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Increasingly, clients are opting for Employee Benefit Trusts (EBTs) which are a highly tax efficient alternative to bonuses or other methods of profit extraction.

What is an EBT?

An EBT is a trust set up by a business for the benefit of employees and their families. This can include current, prospective and former employees and directors. The employer makes contributions to the EBT, possibly as an alternative to paying bonuses. The Trustees of the EBT then have wide discretion as to how, when and to whom contributions are allocated to suit the needs of the business or the employee's personal circumstances. An EBT can be set up as a UK trust, but is more typically located offshore. Until funds are paid out, the EBT Trustees have extensive powers to invest the trust capital in a wide range of investments or assets, and if located offshore the value may roll-up tax free. EBTs bring a range of potential benefits to employees. This bulletin looks at the particular advantages of flexible loans.

EBT loans - a cash bonus alternative

• The EBT can make loans to the employee on a low or interest free basis. This could be instead of a bonus on which they may pay income tax and NIC charges of 41% (51% for high earners from April 2010).

• Loans can be on flexible terms, or at the discretion of the trustees, perhaps allowing for repayment after a fixed term or when employment ends. Ultimately loans could continue indefinitely, well beyond the retirement of the employee or even their death.

• Outstanding loans that are made at less than the UK official rate of interest (currently 4.75%), will incur a benefit in kind charge based on the interest rate differential. Employees paying tax at 40% will incur an effective 1.9% per annum tax charge on monies received. The employer will incur a charge to NIC equating to 0.61% per year which, after corporation tax relief, would cost the employer only 0.44% per annum

• The annual benefit-in-kind charge will continue to apply until the employment ceases. Post employment, interest free loans fall outside the benefit-in-kind legislation, so the annual tax charges cease to apply and the employee can retain use of the money on a tax free basis.

• If the loan made to the employee remains in place at the date of death, the liability will be treated as a debt on the estate for Inheritance Tax purposes - reducing Inheritance Tax at up to 40%.

• Following death, the Trustees have wide discretion as to how to deal with the outstanding loan, such as allowing it to be waived, or re-lent or appointed out to the deceased's family.

Example: EBT vs bonus or dividend

The table below shows the net cash received by an employee/shareholder if £100,000 of profit is extracted by way of bonus, dividend or EBT loan.

                                      Bonus                Dividend             EBT loan

Pre-tax profit                 £100,000            £100,000              £100,000

Company Tax/NIC         (£11,348)            (£28,000)              (£28,000)

Individual tax + NIC      (£36,347)            (£18,000)              (£0)

Net cash to individual    £52,305             £54,000                 £72,000

Annual benefit in kind         -                         -                     £1,368

of EBT loan

Therefore by taking an EBT Loan rather than a bonus or dividend, the employee can receive additional cash funds of up to £19,695. This rises to £28,560 for a higher rate tax payer after April 2010.

Pre-tax profit

Therefore by taking an EBT Loan rather than a bonus or dividend, the employee can receive additional cash funds of up to £19,695. This rises to £28,560 for a higher rate tax payer after April 2010.

Other tax benefits

Close company loans

Closely controlled companies can effectively make loans to shareholders or their families through an EBT without incurring the 25% corporation tax charge that would arise if the company made the loans direct.

Nil Income Tax or NIC contributions

There are no income tax or NIC charges when funds are contributed to the EBT. The Trustees are free to notionally allocate the funds, or create sub-trusts for specific employees and their families.

Tax free roll-up of EBT funds

Income and capital gains made within an EBT can roll-up tax free where the EBT is located offshore and invests in non-UK based assets. Where the EBT is located onshore, the Trustees will be liable to income tax at 40% and 32.5% on dividend income (rising to 50% and 42.5% from April 2010).

Inheritance Tax shelter

Assets held within an EBT are outside UK Inheritance Tax laws as the trust qualifies as a tax favoured "employee trust". This includes the trust 10-year principal and exit charges. Where the employee has taken an EBT loan, the liability will also potentially reduce their estate subject to IHT on death.

Tax efficient for employees

Payments of cash out of the trust to employees will be liable to income tax and NIC in the normal way. Similarly benefit-in-kind provisions apply where the employee obtains non-cash benefits and remains in employment. However, the benefit-in-kind rules cease to apply when the employment ends, and payments or loans from the Trust to an employee's family following death can be made tax efficiently.

Tax relief for contributions

Employer contributions are tax deductable, but only when matching payments are made to employees as taxable emoluments. Where the employee takes a loan instead of emoluments, then the timing of any deduction will be deferred.

Other benefits of an EBT

An EBT can be used to provide an array of benefits to employees:

• Payment of discretionary bonuses, e.g. linked to performance or continuing service

• Provision of shares or share options - possibly under an Employer sponsored scheme

• Flexible loans to employee or their immediate family (these can be on an interest free basis as noted above)

• Holiday homes for use by employees or their families

• Other non-contractual benefits, e.g. life or health insurance, staff parties or annual holidays

• A "market maker" to allow employees to buy and sell shares in the company

• Lump sum payments following death or retirement

EBTs in summary...

EBTs are an attractive tax efficient structure for incentivising, rewarding and motivating employees. They are well understood and accepted by HMRC and advisors alike, having a valid commercial purpose for the modern business. They can also provide significant tax and cash flow benefits from a tax planning perspective. For example, the ability to provide interest free loans at a tax cost of only 1.9% per annum. This is very appealing for high earners, particularly where a 50% tax rate will apply after April 2010.

For more information on the benefits of EBTs, please contact a member of the Tax Planning team.