In this case the Court of Appeal considered whether payments made from an employee trust constituted dividends or emoluments taxable as employment income.

Background

PA was an international group company, resident in the United Kingdom, with subsidiaries and branches in over twenty countries which offered consultancy services. It was an employee-owned service company with employees resident in many parts of the world.

PA had a well-publicised policy to pay its staff median salaries and then to award them generous bonuses from profits by individual annual awards. Each year it paid a substantial proportion of its profits into employee trusts out of which awards were made to employees under discretionary bonus schemes.

Employees had no contractual entitlement to bonuses but, as the First Tier Tribunal noted, the 1999 Report and Accounts, the main audience for which was PA's employees/shareholders, included provisions for bonuses on the basis that the employees as employees had a valid expectation before the end of the relevant financial year that PA would meet its responsibility to pay bonuses. The “bonuses” were designed to reflect an employee's efforts, the achievements of the section of PA in which that employee worked and profitability as a whole.

An Employee Benefit Trust (EBT) was established for PA in 1995. A share of PA's profits for 1998 and immediate previous years was paid into the 1995 EBT. The trustees then awarded benefits according to rules to employees working in all sectors of the company. Those awarded bonuses for 1998 received them in March 1999 and, where appropriate, those bonuses were subject to deduction of income tax under PAYE and to payments of NI contributions. This approach continued even after the establishment of different arrangements for the payment of bonuses after 1999.

In 1999 Ernst & Young proposed an arrangement to re-route bonuses so that they were paid as dividends from a United Kingdom resident company and were taxed as distributions. At that time the “PA Holdings Limited 1999 Employee Trust” (the 1999 ET) was established.

The Trust stated in the recitals that its purpose was “to motivate and encourage employees in the performance of their duties by the provision of bonus incentives and other awards at the discretion of the trustees”. In December 1999 PA paid £24,600,050 for payment into the 1999 ET from its income for that year, this was described in the 1999 Report and Accounts as “staff costs”.

In January 2000 a “restricted share plan” was adopted empowering granting of awards to eligible employees over such number of shares in the capital of a Jersey company.

Under the rules of the plan, any eligible employee granted “an award” received a beneficial interest in shares and an award certificate indicating the number of shares they had been awarded. The rules required payment of all dividends or distribution accruing to those shares to the employee. The shares were to be transferred to the employee at the end of a defined, restricted period.

PA then calculated bonus awards for all employees for 1999 in early 2000 using a set formula in the same way as adopted in the previous year. At the same time PA employees were notified about “exciting proposed changes to the delivery of current bonus awards”. Those who were resident and ordinarily resident in the United Kingdom were invited to choose between receiving a bonus for 1999 from the 1995 ET or from the 1999 ET. The few who did not choose to use the 1999 ET remained entitled under the 1995 ET.

Employees were sent an award certificate if they had been awarded a beneficial interest in the shares and were asked to notify details of their bank accounts for direct payment of dividends.

In April 2000 transfer of the dividend payments to the award holders was authorised, the payments were subject to an agreed deduction of 25%. The gross amounts reflected the size of the awards of the beneficial interests in the shares. These arrangements were repeated for 2000 and 2001.

The effect, as contended by the company, was that the cash the employees received as dividend income was subject to the Schedule F rates and not to the basic or higher rates. Additionally, it contended, there was no liability to make National Insurance contributions in respect of these payments.

Both the First Tier Tribunal and the Upper Tribunal were agreed that the income the employees received was from their employment. But both also agreed that, because that income was received in the form of dividends, the provisions of Schedule F and Section 20(2) of the Income and Corporation Taxes Act 1988 (ICTA) dictated the conclusion that the income had to be taxed as dividends or distributions under Schedule F and could not be charged as emoluments under Schedule E.

Since there was no equivalent to Section 20(2) in the Social Security Contributions and Benefits Act 1992 (SSCBA), the finding that the income was from employment meant that the payments were “earnings” for the purposes of the SSCBA and thus liable to NICs.

HMRC appealed against the decision of the Upper Tribunal, contending that the dividends were in reality bonuses and liable to be taxed under Schedule E; Schedule F and that Section 20(2) did not apply. PA contended that, as an additional ground for upholding the decision, the dividend income was not from employment. It also appealed against the decision that the payments received in the form of dividends were “earnings” for the purposes of SSCBA on the same basis: that the income was not from employment.

