Business confidence is cautiously returning, and with it a change in organizations’ 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, as well as an environment of potentially increasing personal tax rates and shareholder scrutiny.
The spotlight on executive pay has been well documented, but compensation for what may be regarded as the “engine room” of any organization 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 organization has never been greater. For the middle 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 employees who are promoted may find their pay increment is substantially negated by higher tax rates, 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, organizations with global reward strategies need to consider the degree of latitude that they are prepared to permit to local tax liability factors where they are sufficient to justify a deviation from the strategic norm.
The U.S. Environment
The United States provides a good example of the growing tax landscape 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, income tax rates will increase to pre-2001 levels and the current top bracket of 35 percent will be eliminated, the top tax brackets reverting to 36 percent and 39.6 percent. Additionally, the lowest bracket of 10 percent would be replaced with the pre-2001 15 percent 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 percent to 20 percent. The 0 percent rate for those in the lowest tax brackets will be replaced by a 10 percent rate.
- Effective on or after January 1, 2013, the Medicare Hospital Insurance (HI) payroll tax rate will rise from 1.45 percent to 2.35 percent 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 January 1, 2013, an additional 3.8 percent 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 derived in the ordinary course of a trade or business that is not a passive activity.
The U.K. Environment
The landscape in the United Kingdom is no better. The key changes can be summarized as:
- New 50 percent highest rate of income tax for those earning over £150,000 per year;
- 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 allowance is eroded to nil;
- 1 percent increase in employee and employer National Insurance contributions as of April 6, 2011, to roughly 12 percent (to an upper earnings limit of approximately £44,000) and 2 percent (uncapped) thereafter for the employee and 13.8 percent (uncapped) for the employer;
- Restriction of higher rate tax relief on contributions to pensions. 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 to accelerate plans to increase the state pension age to 66;
- Increase in highest rate of capital gains tax to 28 percent for those earning £37,400 or more; and
- One piece of good news: an increase in Entrepreneurs' Relief, which is a capital gains tax concession on qualifying business disposals, providing a 10 percent CGT rate on business sales to £5 million.
The focus has been on employees earning about £150,000, but income tax rates jump from 20 percent to 40 percent 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 that are tax or National Insurance free or where there is a reduced rate.
Tax-Efficient Compensation Ideas in the United States
Companies should review compensation arrangements to determine ways to reduce the potential tax exposure to employees. 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 because of 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-Favored Equity Grants
Companies can still use tax-favored equity compensation plans, such as the granting of incentive stock options and the use of employee stock purchase plans (ESPPs). To attain the favorable 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 percent 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, 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 recognize 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 realized on the disposition of the stock over the exercise price of the purchase right. Any ordinary income recognized 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 recognize 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 recognized 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 United Kingdom
The most commonly used tax-efficient pay tool is the benefit-in-kind. The benefit-in-kind has several advantages:
- It provides employees with choices to suit their personal circumstances — for example, medical and dental insurance, financial assistance or retail vouchers — making them feel more valued by their organization. In return, they are more committed to their employer, which aids retention.
- The cost of provision to the employer who can buy benefits such as life assurance, concierge services and training “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.
- There can be savings to both employee and employer through exemption from National Insurance for benefits such as childcare vouchers, bicycles, gym memberships and welfare assistance.
- There are good external providers who have technology-based administration tools that make the 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 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, e.g., retail vouchers, linked to salary sacrifice is the provision of services for value-added tax. As most employers are registered for value-added tax, this is not a big issue, but care still 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 employees forgoing 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 the employee and the employer, so there is a valuable annual saving to the employer. This saving can be shared with the employee.
Finally, tax-favored all-employee share acquisition plans can also play a valuable role, since any gains are taxed as capital (18 percent or 28 percent) rather than income (20 percent, 40 percent or 50 percent), and they are usually National Insurance free for both the employee and the 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.
Alvarez & Marsal Taxand Says:
Organizations need to decide on 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 consistent with that global strategy needs to be considered. If it’s 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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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.
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