UK: PRP plus turns to minus.

UK: PRP plus turns to minus. - The withdrawal of tax exemption on profit-related pay has left participating employers and employees wondering who or what will plug the gap in wage packets.

by Daniel Butler.
Last Updated: 31 Aug 2010

The withdrawal of tax exemption on profit-related pay has left participating employers and employees wondering who or what will plug the gap in wage packets.

'Profit-related pay is now firmly established as part of British businesses' pay policy. It is one of the reasons for our success. More than 3.7 million people are in schemes ... (The tax-exempt scheme) has successfully served its pump-priming purpose.'

Abolishing a scheme for being too successful and popular might seem an odd step for a politician, particularly in the run-up to a general election, but these were the reasons cited by the former chancellor, Kenneth Clarke, when he announced the phasing out of the tax exemption on profit-related pay (PRP) in November 1996.

Launched by Nigel (now Lord) Lawson in the 1987 budget, the government's PRP scheme was intended to strengthen the enterprise culture by allowing people lower down the hierarchy to benefit from company profits. The outgoing rules allow companies to pay up to 20% of salary - or £4,000 if lower - in the form of a tax-free bonus. In practice this means that a top-rate taxpayer gains up to £1,600, while someone on the basic rate might net as much as £960.

'The scheme really was phenomenally attractive,' laughs Ian Nichol, a partner at Coopers & Lybrand. 'In fact it was generous to a fault.'

Predictably, there was no shortage of companies interested in reaping the benefits of the government's munificence - for their employees and for themselves. In its first year, the scheme attracted 145 participants.

Word spread among company secretaries and by the end of 1994/5, some 9,425 companies were taking advantage of its terms. A year later the figure was 12,700 and by the time the scheme's abolition was announced, the total was probably nearer to 14,000.

But the same generosity that made the scheme so popular is now causing a severe headache for participating companies. Quite who is going to make good the hole left in take-home pay by the withdrawal of tax exemption?

If employers make good the shortfall, it could add over 8% to their wages bill. If, on the other hand, they fail to plug the gap, they may alienate some of their most capable staff whose pay will effectively be docked by hundreds or thousands of pounds a year.

For some employers, motivated to join the scheme purely by an altruistic desire to benefit their employees, the answer lies in examining other ways of making up the loss of tax exemption to their employees. But for others, the right course is less clear. These are the companies which were apparently drawn to PRP by the idea of cashing in on their staff's allowance, in effect using their employees' tax break to cut payroll costs.

'Some companies introduced PRP instead of a rise or to subsidise their wages bill,' explains David Ogden, share plans director at pay consultants Sedgwick Noble Lowndes. They achieved this by persuading staff to take a pay cut, or by not increasing pay when a rise was due, and then making good the difference with the tax-free bonus.

According to Cliff Weight of management consultants Hay, the influence of company accountants trying to improve the bottom line is apparent from the chronology of deals: 'Nearly all the early schemes were simply bonuses converted to PRP. These will all have stipulated that if the government removes the tax break, that's not the employer's fault.' He estimates that 60%-70% of later schemes are salary sacrifices, where employees take a pay cut which is replaced by PRP. In these cases employers often split the tax benefits with their employees, sometimes even going so far as to absorb the entire benefit.

All good things come to an end, however, and as the ebullient chancellor sipped his trademark tumbler of whisky, he announced that from 1997/8 the maximum tax-free allowance of £4,000 would fall to £2,000 in 1998, £1,000 in 1999 and disappear completely in the new millennium. This, calculate the experts, will net the Treasury an extra £5.6 billion over four years.

Generally the decision was greeted with approval as the end of a tax loophole rather than the demise of an excellent means of motivating staff, but this still leaves around four million employees in thousands of companies wondering how they are going to fill the gap in pay packets. According to a recent Arthur Andersen report, Beyond PRP: Exit Strategies, some 14,000 businesses are facing a deficit of between 3.5% and 8.4% in their payrolls: 'In many cases there is not an easy replacement, so it is a question of how the pain of extra tax is shared between employers and employees,' says Brian Friedman head of Andersen's human capital services division.

Friedman and his colleagues surveyed more than 80 members of the FTSE-350, each employing over 1,000 staff. The team found that about a third (36%) plan to ditch their PRP arrangements, resulting in an average pay cut of 6%. He says few have yet communicated this decision to their employees, even though it will cost the average employee earning £20,000 a year some £2,070 over the next three years. But according to Tony Butcher, Deloitte & Touche's partner in charge of PRP, this may not be a practical option.

'Every PRP scheme I know was introduced with a clause in it guaranteeing that the employee will not end up a loser,' he says. 'Most sophisticated employees will expect to be put back in the position they were in before the scheme was introduced.'

