1. Avoiding Corporation Tax, making EBT’s a very good corporate tax planning tool.

2. Reducing Income tax.

There are additional benefits related to EBT’s which will be covered a bit later in the article.

The Employee Benefit Trust was usually situated in a tax haven like the Isle of Man, where the trust’s income was not going to be taxed, which was crucial to the tax planning. The Isle of Man was usually chosen because it was close to the UK in distance and time zone and is a tax-free location for non-resident companies and non-resident beneficiaries of Isle of Man trusts.

An Employee Benefit Trust is a like its’ name suggests, a trust set up for the benefit of its’ employees. This money would be for such things as gifts, bonuses, staff parties etc. As already stated an EBT is a way how to reduce corporation tax and this is achieved because any cash transferred from the company account to the EBT’s account is a deduction for tax purposes. Therefore if the company holds profits of £300,000 and £100,000 is transferred to the EBT, the corporation tax bill for the company will be derived from the profits of £200,000 and not £300,000. This particular transfer will reduce corporation tax by 33%.

An additional benefit to the company that had the Employee Benefit Trust is that once it had received a deduction against corporation tax, quite incredibly the company can then loan its’ own cash back for company purposes. So not only did it get a deduction of corporation tax, it still got the use of the money! An additional benefit is the EBT then charges interest on the loan, which is a further deduction for corporation tax purposes. The company had its’ cake and ate it too!

An Employee Benefit trust is also a way to reduce income tax. This is achieved because within the EBT, a number of sub-trusts are established for the chosen beneficiaries. The beneficiaries are usually key employees like the Directors or Shareholders. The way the EBT is able to reduce income tax is when cash is moved from the EBT’s main account to the account of a given sub-trust, the beneficiaries can loan the cash back, tax-free. This is because loans are not income and are therefore not taxed. The loans are then constructed in such a way that they are never in reality paid back, but are commercial loans for tax purposes.

There is an additional benefit for the key employees who are beneficiaries of a sub-trust are that they can leave the cash in the trust and invest the cash from there in a tax-free environment. This means that shares, property and other investments can accrue and compound faster in a tax-free environment. The cash can then be loaned out as required or the beneficiary can even become a non-resident for a year and take all the cash tax-free while not being liable for UK income tax. This will also further reduce income tax and potentially capital gains tax.

Who uses Employee Benefit Benefit Trusts?

EBT’s are used primarily by:

1. Limited Companies for corporate tax avoidance.

2. Contractors who want to reduce income tax.

An EBT is viable for any company with pre-tax profits of approximately 300,000 Pounds. This is because there is a cost in establishing and maintaining the trusts within the EBT and the EBT itself. The other main group of users for EBTS’s are Contractors who want to avoid the effects of IR35 but in doing so reduce income tax. Contractor schemes are set up to cater to the needs of contractors and each contractor was made the beneficiary of a sub-trust.

However, since the 9th December 2010 the HMRC (UK Inland Revenue) has legislated against the Employee Benefit Trust and it is therefore no longer a legal structure for corporate tax avoidance and reducing income tax. However, as with all tax planning, when one door is closed another opens. This is the case with the Employee Benefit Trust and alternatives are already available, which achieve the same favourable outcomes for corporation tax avoidance and can reduce income tax as well. Contractors are using Umbrella companies so they can now write off their expenses against tax and be paid PAYE for the balance. The Employer Funded Retirement Benefit Scheme II (EFRBS) has been created and is now capable of achieving what an Employee Benefit Trust did.

In being an employee of the offshore company you are eligible to participate in an Employee Benefit Trust (EBT) scheme, which makes payments to company employees. This is quite legitimate and is seen as a way of rewarding key staff. EBT payments are based on the profit the company has generated from employing you, which is effectively the difference between the amount invoiced for your services whilst contracting and the cost of employing you (your basic salary – £6000). For legal reasons, to remain free from taxation these payments from the Employee EBT cannot be guaranteed. This is where the financial risk with EBT schemes is.

Is it legal?

This is where the really tricky bit comes in for IT contractors – will the tax man be on your back if you work through an EBT scheme?

