29 January 2012

Stephen Hester’s bonus: how not to structure exec remuneration

Tax and bonuses in shares

Sorry if you’re expecting a polemic about the level of bankers’ bonuses. There’s been far too much of that in my view: I have the old-fashioned view that if the Government negotiates a contract it’s probably not a good thing for it to renege on it.

What I wanted to tell you about is the tax treatment of such a bonus, and how smaller companies can do much better. This is an area in which those poor oppressed bankers really have been losing out.

The Government has been keen to see bonuses paid in shares rather than cash, but it has made no tax concessions to encourage it. An employee receiving free shares as a bonus is taxed on their value as if they were cash. Listed company shares are “readily-convertible assets” so the tax has to be paid through the PAYE system, and national insurance is payable. Mr Hester is not allowed to sell his shares, so he will have to find over £500,000 out of his net salary to pay the tax on his £963,000 bonus. On his reported salary of £1.2 million, that will leave him with about £85,000 net [1]. The taxpayer-controlled bank will have to pay national insurance contributions of almost £300,000. So in total for 20011-12 Stephen Hester gets £85,000 and George Osborne gets £1.425 million! RBS does get a corporation tax deduction for the salary, the value of the shares and employer’s NIC (if RBS makes a profit) but the Exchequer still gets £785,000 net.

The position changes, of course, when the shares are eventually sold. If they go down in value, there is no tax to pay, but no credit for the tax already paid. If they halved in value, Mr Hester would make a net of tax loss (the tax paid would be more than the proceeds of sale). If the shares go up, there is no tax on the first £963,000 (on which he has paid tax already) but the profit will be chargeable to capital gains tax. But of course the taxpayer loses out through dilution of the Treasury’s shareholding: if the shares double in value, the bonus will have cost the shareholders twice as much as if they had paid the bonus in cash.

Mr Hester may be able to afford to pay £520,000 of tax and NIC out of other salary and resources, but most employees are not likely to be grateful for a bonus in shares they can’t sell, which lands them with a large tax bill they can’t pay. This makes bonuses in shares very unattractive.

Fortunately private companies have a much better route available to them. We can thank the LibDems (in the 1970’s [2] for starting a range of tax-approved employee share schemes. Best of these now is the Enterprise Management Incentive (EMI) Scheme [3]. Its tax advantages remain amongst the best of any tax relief. Complete exemption of gains from tax or NIC and a full corporation tax deduction for the value of the shares mean the net tax rate is often actually negative!

I have been setting up EMI schemes for private companies for many years. They are wonderfully flexible, and can be structured to avoid diluting owners’ equity until the company is sold. If you would like more details please contact me.

[1] assuming he uses his allowances and basic rate tax band elsewhere

[2] actually they were still Liberals then

[3] under Schedule 5 of ITEPA 2003

23 January 2012

A tax windfall for solicitors?

Make a back claim for VAT bad debt relief

An extraordinary VAT case that could be worth a lot of money to solicitors: if you issue a VAT-only invoice to your client and the client fails to pay, you can claim VAT bad debt relief and get the full amount back, not just a proportion representing the VAT rate.

This arises when someone else is paying the costs, but your client is VAT registered and can reclaim VAT on your fees. You bill the client for the VAT element and send a non-VAT invoice to the third party, who pays the net of VAT costs. Most often that is the client’s insurer paying your litigation costs, but it could also be a tenant paying a landlord’s costs, or the losing party in litigation paying the winner’s lawyer’s costs. But what if your client fails to pay the VAT? You may have difficulty recovering it; if you were instructed by the insurer you may have no real relationship with the client, and you will not have been able to do credit checks or get money on account.

Previously it was assumed (and case law said) that you had to treat this like any other bad debt, and the fact that you had issued separate invoices for the fee and the VAT was irrelevant: you had (at 20%) recovered 5/6th of your VAT-inclusive fee so you claimed bad debt relief on 1/6th, and got 1/6th of that back, or 1/36th of the total; you were out of pocket by 5/36th. In Simpson & Marwick v HMRC[1] the Upper Tribunal said this was wrong: if the bad debt is clearly identified as the VAT element, it can be claimed in full – HMRC loses the entire 6/36th.

It is worth reviewing records and talking to your accountants about making back claims for relief. The case could yet be appealed so make appropriate disclosures in any claim.

[1] [2011] UKUT 498 (TCC)

19 January 2012

Points for Property Professionals 3

Competition law and user restrictions in leases

This is the third in my short series of notes on non-property legal points relevant to property lawyers and others in the property industry. It focuses on the effect of competition law on the negotiation of lease terms.

From April 2011, land agreements (which include leases) lost their blanket exemption [1] under the Competition Act 1998. The Chapter I prohibition in that Act applies to agreements that prevent, restrict or distort competition to an appreciable extent. An agreement that breaches the prohibition is void, and can attract large fines for the parties.

A common form of restriction in a lease that might infringe the ban is the user clause in a retail lease. Leases normally restrict the use of the premises to a particular purpose, which might be broad or narrow.

The effect on competition must be “appreciable”. If both parties have less than a 10% share of the relevant market, the prohibition is not likely to apply (unless there are “hardcore” restrictions such as price fixing). But defining the market can be tricky, and in the case of retail leases the relevant market may be very local. You cannot tell whether a restriction is permitted just by looking at the clause. Also, you can’t judge it only at the date of the lease: a restriction that was valid could become prohibited due to a change in market conditions.

