give rise to a separate entitlement and the total entitlement must be the sum of those entitlements and not the product.
HMRC have not yet addressed all these matters in detail in their published guidance. For now, therefore, we apply interpretative support from the analogous guidance relating to the ‘same terms’ requirement for SIP.
It is best practice to adopt a formal set of plan rules along with guidance notes to aid compliant operation. Any selective top-up can be paid under a separate, taxable, discretionary bonus plan.
If using a remuneration allocation factor, the calculation terms may be, for example, that eligible employees receive £100 bonus per £1,000 of salary (rounded up to the nearest £1,000). An employee earning £15,000 will be allocated a £1,500 bonus. An employee earning £25,000 will be allocated £2,500.
If using a percentage, the same percentage must apply to all. Alternatively, awards may be calculated by reference to pay bands, provided the bands are of equal width.
Employers with clear job grade structures and pay banding across their organisation (for more on that see this separate article) will find this process easier and will have a more robust framework in place to aid decision making.
Remuneration and length of service
If a multiplication formula covers multiple factors, e.g. three percent of salary multiplied by the total number of years worked, an infringement occurs. The scheme then produces a single result using more than one of the permitted factors.
If, alternatively, the scheme allocates a bonus as three percent of salary plus £100 per year of employment, there are two separate entitlements. This would produce a compliant award equal to the sum of those two entitlements.
Overarching requirement not to skew bonus
The scheme must not enable weighting of benefit to:
- Directors or former directors;
- Highest paid employees;
- Those employed in a particular part of the company or group; or
- Those undertaking particular activities.
It is non-compliant if a group operates bonus pots based on the profits of different parts of the group.
For this reason some businesses pay a flat equal sum to all employees (even if this is lower than the maximum £3,600 and therefore wastes some of the tax relief potential) as it eases the administrative burden and minimises PAYE compliance risk.
A combination of remuneration and length of service helps ensure that the bonus is not skewed only to highest paid. Advice on what constitutes ‘remuneration’ and ‘length of service’ should be taken. Acquisitive companies should consider how length of service is defined in the plan rules and then applied to employees who join the group under Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE).
The Department for Work and Pensions has helpfully confirmed that Qualifying Bonuses should not affect Universal Credit. Welcome news for those wishing to bolster reward for their lowest paid workers amidst the rising cost of living.