In reaching that view, the First Tier Tribunal noted that as a consequence of the structure of PA, if it wished to benefit its staff as shareholders rather than employees, it had the option of paying a dividend on PA's shares rather than designating funds as employee costs before arriving at its gross profits.

Decision

Upholding HMRC's appeal, the Court of Appeal held that the essential task in the case was to identify the source of the dividend income received by PA's employees in the relevant years. It was the source of those income receipts which determined the rules and rates appropriate for taxing those receipts.

PA Holdings contended that the source of payments transferred to the persons beneficially entitled to them was their beneficial interest in the shares. The shares, and not the dividends, were emoluments and exempt from charge by virtue of Section 140A ICTA 1988. Section 140A(3) exempts from tax chargeable under Schedule E an employee's acquisition of a conditional interest in shares (provided that the employee's interest ceases to be conditional within five years from acquisition). The source of the dividends received by the employees was the shares and they received them in their capacity as shareholders and not as employees.

No one can doubt that there are circumstances in which employees may be awarded shares as an incentive or reward and that those employees may subsequently receive dividends/distributions in respect of their shareholding, the source of which may properly be identified as the shares and not their employment. The employees, in such a case, receive those payments in their capacity as shareholder or investor and not as employee.

When employees were granted options to acquire shares in their employer and exercised those options, they profited by the increased difference between the option price and the market price when they exercised their options. The profit accrued to the employees as holders of their options and not as employees; it was derived from the option and not from employment (Abbot v Philbin [1961] AC 352).

But it is not in every case that an employee who is awarded shares and receives dividends can escape the conclusion that the dividends are remuneration and not investment income. In White v Franklin [1965] 1 WLR 492, the dividends the managing director received, by virtue of an entitlement under a trust so long as he remained engaged in management of the company, were earned income.

The Court then moved on to look at how the distinction is to be made between the receipt of payments in the form of dividends as employee and the receipt of dividends as shareholder.

What determines the character of the income in the hands of the recipient? What determines the capacity in which the recipient receives such income? The conventional approach of the courts is to look at all the circumstances of the case in order to answer the one statutory question, namely whether the income receipts of the employee are emoluments or profits from employment (Brumby v Milner 1976 51 TC 583 at 607G).

In that case a trust fund established to acquire shares in a family company for the purpose of distributing dividends to employees as a reward and incentive was wound up and the proceeds distributed to employees. It was suggested that it might only be permissible to consider the terms of the trust deed to determine whether the proceeds were from employment. That approach was rejected.

The correct approach is to consider all the facts relevant to the receipt of the income. This requires the court not to be restricted to the legal form of the source of the payment but to focus on the character of the receipt in the hands of the recipient “the question is one of substance and not form.”

This was the approach of the First Tier Tribunal in the instant case. The First Tier Tribunal asked whether the payments were in reference to the services rendered by the employees, as rewards for services past, present or future and concluded the payments were emoluments or earnings falling within the statutory definition.

It relied on a number of features which demonstrated the character of the receipts as follows:

1. The purchase of the shares was funded in full by PA, the employer, the dividends and full value of the shares were transferred at no cost to the employees;
2. The intention was to motivate and encourage the employees, and payment was represented to them as payment of the bonus for that year;
3. Those who left, even after PA had provided funds for a “dividend payment” were not eligible;
4. That the employees had no right to the payments was irrelevant.
5. The payments received by the employees owed nothing to fluctuations or increases in the value of shares in the company and everything to the amount which PA had decided to award as bonuses to its employees.

Whilst it is true that the trustees exercised a discretion in the sense of independently questioning who should be recipients, the quantum of that which the employees received was entirely dictated by the amount PA decided to award as bonuses.

The receipts were triggered by PA's decision to continue its policy of making bonus payments and to fund the 1999 Trust and arrived in the hands of employees, as they were intended to do, as bonuses.

That conclusion lead inevitably to rejection of PA's appeal in relation to liability to make NICs under SSCBA. The employees were earners since they were gainfully employed under a contract of service with emoluments chargeable to income tax under Schedule E (section 2 SSCBA). The receipts were earnings which included any remuneration or profit from employment.

The full text of the case is available at http://www.bailii.org/ew/cases/EWCA/Civ/2011/1414.html