Most employers will seek to provide some form of cash bonus award to incentivise staff performance in the short term. Whilst tax-free profit-related-pay ("PRP") was once widely available, the eligibility criteria are now far more tightly drawn.
Tax-free profit-share
When PRP was introduced in 1987, up to £4,000 or 20% of an employee's total salary (whichever was lowest) could be paid tax-free. The arrangement, which rendered part of an employee's remuneration variable by reference to the financial results of the employer company, had to be registered with the Inland Revenue (as HMRC was then called). There was a 'similar terms' test that mandated participating employees received an equal amount per person, or participated pro rata to their earnings, length of service or other objective factors. The tax relief was subsequently tapered down from 1998 and was abolished entirely from 1 January 2000.
Since 1 October 2014, qualifying bonus payments of up to £3,600 per eligible employee may be paid tax-free, per tax year, by certain companies.
Qualifying Bonus payments
A gateway test that needs to be met before a company can pay a statutory qualifying bonus to employees tax-free is that the company (or the principal company in a group) must be under the control of an Employee Ownership Trust ("EOT").
This statutory trust model of ownership has gained popularity in recent years for many reasons, in part as it allows vendor shareholders to secure business ownership succession without a charge to capital gains tax. The model operates as a patient capital buy-out approach via a trust, established to act as the controlling shareholder with a fiduciary duty to the employees, as the EOT beneficiaries.
When a qualifying EOT controls a company, tax-free qualifying bonus payments can be paid. National Insurance Contributions (NIC) currently still apply, however representations have been made to HM Treasury, during a consultation in summer 2023, to exempt that liability also.
To qualify, the employing company and not the EOT trustee must pay the bonus and both a ‘participation requirement’ and an ‘equality requirement’ need to be satisfied.
A point occasionally overlooked is that a participator (which for these purposes is an individual who has, or within the last ten years has had, a beneficial interest in 5% of any class of share in the EOT-controlled company) who must be excluded from the EOT beneficiary class must nevertheless be included in any qualifying bonus distribution if they are employed in the trading group. (This means a participator who sold shares to the EOT but continues to hold office or employment in the trading group needs to be included in the qualifying bonus distribution).
An anti-avoidance measure prevents the tax relief applying if the ratio of office-holders (and connected employees) to all employees plus office-holders is greater than two-fifths. Each group company needs to be checked for compliance on this point each time a bonus is to be determined.
Participation requirement
A minimum probation period is allowed and employees may be excluded for certain disciplinary reasons, otherwise awards must be made to all eligible employees globally.
Unlike the criteria for the all-employee statutory Share Incentive Plan ("SIP"), which allows a principal company to decide which other group companies will join the arrangement, the qualifying bonus legislation requires that employees of group companies globally must participate. Bonus allocations can’t be adjusted to address any cost-of-living differential in overseas jurisdictions and the tax exemption applies to UK income tax only.
Equality requirement
Similar to the historic conditions for PRP, eligible employees must participate 'on the same terms’. However, this requirement will not be breached if a bonus payment is determined by reference to:
- remuneration;
- length of service; or
- hours worked (although in practice this metric is best avoided as it can easily cause an infringement e.g. regarding employees on zero hours contracts).
If other metrics are referenced, the bonus will be taxable. If applying multiple factors, each element must result in a separate entitlement and the aggregate entitlement must be the sum of those entitlements and not the product.
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 awarded under a separate, taxable, discretionary bonus plan.
Remuneration
Where a calculation methodology uses a remuneration allocation metric, the reference terms may be, for example, that eligible employees receive a £50 bonus per £500 of salary (rounded up to the nearest £500).
Alternatively, where applying a percentage, the same percentage must apply consistently and if awards are calculated aligned with pay bands, those bands must be of equal width. Employers with formal job grade structures and pay banding will have a more robust framework in place to aid compliance.
Remuneration and length of service
If a multiplication formula covers multiple factors, e.g. two percent of salary multiplied by the total number of years worked, a breach occurs as a single result is derived using more than one metric.
If, instead, the board determines a bonus as two percent of salary plus £200 per year of service, there are two separate entitlements. This would produce a compliant bonus equal to the sum of those two parts.
Guarding against abuse
The scheme must not enable skewing of benefit to favour:
- 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 therefore non-compliant if only a remuneration factor is used (as this weights benefit to the highest paid), or potentially only a length of service factor as this might be non-compliant where a group has a mix of established entities and newly commenced entities (as it would favour those in a particular part of the group). There would also be an infringement if a group operates separate bonus pots based on the profits of different divisions of a group.
Complex or Simple
To keep things simple, 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.
Some employee-owned businesses have used a tax-free fixed sum bonus to give a Covid endeavours thank-you to staff or a cost-of-living one-off bonus to employees or pay a flat rate award to all those eligible at Christmas, as part of an 'in-it-together' culture approach to reward.
It is possible to distribute more than one bonus payment per tax year but any surplus over the annual limit is taxable.
Where a payment is calculated on a differentiated basis (i.e. not a flat rate amount paid equally to all but using, instead, a tailored payment calculation based on the permitted metrics), a combination of remuneration and length of service factors in the calculation prevents non-compliant weighting only to the highest paid employees. 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 the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE).
As with anything tax-free, the devil is in the detail. If you're wanting to give your staff more spending power via a tax-free bonus it's best to ensure you have your compliance watertight.
For further information contact: Liz Hunter