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The Same, But Different: Compensation Tax Issues for Employers and Employees
Business confidence is cautiously returning, and with it a change in organisation's business focus towards increasing employee engagement and retention of key employees. These human resource challenges are typically addressed through a combination of initiatives, particularly creative remuneration structures. The difference currently, is that these challenges are being addressed against a background of low bonuses, static annual pay, underwater or unvested stock plan awards and budget cutting strategies as well as an environment of potentially increasing personal tax rates and shareholder scrutiny. Taxand UK and Taxand US discusses the current environment in their respective countries and proposes tax efficient compensation ideas for employers and employees to consider.
The spotlight on executive pay has been well documented but the compensation for what may be regarded as the "engine room" of any organisation as well as the future business leaders, the middle manager, has been neglected. We would argue that the need for creative remuneration planning at all levels of the organisation has never been greater. For this management layer there is a good argument that compensation strategies need to additionally consider the impact of tax band thresholds and rates on their compensation structure. Failure to bear this in mind may mean that an employee who is promoted may otherwise find their pay increment is substantially negated by higher tax rates so reducing one of the key engagement and retention impacts. The counter argument is that if steps are taken to address tax increases, changes must also be considered when tax rates decline, if they do. Additionally, organisations with global reward strategies need to consider the degree of latitude which they are prepared to permit to local tax liability factors where they are sufficient to justify a deviation from the strategic norm.
The US Environment
The US provides a good example of the growing tax landscape being faced by employers and employees. With ever increasing scrutiny placed on executive pay, health care reform now in the works, and questions as to how to fund such changes, the tax rates on compensation are expected to rise in 2011 for at least a certain population.
- The tax cuts President Bush implemented in 2001 and 2003 are set to expire in 2010. If Congress doesn't act during 2010, the income tax rates will increase to pre-2001 levels and the current top bracket of 35% will be eliminated, the top tax brackets reverting to 36% and 39.6%. Additionally, the lowest bracket of 10% would be replaced with the pre-2001 15% tax bracket.
- If Congress doesn't act during 2010, the capital gains tax rates will increase to pre-2001 levels. The top rate for long-term capital gains will rise from 15% to 20%. The 0% rate for those in the lowest tax brackets will be replaced by a 10% rate.
- Effective on or after 1 January 2013, the Medicare Hospital Insurance (HI) payroll tax rate will rise from 1.45% to 2.35% for employees with wages and self-employed individuals with net earnings that exceed $200,000 (single return) or $250,000 (joint return).
- Effective on or after 1 January 2013, an additional of 3.8% tax will be imposed on net income from interest, dividends, capital gains, annuities, royalties, rents and capital gains (or "net gains from disposition of property"). This tax will also apply to net investment income from a passive activity, income from a trade or business of trading in financial instruments or commodities, and income from an investment of working capital. The tax does not include income that is derived in the ordinary course of a trade or business that is not a passive activity.
The UK Environment
The landscape in the United Kingdom is no better. The key changes can be summarised as:
- New 50% highest rate of income tax for those earning over ?150,000 pa
- Reduced or nil personal annual tax allowance for incomes over ?100,000. This allowance reduces by ?1 for every ?2 of income above the ?100,000 limit until the allowances is eroded to nil
- 1% increase in employee and employer National Insurance from 6 April 2011 to roughly 12% (to an upper earnings limit of approximately ?44,000) and 2% (uncapped) thereafter for the employee and for the employer 13.8% (uncapped)
- Restriction of higher rate tax relief on contributions to pension. The Government is looking at alternative proposals involving a significantly reduced annual tax relief allowance, perhaps in the range of ?30,000 to ?45,000. Additionally, the Government is looking at how plans to increase the State Pension Age to 66 can be accelerated
- Increase in highest rate of capital gains tax to 28% for those earning ?37,400 or more; and
- The one piece of good news, an increase in Entrepreneurs' Relief which is a capital gains tax concession on qualifying business disposals, providing a 10% CGT rate on business sales to ?5m
The focus has been on employees earning about ?150,000 but income tax rates jump from 20% to 40% for income in excess of ?37,400. Therefore for middle managers earning ?40,000 upwards, any increase in taxable compensation can have a dramatic effect on their total tax bill. With employees facing a substantial decrease in net take home pay, there is a win-win opportunity for employers who can provide employees with remuneration elements or choices which are tax or National Insurance free or where there is a reduced rate.
Tax Efficient Compensation Ideas in the US
Companies should review compensation arrangements to determine ways in which the potential tax exposure to employees can be reduced. There are several options companies can consider and some traps to avoid.