Where both parties are trading in the same market, restrictions are particularly sensitive and should be looked at individually. For instance, where the landlord is a large retailer, letting smaller units on its own retail estate, any restriction on what those units can sell (with a view to restricting competition with the landlord) should be looked at very carefully. Where the parties are potential competitors and the object of a restriction is to share markets by territory, type or size of customer, the agreement will almost invariably infringe the Chapter I prohibition.

If the landlord is not a potential competitor of the tenant, most forms of restricted user clause will not normally infringe the prohibition. The main thing to look for is anything that imposes a restriction on the landlord – usually preventing it from granting leases to competitors of a tenant.

The OFT accepts that restricting use of premises in shopping centres and retail parks is just good estate management, providing a good retail mix. The landlord normally has no interest in restricting competition amongst its tenants, but it wants a thriving estate with a large footfall. Sometimes, though, the landlord will agree not to grant other leases for the same use, or not to permit changes of use, to protect the businesses of tenants from competition. Those restrictions could well be prohibited agreements, if they have an appreciable effect on competition.

However, an agreement is exempt from the prohibition if four cumulative criteria are satisfied:

• The agreement must contribute to improving production or distribution, or to promoting technical or economic progress.

• It must allow consumers a fair share of the resulting benefits.

• It must not impose restrictions beyond those indispensable to achieving those objectives.

• It must not afford the parties the possibility of eliminating competition in respect of a substantial part of the products in question.

The OFT considers that the exemption is capable of applying, for example, where a restriction is essential to attract an anchor tenant to a retail development. The tenant may need to justify substantial investment. Excluding the landlord from bringing in a direct competitor elsewhere in the development could be necessary to achieve that, making the whole development viable and bringing benefits for consumers. But the OFT points out that the restriction should be time-limited, since it must otherwise go beyond what is “indispensable”.

Finally, networks of agreements have to be looked at together. That could include all the leases for one estate, or leases between the same landlord and tenant in different shopping centres across the country.

The OFT publishes a detailed guide to competition law and land agreements on its website.

[1] Under the Competition Act 1998 (Land Agreements Exclusion and Revocation) Order 2004 which replaced the Competition Act 1998 (Land and Vertical Agreements Exclusion) Order 2000, revoked by the Competition Act 1998 (Land Agreements Exclusion Revocation) Order 2010.

17 January 2012

Should the insurers pay?

Business insurance in the light of the PIP implant scandal

In recent discussions about the PIP breast implants scandal, many people have asked why PIP’s insurers are not paying for replacement of the implants. It may be a good time to remind readers about the different types of business insurance for third party claims, and how they might respond to a product liability claim.

Leaving aside employer’s liability insurance and motor insurance, the most common form of liability insurance is public liability insurance. It covers injury to persons or property arising from business activities, which will normally only arise at the company’s premises, or on others‘ premises when visiting them. Liability for defective products will not be covered, nor will obligations under contracts. I am sometimes bemused by the common requirement in public sector contracts for a minimum level of public liability insurance: there is often woeful ignorance of what is likely to be covered by such insurance, and so long as the contractor can produce a certificate showing he has insurance for a sufficiently large amount, the likelihood of being able to claim doesn't get questioned. The chances of a claim by contract counterparty under public liability insurance are extremely small.

Basic product liability insurance covers injury to persons or property arising from defective products. It does not cover repair or replacement of the products themselves. That would normally require product recall insurance, which is much rarer.

Finally, professional indemnity insurance covers liability for negligent advice or negligent design.

Unless it is required in a particular industry – for instance solicitors must have professional indemnity insurance – and apart from employer’s liability and motor insurance, none of these types of insurance is compulsory, so any given supplier may not have it, or may not have sufficient cover.

To get the benefit of the insurance, the third party claimant first has to establish her claim against the insured business. In most cases there must be a legal liability – for example liability for a defective product under the Consumer Protection Act 1987. The outcry over PIP breast implants is far short of proving that any particular implant is defective or has caused harm. In the PIP case the claimant could be the patient trying to claim direct against the manufacturer, or could be the buyer of the product from PIP wanting to recover its own loss if it compensates its patient or customer.

Insurance usually exists to protect the policy-holder, and third parties normally have no direct right to claim under it (motor policies are different). It is up to the insured business to decide whether to claim on its insurance, and the policy will be subject to limits and exclusions, or may be void for breach of conditions or non-disclosure – eg if the insured manufacturer had deliberately used sub-standard materials. A common condition of product recall insurance excludes recalls forced on the manufacturer by government or a regulator – to prevent authorities passing liabilities to insurers they would not otherwise have, perhaps under the pressure of a public scandal.

The position changes slightly where the policy-holder has become insolvent. Its rights are transferred to the third party claimant under the Third Parties (Rights Against Insurers) Act 1930 (to be replaced by the 2010 Act when the Government decides to bring it into force). Both Acts invalidate a condition terminating liability on insolvency, and the new Act will remove the need to sue the insolvent company. The Acts prevent the proceeds of the insurance claim falling into the insolvent estate and being distributed to the creditors generally.

Insurance written on a "claims made" basis requires a claim to have been made while the policy was in force. If no claim was notified to the insurer during the policy period, no claim can be made subsequently. Product liability insurance may be on a "claims made" or "claims arising" basis. So the insurance could have expired before the third party makes her claim, especially if the business has ceased trading and stopped paying premiums.

In the case of a foreign manufacturer, the policy terms may well be under foreign law, though the Third Parties (Rights Against Insurers) Act probably applies to UK claimants against the foreign insurers after insolvency, if the foreign law would not allow them to claim.

Further reading: a good explanation by Airmic of business insurance generally, including the different types of cover, is here. An excellent summary of the law on product liability and product recall insurance by Herbert Smith is here.