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The Revenue has long tried to argue that arrangements deferring the payment of remuneration to an employee should be ignored. The reason is simple – if the fact that the employee does not yet have the money can be ignored, the tax is paid earlier.
In order to bring about this result HMRC persists in attempting to argue that legal relationships should be ignored, along with concepts such as beneficial ownership, with the result that contractual arrangements can simply be looked through. However, while it may suit the tax authorities this line of argument finds no favour whatsoever before the Courts. The Dextra case (Dextra Accessories Ltd and others v Macdonald (Inspector of Taxes)  STC (SCD) 413)) concerned contributions to an employee benefit trust ("EBT") by a company. The argument was about whether the contributing company should be entitled to a tax deduction for the contribution, however one of the aspects that HMRC tested in court was the fact that sub-funds for specified employees had been created by the trustee of the EBT. This was commonplace and might well involve employees being able to suggest to the trustee how the assets in a sub-fund should be invested – however although they might have been 'earmarked', the assets did not leave the trust and find their way into the hands of the employees concerned. The employees would only receive an actual benefit in cash terms if the trustee of the sub-fund exercised the discretion to make a payment. HMRC's argument that the mere allocation of funds to a sub-fund amounted to the receipt of emoluments on the part of the employees was firmly rejected by the Tribunal and, wisely, the Revenue did not raise the issue again in the subsequent appeal hearings.
Apparently undeterred, however, HMRC tried to mount a similar argument before the Special Commissioners in Sempra (Sempra Metals Ltd v HMRC (2008 STC (SCD) 1062)). Again the Revenue were arguing that payments to a trust for the benefit of employees constituted the payment of emoluments for PAYE and earnings for NIC purposes, on the grounds that the payments became earnings when they vested unconditionally in the employees. Their contention was that this happened when amounts were allocated to particular employees or their nominated beneficiaries by the trustee. Again this contention was roundly rejected by the Court.
The Ruling in HMRC (Respondents) v Forde and McHugh Limited (Appellant)
Now, we get a similar argument in HMRC v Forde and McHugh Limited [2014 UKSC 14], which has been fought all the way up to the Supreme Court. This case concerned the treatment of NICs in respect of an employer company's contributions of cash and treasury stock to a Funded Unapproved Retirement Benefits Scheme (FURBS).
The salient facts of the case were as follows:
a) Forde and McHugh Limited ('the Company') established the FURBS for the benefit of its employees and directors.
b) In 2002, the Company made a discretionary contribution to a single member FURBS in favour of a director, Mr McHugh. At the date of contribution Mr McHugh was 54.
c) The terms of the FURBS provided that upon a member's retirement, the trustees were to provide the member with a pension for life or other relevant benefits.
d) The receipt of the pension funds and/or relevant benefits by Mr McHugh was contingent upon him surviving until the age of 60. (This was his self-elected retirement age, which was capable of being brought forward at Mr McHugh's further election and with agreement of the trustees of the fund). Until such time, (and crucially in relation to the issue before the Court, at the time that the Company contributed to the scheme), Mr McHugh did not receive any benefit under the scheme. If Mr McHugh died before the age of 60, the FURBS rules stipulated that the benefits were payable to his wife.
The question to be answered by the Tax Tribunal was: were the Company's contributions to the FURBS liable to Class 1 NICs on the value of the transfer within the meaning of "earnings paid to or for the benefit of an earner" in section 6(1) Social Security Contributions and Benefits Act 1992 ('the Act')?
It was accepted by both parties that there could be no question that the employer's contribution had been paid "for the benefit of" Mr McHugh, within the meaning of the Act. The disputed issue was therefore whether or not the Company's contributions at the time of transfer into the FURBS were capable of being classified as "earnings" within the definition of the Act.
The Company relied upon the precedents established in Smyth v Stretton ((1904) 5 TC 36) and Edwards v Roberts ((1935) 19 TC 618), which concerned the question of contingent receipt and deferred "emoluments" in the context of income tax. It submitted that in addressing the question of the contingent nature of Mr McHugh's interest, "earnings" in NIC legislation took the same meaning as "emoluments" in income tax legislation, and as such the rules established in those cases should be applied. Edwards v Roberts considered whether an employer's annual contribution to a fund was an "emolument" for the employee either in the year of contribution, or when a sum was ultimately paid to the employee from the fund (which included all contributions and accretions). In that case, the Court held that by reason of his contingent entitlement, the funds were only emoluments when the funds vested in, that is were paid out to, the employee upon the occurrence of the contingency.
The Upper Tribunal agreed that this case could be decided by reference to income tax principles, so the ordinary meaning of "earnings" was the same as "emoluments". Consequently, there was no basis on which to distinguish employer contributions to a FURBS from the income tax position established in Edwards v Roberts.
HMRC disagreed and challenged the Upper Tax Tribunal's decision in the Court of Appeal. Their case was that payments made for the benefit of the member were "earnings" within the Act, on the basis that:
a) the decision in Edwards v Roberts relied upon the application of the 'convertibility principle', that expenditure by an employer which provides a benefit to an employee is not taxable as an emolument unless and to the extent that the benefit is able to be converted into money; and
b) the convertibility principle ought not to be applied for the purposes of NICs, because "earnings" were distinguished from "emoluments" by the Social Security Acts 1973 and 1975; and
c) in this case, once one frees oneself from the limitations imposed by judge-made constraints on the term "emoluments" within income tax legislation, the employer's contribution to the FURBS fell within the ordinary meaning of "earnings", it being a form of remuneration for the past or future service of Mr McHugh; and
d) that upon the Company's payment into the FURBS Mr McHugh became better off, because he (or, if he should die before retirement age, his family) have an immediate, (albeit contingent) interest, because at the point of contribution they obtain a hope of receiving those funds in the future, which they did not previously have.
