Tailor made - employment tax fundamental principles hit the headlines again
By Justine Riccomini, Head of Taxation (Scottish Taxes, Employment and ICAS Tax Community)
31 August 2020
Justine Riccomini provides an overview of a recent case involving the fundamental principles of employment income and how it interacts with newly appointed members of an LLP.
The Tailor’s Tale
This article discusses the outcome of a case involving a well-known high street retailer which also happens to be an LLP. The First Tier Tribunal case (so, not binding) relates to the payments made under an executive bonus scheme and serves to provide further insight into the significance of employment income legislation.
The case centres around remuneration paid to the members of the LLP after they had become members, highlights why the principles of employment income are so important in differentiating between when something is earned and when it is paid, and also provides an interesting insight into how the employment earnings regulations interact with partnership income rules.
The issue – earnings from employment or self-employed earnings?
Prior to becoming members of the LLP, five employees were offered access to an Executive Long-Term Incentive Plan (LTIP) bonus arrangement. The members’ bonuses were calculated using the profit figure from the time when they were still employees, and the LLP did in fact apply NICs to the payments when they were paid. However, the LLP subsequently received professional advice which led it to conclude it need not have done this. The LLP applied for a refund of the NICs, which triggered an enquiry into the partnership tax return of the LLP.
The LLP had treated the payments made in May and November 2013 as a profit received by the members from the LLP, but HMRC argued that these payments were in fact deferred bonuses.
The LLP argued that the bonus payments made under the LTIP were self-employed earnings and not earnings from an employment. As such, the NICs payable were due under the self-employed scheme (Classes 2 & 4) per the provisions of Social Security Contributions and Benefits Act (SSCBA) 1992 ss 11 and 15 rather than being classified as employed earner’s earnings (Class 1) per s.6 of the same Act.
Eligibility for the bonus
As regards eligibility for the bonus, the LLP board was entitled to decide which eligible employees qualified for a bonus. Eligibility was governed by being a full-time director or senior employee who was continuously employed by Charles Tyrwhitt or a group company up to a certain date, or who was a “good” or “early” leaver – otherwise they would be classified as a “bad leaver”, which was defined as someone who was dismissed for breaching their service agreement (albeit not in the case of wrongful or unfair dismissal) or had resigned before the given date (known as the ‘long stop’ date) or in breach of the service agreement.
It transpired that if someone was to become a member of the LLP, this may inadvertently classify them as a “bad leaver” in terms of the LTIP, which was not the intention, therefore some of the original Executive LTIP clauses were changed to remedy this so the relevant individuals did not lose out when it came to paying the bonuses.
Legislative framework for LLPs
The judge examined the legislative framework governing LLPs and concluded that there was no evidence to show that the five individuals were employees and members concurrently and that it was clear the individuals had received the bonus payments whilst they were members, not employees. However, HMRC’s contention was that the five recipients were receiving deferred bonuses which accrued to them whilst they were all still employees of the business.
The Tribunal then examined the Income tax and NICs legislation, specifically noting that the employed earnings legislation within ITEPA 2003 was particularly wide-ranging and that the NICs rules within SSCBA 1992 mirror the tax treatment for employed earners under sections 11, 16 and 17 ITEPA 2003 and that self-employed earnings for NICs mirror the tax treatment under sections 7 and 198 of ITTOIA 1995.
Timing is everything
ITEPA 2003 provides at sections 16, 17 and 18 that the employment status of the individual at the time at which the income is received is key to establishing a connection to employment earnings – but that their status at the time the earnings were earned overrides this if it was earlier than when the earnings were received.
Case law and the “source” principle
A number of cases were examined by the judge in connection with the above legislative principles, and specifically, the source of the income was also discussed in the judgement. The judge was persuaded by the arguments presented by HMRC that the correct designatory source was income from an employment earned by an employed earner, and also that being members of an LLP by the time the Executive bonus LTIP was received did not preclude them from receiving employment income from another source, as happened in this case.
Findings
In simple terms, the bonus payments out of the Executive LTIP were not classed as a share of the LLPs profits, or even as income from a discrete self-employment, but they were deemed to represent payments from a specific scheme which was only open to employees and not to members.
It is not clear whether the LLP will appeal to further explore the question of whether the NICs legislation which attributes to employed earner’s earnings can legitimately, independently of the tax legislation which it mirrors, continue to apply when the individuals concerned are no longer technically employed by the time they received the funds.
This principle was discussed in RCI Europe v Woods (Inspector of Taxes) [2003] EWHC 3129 (Ch) [2004] STC 315 which concerned the chargeability of NICs in respect of payments made to an ex-employee in return for his having signed a restrictive non-compete covenant agreement, where the arguments made in favour of the NICs legislation not extending beyond the year in which the restrictive covenant payments were earned were rejected.
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