High-earner tax changes will affect reward for all

Chancellor Alistair Darling’s tax changes for high earners are likely to have far-reaching consequences for employee reward at all levels, says Tom Washington

Has there ever been a time when reward has stirred such emotion and been so newsworthy as it is now? Whether it is public anger over bloated bonuses or inflated pension pots, the way top employees are remunerated is a hot topic in political, business and economic circles.

Back in April, reward hit the headlines, when Chancellor Alistair Darling revealed that, from April 2011, pensions tax relief for those earning over £150,000 a year would be decreased. He also announced a sharp rise in higher-rate income tax to 50% for this group from April 2010, while the income tax personal allowance will be abolished on a sliding scale for those earning between £100,000 to £150,000. Darling argued it was hard to justify a quarter of all the money the UK spends on pensions tax relief going to the top 1.5% of earners, and that those who have gained the most should contribute more.

These changes have started to influence reward more widely than headline information suggests, affecting more than just the estimated 300,000 staff in the top earnings bracket as employers look to other ways of rewarding their workforce.

Staff seek ways to avoid higher tax rate

For example, the changes mean that staff earning between £100,000 and £112,950 will have a marginal tax rate of 60%. Sue Bartlett, senior consultant at Watson Wyatt, says staff are already looking for ways to reduce their income figure if they are in danger of crossing the threshold into a higher tax rate. Salary sacrifice arrangements will be an attractive option for those in this bracket because they will be able to reclaim 60% tax if they sacrifice earnings above £100,000 into their pension.

There have even been reports of large employers moving their financial year to a different date to avoid the 50% tax rate. Moving to a March year-end offers staff an extra 11 months at 40% before the new rates come into force in April 2010. “I think there is a psychological tipping point at 50% when people say ‘enough, no more’,” says Bartlett.

Meanwhile, Dave Wilkinson, senior partner at Foster Denovo, has seen a huge demand from employers and executives wanting help in understanding the implications of the Budget. “One person I was speaking to had children at private school and the impact of the new 50% income tax rate could be the difference between sending their kids there and not,” he says.

Changes seen as unfair

Philip Smith, director of financial planning at Buck Consultants, says there is a feeling of frustration and unfairness among those affected. “You can argue all you want that someone earning £150,000 a year is a high earner, but it all depends on individual circumstances,” he explains.

Most employers will have staff that are affected by the changes, but there is only so much organisations can do. Michael Rose, director at Reward Solutions, says: “It is not up to organisations to compensate individuals when the tax regime changes. When the tax rate drops, you do not expect employers to reduce salaries, so if tax increases, on the face of it, an organisation does not have to compensate for it.”

However, employers are making tactical, short-term changes at the same time as planning for longer-term, strategic adjustments to reward to avoid being at a competitive disadvantage in the hunt for talent. Crucially, with more cash heading for the taxman, pensions will become less attractive to this group of employees because, for the vast majority, it will no longer make financial sense to invest in a scheme.

Impact on lower-paid employees’ reward

At the time of the Budget, industry experts said an attack on pensions tax relief could send the wrong message to both scheme members and employers. Rob Warren, director of regulation at IFF Research, believes decision-makers in organisations could become disengaged with the benefit: “What has yet to be seen is the impact of the tax change on lower-paid employees’ rewards.”

“Senior executives who have previously maintained a business’ final salary pension scheme may no longer see the incentive to do so. As they are forced to shift to alternative investments, the unintended consequence could be an accelerated decline in the number of defined benefit schemes available to others, which could have a devastating impact on ordinary people’s future income.”

Tax-efficient savings schemes

Instead, employers could segment their benefits strategy according to income levels, offering staff hit by tax changes more attractive alternatives in the form of tax-efficient savings vehicles. This raises the question of whether employers will provide separate, or watered-down, versions of new tax-efficient arrangements for lower-paid staff.

Lee Hollingworth, head of defined contribution (DC) consulting at Hymans Robertson, says: “A DC pension is now one of the least effective means of saving [for high earners]. We have looked at various products that could be offered through the workplace and come up with an efficiency index. Areas that are efficient for that kind of individual include a corporate individual savings accounts [Isa], employer-financed retirement benefit schemes [Efrbs] and share incentive plans.”

Efrbs are non-registered pension schemes that are exempt from the tax rise and can be facilitated by employers. They have been around since 1989, when the government put a cap on the amount of pay that could be pensioned. The big advantage of Efrbs is that no tax is payable until the individual withdraws the benefits. “These will undoubtedly be marketed more towards higher earners now,” says Warren.

Employer-financed retirement benefit schemes

But Robin Hames, head of technical, marketing and research at Bluefin Corporate Consulting, points out that Efrbs are not protected by the Pension Protection Fund (PPF) and do not offer tax-free lump sums, as other types of pension do. “If [an organisation] goes bust, the employee or ex-employee will have to stand in line with [its] other unsecured creditors, meaning the pay-out may well be reduced, possibly to nil,” he says.

Meanwhile, corporate cash Isas, as a tax-free form of saving, appeal to all but are limited in how much can be saved each year. They allow staff to save over a shorter period and enable them access to their money more freely. Isas offer an annual £7,200 stocks and shares allowance or £3,600 if the £3,600 cash allowance has already been used.

For those who have exhausted other tax-efficient vehicles, the increased overall Isa annual contribution limit of £10,200 for those aged 50 and over will become more attractive. Reward Consulting’s Rose predicts employee Isa contributions through salary deduction could become commonplace.

Share options likely to increase

The tax changes are also likely to result in an increase in equity-based remuneration, such as share options, where benefits are deferred. For example, employee benefits trusts are also likely to become popular. These are typically used for deferred discretionary bonuses or to house employee share schemes and essentially act as a discretionary trust for the benefit of staff.