The Court of Appeal agreed, and reversed the decision of the Upper Tax Tribunal. In her judgment, Lady Justice Arden reasoned that: "The words 'earnings paid to or for the benefit of the earner' have to be applied as they stand. The word 'paid' means 'paid' and not 'received'. It is therefore irrelevant for the triggering of the liability to pay class 1 contributions under s. 6(1) that the payment is actually vested".
The Supreme Court heard the case in January 2014, and judgment was handed down on 26 February 2014.
On appeal, it was accepted that "earnings" had a wider definition and applicability than "emoluments", and that the link between NIC contributions and income tax was abolished by the Social Security Acts in 1973 and 1975. Lord Hodge delivered the majority judgment, and confirmed his agreement with this. He ruled: "NICs have been levied on a basis which is different from the "emoluments" on which income tax has been raised"; he further surmised that on the question of the application of the convertability principle, "earnings" in NIC legislation includes non-convertible benefits in kind unless they are expressly disregarded "either expressly or by necessary implication".
The only question for the Supreme Court to address was therefore: was the Company's contribution "earnings" at the time of the transfer of value into the FURBS within the meaning of the Act?
HMRC's position in response to this question was, Lord Hodge said, "remarkable". HMRC submitted that the payment by the Company into the FURBS fell within the definition of "earnings" and came under the ambit of the Act because it was a sum paid as the quid pro quo for past and future earnings solely for the benefit of Mr McHugh and his wife. HMRC went on to suggest that on these facts, "earnings" could be received by Mr McHugh twice: once at the time of the Company's contribution to the FURBS, and again upon Mr McHugh's receipt of the pension out of the trust fund when the contingency had been fulfilled. The Company submitted that Lady Justice Arden had erred in her suggestion that the word 'paid' did not mean 'received'. This did not, they contended, give effect to the Parliamentary intention, which had been to give the term earnings its ordinary definition, pursuant to which it should be understood that an employee is paid only upon receipt of the remuneration.
Lord Hodge agreed with this, and ruled in favour of Forde & McHugh Limited. His reasons for so doing were threefold:
First, he reasoned that "the ordinary man on the underground would consider [HMRC's proposition] to be counter-intuitive", since (absent clear words to the contrary) it cannot have been Parliament's intention that an employee can receive the same earnings twice. A retired earner, he said, receives "earnings" when he actually draws on his pension; in this case the Company's payment into the FURBS was merely a deferred payment of earnings.
Second, HMRC's proposition would ignore the value of the funds that the earner actually received, and in so doing "denudes the word "earnings" of any meaning".
Third, in practical terms, Lord Hodge questioned what Mr McHugh had received upon the Company's transfer into the FURBS? All he had at this time, he found, was an entitlement to a future pension or other relevant benefits. In practice, if Mr McHugh had died before reaching the requisite retirement age, the trustees would have realised the accumulated fund and paid the proceeds to his wife. Thus, the hypothetical value of Mr McHugh's entitlement upon his premature death would have been "the value of his contingent right to the trust fund such as it would be at his retirement date", taking into account accumulation and the risks of uncertainty of the trustees' investment. Its value would not therefore have been measured by reference to the contributions made by the Company at the date of transfer, but by their predicted value at his intended date of retirement.
The full judgment can be accessed here.
Conclusion: The Wider Impact of the Judgment
This ruling confirms that (until such time as legislation is enacted to the contrary) employer's contributions into a FURBS pension are not to be classified as "earnings" with the meaning of the Act, and therefore do not, at the time of the transfer of value, trigger a liability for the employer to make an NIC contribution.
However, this ruling will also have wider impact on the question of NIC contributions (which was to some extent recognised by Lord Hodge in his judgment) in the context of an employer's provision for other deferred earnings. HMRC essentially argued that employers' NICs are due whenever an employer makes provision of any sort for an employee (with the focus on amounts paid, not received). This focus is understandable, because employers' NICs are in effect a tax on employment and if NICs are not collected on contributions to a pension arrangement then they are lost forever – employers' NICs would not apply to the pension payments made to Mr McHugh. However the legislation was drafted in an age when it seemed natural to link an employer's liability with payment, because most of the workforce was paid weekly in cash and the question of deferred earning simply would not arise.
Nowadays it is commonplace for an employer to pay an employee's bonus into a trust or escrow fund, the value of which is payable to the employee only upon the happening of some future conditional event, perhaps depending on the employer's financial performance. Following Forde and McHugh, NIC liability will not arise on the employer making such provision. However, given the importance of National Insurance as a tax the next step may be a reversal of this position through legislation.
Counsel for Forde & McHugh were Richard Bramwell QC, Anne Redston and Michael Sherry (all of Temple Tax Chambers), instructing solicitors were Farrer & Co LLP.
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This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, February 2014