The EBT route has been in use for many years during which there have been several changes in legislation attempting to block this option, but many of the offshore companies that offer an EBT scheme have modified their procedures to remain within the law. It is still essential to review the legal opinion of any company offering an EBT pay scheme for contractors. The only saying… if it looks too good to be true, it probably is… applies here as well as anywhere else.

If you are being paid through an EBT scheme you will have to enter a tax avoidance reference number on your self assessment tax return, which will be supplied to you by the EBT scheme provider. This immediately puts you in the Inland Revenue’s sights and you may well receive a letter from them each January stating that they intend to enquire into you tax return.

If the Inland Revenue deem a tax avoidance scheme to be illegal at some stage in the future, there is a risk that you will be hit with a bill for back-dated tax going back several years, so be warned!

How much will I pick up if I work through an EBT scheme?

As an employee of a company offering an EBT scheme, you can expect to pick up more than 80% of the amount you invoice.

How long will I have to wait for payment?

EBT schemes do not generally pay out each month and you will probably have a gap of a couple of months or so between payments. Your salary (for example, £6000 per year) might be paid to you on a monthly basis.

HM Revenue & Customs (HMRC) are actively investigating some of the practices used by contractors to minimise their tax payments (tax avoidance) and may well examine each of your contracts individually rather than take your earnings as a whole. Therefore, as a contractor you need to be very careful when you choose your payment solution.

Pay as You Earn (PAYE)

Avoids the entire IR35 headache and is the HMRC compliant standard. The PAYE system is a method of paying income tax. Your employer deducts tax from your wages or occupational pension before paying you your wages. Wages includes sick pay and maternity pay.

This means that you pay tax over the whole year, each time you are paid. Your employer is responsible for sending the tax on to HM Revenue and Customs (HMRC).

Contractors that work through an employment agency and receive all income via PAYE

Agencies, only pay a reduced rate as they still have to pay out National Insurance, holiday and sick pay costs, together with the additional administrative burden of running a payroll and complying with current employment legislation.

Personal Service Companies (PSC) / Limited Companies

PSC’s are commonly one man bands, processing income as part salary and dividend payments. In the past, contractors used this method to exploit tax loopholes and improve tax efficiency. Contractors set up a limited company and pay themselves via a minimum wage and dividends.

However, this method is now classed as risky because:

Contracts inside IR35 dividend payments are simply NOT viable anymore.

HMRC view minimum wage/dividend options as tax avoidance and may impose PAYE.

If there is no “goodwill” in the company, a contractor may be seen as receiving “disproportionate return on initial investment” and dividend will be taxable as PAYE.

(according to section 447 of the ITEPA, 2003)

Outside IR35: if a dividend payment takes a contractor over the 40% tax threshold they will face an end of year tax liability.

You will find many agencies and clients will not allow you to use this method until you’ve had your employment contract reviewed by a IR35 specialist, which can cost upwards of £150 per contract assessed.

Umbrella Company

An umbrella company acts as employer to independent contractors who work under a temporary contract, usually through an employment agency.

Since the introduction of the Managed Service Company (MSC) legislation in the budget 2007, the only way an independent contractor can comply with this requirement is to set up his or her own personal limited company or use an umbrella company.

An umbrella company issues invoices to the recruitment agency (or client) and, when payment of the invoice is made, will typically pay the contractor through PAYE (although historically the term has also been used for salary and dividend type payment structures).

Umbrella Companies are fast becoming both the choice for both contractors and agencies alike:

-Company pays the contractor via PAYE on the total contract sum and uses a HMRC approved dispensation to offset business expenses.

-IR35 is irrelevant as all income is paid as PAYE.

Composite Companies

There is no legal or tax law definition of the word “composite company”. However, this term is commonly used in the context of service providing companies to the contracting industry.

The word “composite” means “made up of various parts” and in the context of contractors, is represented as a service providing company, through which many contractors place their contracts.

A mixture of salary & dividend payments now, could be viewed as blatant “tax evasion” by the HMRC, according to section 447 ITEPA, 2003:

-Company provides administrative services, invoicing and receiving payment for work carried out – eases burden for contractor.

-Contractor paid a small salary plus expenses, remaining income paid via dividends.

Popular in the past, this option was viewed by the government as ‘tax avoidance’. New legislation introduced in the budget 2007 means that it’s now looked upon as blatant ‘tax evasion’ for workers Inside IR35.

