Will HM Revenue and Customs (HMRC) earn a tax bonus from your bonus?

With the current furore surrounding bonus payments, and given the current economic climate, are bonuses a tax effective way of rewarding employees and what are the tax pitfalls to avoid?

Why are businesses paying bonuses at the moment?

Despite the deepening economic gloom there are situations where employees may legitimately be anticipating a bonus payment. This may be due to the practice of paying a low basic salary topped up with a year-end bonus, or it may be based on the achievement of personal or business targets set or achieved in periods before the credit crunch began to bite.

What are the potential tax consequences of paying a bonus?

The payment of a simple cash bonus will, effectively, be treated as extra salary and will be subject to income tax and National Insurance Contributions (NIC) under PAYE. The combined cost to the employee will likely range between 31% (20% income tax and 11% NIC) and 41% (40% income tax and 1% NIC).

Employers will also need to pay uncapped employers' NIC at (normally) 12.8% on any bonuses paid, although they will receive a deduction for corporation tax purposes against their business profits equal to the gross bonus payment and any employers' NIC.

What about paying a dividend?

Often, where key employees are also shareholders in corporate businesses, another option for the extraction of profits  is the payment of dividends. Although the amount of any dividend paid is not deductible for corporation tax purposes, there is no NIC payable by either the employee or the company. In addition, the recipient will be liable to pay income tax at an effective rate of 25% on the dividend received instead of a potential 40% on a bonus, as above.

However, the ability to pay a dividend is dependent on the availability of distributable reserves within the company, and the structure of the share ownership. Dividends must normally be declared at a uniform level across the same class of share, and if there are other shareholders involved, this may not prove to be a suitable option.

Could the other shareholders waive their entitlement to a dividend?

An increasing number of cases are being taken by HMRC regarding the payment of dividends. The 'settlements' legislation provides HMRC with the tools to assess situations where it believes income has been diverted to create a tax advantage, creating an element of 'bounty' and this would normally involve a gift which was not at arm's length. There are a range of specific exemptions in the settlements legislation but the recent case of Buck v HMRC (SpC716) highlights that it is still possible to be caught out.

Although a dividend waiver will not automatically comprise a 'settlement' within the meaning of the legislation, there are situations where 'bounty' is clearly being enjoyed by one or more persons.

If the total dividends payable comprise a fixed monetary amount, then any shareholder waiving his or her entitlement has, by their actions, increased the entitlement of one or more of the other shareholders, thus generating an element of bounty.

Clearly, if dividends are calculated on a fixed amount per share, then any individual shareholder waiving his entitlement will not increase that of another shareholder, thereby generating no element of bounty. However, although this was the case presented by Mr Buck, the dividend value of £35,000 per share could not have been met from the company's reserves if all shareholders had maintained their right to the dividend, thereby proving the existence of arrangements to confer bounty as the dividend of £35,000 per share could only legally be declared with the prior knowledge of the waiver.

David Reilly, Client Service Director specialising in Employer Solutions at Grant Thornton says: "Reward and retention of key employees is an important issue for businesses, especially in current competitive times. Fortunately, cash bonuses are not the only way of rewarding employees and these include a number of tax-efficient alternatives. These include share plans (and similar schemes where the employer does not have or does not wish to issue shares), flexible benefit packages and a whole range of innovative tax-planning ideas."

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