A basic trust requires a set of trustees and beneficiaries (staff). In a discretionary trust, no employee can be taxed on assets transferred into the trust, but only when benefits are paid out. Large investment houses have used these for many years, with traders’ bonuses often being paid into such trusts. Jon Terry, leader of PricewaterhouseCooper’s reward practice, says: “Employee benefit trusts offer a lot more flexibility because you are essentially deferring income tax by growing the money in a tax-free environment. For many people, this is a better provision to be in now.”

Concerns among lower-rate tax payers over the size of the government debt could also create a greater appetite for employee share schemes. Duncan Brown, director of reward services at the Institute for Employment Studies, says: “The worry for lower tax-paying people is that somehow taxes are going to go up to cope with the debt.”

Shift to share plans for all staff

With income being taxed more heavily than capital gains, many organisations will be compelled to implement share plans for all staff to benefit from a better tax rate, not just for the highly-paid. This would represent a shift away from rewarding staff with cash as employers look to motivate them in more tax-efficient ways. The approach is similar to that of the early 1980s, when high taxes made share plans extremely tax-driven rather than designed to motivate staff behaviour.

“There is now a huge differential [33.5%] between capital gains tax rates [18%] and income tax rates [50% plus 1.5% national insurance for those earning £150,000],” explains Terry. “Getting staff involved in the capital growth of the business, which is common in the US but not in the UK, is getting some major airtime now.

“Essentially, this is a commercial transaction shifting some of the risk to the employee. I think you will see a number of organisations doing arrangements like this for select groups of individuals on a voluntary basis. Whether it is worth it from an employee’s perspective depends on their attitudes to risk.”

Way to reward future leaders

Although such alternatives are initially likely to be offered solely to high-earning executives, in due course they are likely to be cascaded down to other groups of staff in lower tax brackets. For example, an employee earning less than £100,000 may occasionally earn enough, through variable income, to move into the higher bracket. For these employees, taking part in such arrangements would be desirable, if not essential, and would be a way for employers to recognise and reward this band of future leaders.

“The government has been naive to think the changes will affect only 1% or 2% of the workforce because there will be people moving into those higher-earning brackets,” says Terry. “We predict around 15% of organisations’ staff will be affected by the changes, either immediately or aspirationally.”

Corporate wrap platforms

The available alternatives are likely to manifest themselves in a range of workplace savings vehicles, or corporate wrap platforms. So, rather than paying 10% into a pension, employers could give staff the option of other savings vehicles, such as Efrbs or Isas. This then empowers staff to make the best choices for themselves.

Hollingworth says the challenge lies in packaging and communicating this effectively. “The discussion then moves on to how [providers and advisers] are going to deliver those solutions, not all acting independently of each other but ideally using a platform such as a modeller or summary of workplace savings vehicles with Isa, DC pension and share schemes in one place,” he says.

So, although the full repercussions of the Chancellor’s Budget may not yet be clear, what is certain is that the ripple effects are already being felt in many areas of reward, and employers must be ready to act accordingly.

Will high earners avoid the UK?

The tax changes are likely to have an impact on organisations competing globally to attract key talent and there will be an increase in the cost of seconding individuals to the UK on net pay schemes.

Together with the UK’s high cost of living, this could significantly affect organisations’ decisions to send staff to work here. This could prompt some employers to seek more favourable tax locations in which to base their talented staff, such as Switzerland or Dubai.

Charles Cotton, reward and employment conditions adviser at the Chartered Institute of Personnel and Development, says it is certain that employers will send groups of high earners abroad.

“This new tax rate is going to lead people to go overseas,” he explains. “There will be an immediate impact on attracting high earners into the UK and employers might question whether these employees need to be based here.”

How to avoid the tax hit:

Tax experts have been busy devising ways to help high earners avoid the tax hit.

Deborah Broom, client services director at Capita, says reviews of share scheme rules are taking place to ensure remuneration committees have enough discretion to allow early vesting to offer maximum benefit to the participant.

“We are likely to see share scheme rules being reviewed to ensure [organisations] are able to allow early exercising and vesting of options and shares pre-April 2010,” she explains.

Rather than giving a pay rise that pushes an employee above the £150,000 income limit, employers could defer it until a time when it does not have adverse tax consequences on staff. Sacrificing earnings for benefits other than employer pension contributions may reduce income below £150,000 because only sacrifices for pension are included in the allowance.

Lesley Fidler, tax director at Baker Tilly, says she has seen an increase in executives setting up a limited liability partnership, whereby partners pay corporation tax on any profits rather than income tax, as well as using their spouses to get better tax rates. “If [an employee’s] husband, wife or civil partner pays tax at a lower rate, it is worth transferring income-producing investments into his or her name,” she says.

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What the Darling Budget said:

  • Employees who earn more than £150,000 a year will pay income tax of 50% from April 2010. On the same date, the income tax personal allowance will be abolished on a sliding scale for those earning between £100,000 and £150,000 a year. In addition, from April 2011, pensions tax relief for staff earning more than £150,000 a year will gradually be tapered from 40% to the basic rate of 20% for those on incomes over £180,000. Irregular pay, such as bonuses, commissions and income on exercise of share options, will be included.
  • The restriction applies to all pension contributions, but employers will continue to receive full relief on their payments into employees’ pension funds through corporation tax and national insurance contributions (NICs).
  • Measures have been put in place to stop those affected trying to forestall the change. Staff cannot increase pensions savings in excess of their normal pattern before the restriction comes into effect, or increase their annual employer and employee contributions beyond £20,000 (or £30,000 for irregular savers). Above this special allowance, tax relief on pension savings will be at the 20% basic rate. This may prevent the use of salary sacrifice arrangements to reduce incomes to below the threshold.