If you are deemed employed, this option should no longer be pursued.

Employee Benefit Trusts (EBTs)

Once an attractive option, the 2002 Pre-Budget Report announced immediate legislation to counter the avoidance of Tax and National Insurance contributions (NICs) through the abuse of EBTs.

Contractor works under company receiving basic salary, usually 20-30% of contract value, with balance paid into an offshore trust from where it is loaned back to the contractor.

Loan is in foreign currency so avoids IR35, taxation and NI.

HMRC has now closed the loophole on this scheme and EBTs can no longer operate.

Tax relief is now only allowed on PAYE payments made by the trusts, i.e. the lower salary figure, and not on loan.

The HMRC Anti-Avoidance Group has set up a team to project manage these cases to ensure that the tax outstanding is collected systematically and consistently.

Foreign Loans

Foreign loans are a legal means of “avoiding” Tax and National Insurance, however Gordon Brown announced in his budget on 17th March 2004 the intention to introduce a scheme which will force any Company setting up and marketing “tax avoidance schemes”, to register with the HMRC.

As with most tax law, the measures are not at all clear. For example who defines “the obtaining of a tax advantage”? Presumably anything we do which does not involve us paying the highest amount of tax possible could be covered by this? The penalties for not registering or notifying will be up to £600 per DAY.

-Loans made to contractors in foreign currencies and repaid (often at very low rate).

-Must be operated in conjunction with an offshore company, not taxed on profits.

-Offshore companies are scrutinized by HMRC and all dealings would be challenged and taxed as income if received by a UK resident.

In short, this tax avoidance scheme is under so much scrutiny that for the average contractor the hassle and risks involved are just not viable.

Offshore Schemes

Offshore schemes are classified as any financial setup where income is moved outside the UK to avoid paying the host countries rate of Tax and National Insurance contributions. Payments are usually made as distributions, loans and dividends.

The Inland Revenue’s Special Compliance Office is gearing up for a crackdown on offshore umbrella companies and other tax avoidance schemes designed for solo contractors caught by the unpopular IR35 legislation.

The HMRC have warned contractors not to rely on schemes they have developed to get around IR35, as they could crumble when examined.

All income generated in the UK by a UK resident must be declared – whether received or not – and is subject to IR35 criteria and taxation.

HM Revenue & Customs now have power to view details of around 100,000 UK-domiciled clients of Offshore Schemes.

Investors with undeclared offshore accounts are being urged to come forward and HMRC is proposing to offer reduced penalties for a limited period, although investors will still have to pay their tax bill plus interest for up to 20 years.

An offshore account is a high risk option.

Outsourcing projects meant finding an offshore contractor to assume responsibility for some or all of one of a company’s IT activity; the contractor will handle the stipulated aspects of that activity, for a pre-set fee, and for a pre-set length of time.

Types Of Outsourcing Projects

There is no typical outsourcing project; they can include anything from simple data entry to medical transcription, to call center and customer service duties, to payroll processing; anything that is a non-core part of a business’ operations has the potential to become an outsourcing project. Because outsourcing projects to local contractor whose efforts may well cost as much or more as the efforts of the company’s personnel, most outsourcing of projects is now done to developing countries. Not only does outsourcing of projects to India, Brazil, China, and Malaysia occur on a regular basis, many of those projects are maintained long-term by those to whom they were outsourced.

The Internet And Outsourcing Projects

The global availability of Internet access has made the outsourcing of projects to freelance contractors in poor countries easier than ever; and there have been a number of websites set up by people who, for a commission, will facilitate the process of locating a contractor to complete an outsourced project. Many of these freelance contractors, because they are in undeveloped countries, can work for wages unheard of in the US and Europe; their fees often range between five and fifteen US dollars per hour.

Those who are outsourcing projects post a description of what their projects entail on the websites, and the freelancers interested will post their bids to completer the work. Most outsourcing of projects to freelance contractors done in this manner will run no more than a few hundred dollars.

Because the point of all outsourcing of projects is to save money while maintaining or improving the quality and speed at which the work is done, those intending to do the outsourcing should set up a company policy on their outsourcing strategies in advance. Many companies, in fact, have found it works in their interests to establish branches in countries of the world to which they outsource most of their projects.