Accelerate Compensation Where Possible. Internal Revenue Code Section 409A has a prohibition on the acceleration of payments of nonqualified deferred compensation. However, arrangements can be reviewed to determine whether payments can or should be accelerated. Many bonus plans are exempt from Section 409A due to the "short-term deferral" exception. To the extent possible, employers may want to consider accelerating the payment of cash bonuses that are not subject to Section 409A to 2010 so as to avoid the anticipated tax rate increases. Consideration should be given to other impacts that accelerating bonuses could have.
Tax Favoured Equity Grants. Companies can still utilise tax favoured equity compensation plans, such as the grant of incentive stock options and the use of employee stock purchase plans ("ESPP"). In order to attain the favourable tax treatment, many requirements must be satisfied, but the benefits to the employee are significant.
Upon the grant and exercise of an incentive stock option at fair market value (as opposed to nonqualified stock options) and upon the grant and purchase of shares, which can be discounted by up to 15% of fair market value, through an ESPP, there is no income producing event. This is significant since income recognition is delayed until the time of the disposition or sale of the shares. However, in order to be eligible for this beneficial tax treatment, the shares must be held until the later of: (i) two years from the date of grant of the purchase right; and (ii) one year from the date of exercise of the purchase right.
With respect to incentive stock options at the time of a qualifying disposition, the treatment of the recognition of income is capital as opposed to ordinary income. With respect to the ESPP shares, upon a qualifying disposition, the employee must recognise ordinary income equal to the lesser of: (i) the excess of the fair market value of the stock on the date of grant of the purchase right less the exercise price of the purchase right; and (ii) the excess of the amount realised on the disposition of the stock over the exercise price of the purchase right. Any ordinary income recognised will be added to the share's basis and any future appreciation will be capital gain.
If the employee sells or otherwise disposes of stock before the expiration of the statutory holding period, i.e. a disqualifying disposition, then in the year of the disqualifying disposition, the employee is required to recognise ordinary income equal to the excess of the fair market value of the stock on the date of exercise of the purchase right less the purchase price. Any additional gain or loss recognised on the disposition of the stock will be short-term or long-term capital gain or loss, depending on the length of time the employee holds the stock after exercise of the purchase right.
Tax Efficient Compensation Ideas in the UK
The most commonly utilised tax efficient pay tool is the benefit-in-kind. The benefit in kind has several advantages amongst them the fact that:
- It provides employees with choices to suit their personal circumstances making them feel more valued by their organisation and in return they are more committed to their employer which aids retention, for example, medical and dental insurance, financial assistance and retail vouchers.
- The cost of provision to the employer who can buy "in bulk" often means that the actual and perceived benefit to the employee is far greater. Pound for pound therefore they are one of the most value efficient elements of compensation, for example, life assurance, concierge services, training.
- There can be savings to both employee and employer through exemption from National Insurance such as childcare vouchers, bicycles, gym membership, welfare assistance.
- There are good external providers who have technology based administration tools who make operation of such arrangements easily outsourced.
The implementation of additional benefits is commonly linked to the introduction of salary sacrifice. Employees voluntarily give up a proportion of salary in return for a fund which they can spend on a menu of benefits. A recent European Court of Justice decision (Astra Zeneca v Commissioners for Her Majesty's Revenue and Customs) means that in Europe the provision of certain benefits eg retail vouchers, linked to salary sacrifice is the provision of services for value added tax but as most employers are registered for value added tax this is not really an issue but care needs to be taken.
One of the most prevalent tax efficient remuneration plans used by employers of all sizes is salary sacrifice into pension. In return for foregoing part of their salary, or salary increase, the employer makes additional contributions into the employee's pension plan. Employer contributions are free of national insurance for both employee and employer so there is a valuable annual saving to the employer. This saving can be shared with the employee.
Finally, tax favoured all employee share acquisition plans can also play a valuable role since any gains are taxed as capital (18% or 28%) rather than income (20%, 40% or 50%) and they are usually National insurance free for both employee and employer. Both stock option plans (save-as you earn) and stock acquisition plans (share incentive plans) can be offered on a similar basis to all employees and discretionary stock option plans are also available. A corporate income tax deduction for the gain can usually be claimed by the employer too.
Organisations need to decide their strategy in response to changing tax rates. This strategy should be communicated to local leadership to assist with consistency of approach.
From both a market competitive standpoint and cost efficiency perspective local tax efficient planning which is consistent with that global strategy needs to be considered. If acceptable then speedy, well designed implementation, effective administration and a business focused communication strategy will ensure real value is delivered to the employees and shareholders.
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