While in theory this shouldn't matter in firms which passed on the whole saving to their employees, Butcher says there are thousands of companies where at least some proportion of the benefit was absorbed by the employer.

For these, the problem is a thorny one. Says Sue Bartlett, principal in human resources consulting practice Watson Wyatt Partners, 'I can't see any rationale for a company picking up the bill in cases where all the savings were passed onto the employee - in effect that would just be giving an unearned pay rise. But in cases where employers pocketed some or all of the benefits, there is a moral obligation to make up the difference at the very least.'

The brewing giant Whitbread, for example, operates a salary sacrifice scheme amounting to 2.5% of total pay: 'We'll definitely make that good and will probably keep an element of PRP too, but we haven't come to any firm decision,' says human resources policy director John Shaw. He points out, however, that there is plenty of time because the current financial year ends next February. Hay's Weight agrees, pointing to one client whose profit period starts on 12 November, who will thus not have to implement any replacement scheme until the end of 1998: 'The enlightened ones are beginning to address the issue and to look at the alternatives,' he adds.

'But to be honest, for a lot of companies it has yet to become a priority.'

'A fudged compromise sums up how most companies are going to respond to the problem,' says Coopers & Lybrand's Nichol. 'Each company will do their own thing depending on competitive pressures and the strength of employees' feelings.'

Among the alternatives to simply cutting the benefit, the Arthur Andersen report identifies four main preferences: developing a taxable form of PRP (favoured by 14% of respondents); offering new benefits such as childcare and increased pensions contributions (13%); substituting a share-based incentive plan - often called 'son of PRP' (12%); or simply gritting the teeth and paying for the shortfall (12%).

Mike Warburton, senior tax partner at accountants Grant Thornton, dismisses such compromises: 'There aren't any clear alternatives to PRP - it's a one-off,' he says. 'The ideas being punted around have essentially always been there. Don't expect to see son of PRP riding over the horizon like the Fifth Cavalry.'

Michael Pearce, director at Sedgwick Noble Lowndes, explains that the most widely touted alternatives have major drawbacks: 'Share schemes will not be as popular with employees,' he says. 'Although they are exempt from NI contributions, employees must hold on to them for three years to get the tax relief. With PRP, they get their money straightaway.'

Among genuine adherents, the end of the tax exemption for PRP has been greeted with widely varying reactions. The John Lewis Partnership operates as a form of co-operative where all 36,000 staff are partners. Given that the scheme has been in operation since the 1920s, it is perhaps not surprising that chairman Stuart Hampson is a PRP enthusiast and angered by the phasing out of tax exemption, saying it undermines 'a route to competitiveness'.

Others are not so sure, however. Roger Dunn, managing director of Arcontrol, a privately-owned switchgear company, says his company's scheme - which also pre-dates the 1987 announcement - fell foul of the fine print and does not qualify for tax exemption. He is glad therefore to see the back of the government's scheme: 'It has been something of an embarrassment for us,' he says. 'However we firmly believe in profit-related payment and will continue to run our existing scheme which is based on the audited profit figure.'

In general, however, there is a deafening silence from British industry when asked about its response to the phase-out - which is surprising given the number of firms involved. The best that most can manage is a tentative hint at the future direction. Boots, for example, suggests its PRP will be replaced, at least in part, with an alternative results-based scheme: 'It is important to distinguish between PRP as a way of shielding tax liability from a genuine bonus scheme - we have profit-related bonuses,' says a spokesman defensively. 'This is a bonus, it should not be confused with pay and our staff should understand that.'

Hay management consultants Weight is philosophical about his own position: 'I shall lose £1,600 of benefit myself, but I don't expect anyone to make it up for me,' he says, with a laugh. 'But then that's not surprising given that I work with PRP every day - it's going to be very different in a lot of workplaces.'

The experience of Sedgwick Noble Lowndes' Ogden also reflects the perception of PRP as a reward: 'Most of our clients entered into PRP as a genuine way of sharing profits. They saw it as giving a bonus in a tax-free way rather than a means of saving money.' As a result he says most are now looking at a share-ownership alternative and intend to keep their present schemes going for as long as possible while they ease in new benefits.

Interesting hints of things to come might be found among some of the very architects of today's PRP schemes. Price Waterhouse, for example, has decided to substitute a flexible package of 19 benefits (including childcare subsidies and increased pensions contributions) for its own PRP scheme.

Weight believes that for those companies which genuinely believe in the principles behind PRP, there should be no question of simply watching impassively as the old system is phased out. 'It would be very inappropriate to leave staff looking at dwindling pay packets,' he says. His favoured solutions are share schemes which, if set up now, will be releasing money to employees just as the old system ends.

'Good schemes should always have stressed that this was probably temporary and should also have had a notional salary somewhere for employees to inspect,' summarises Nichol. He says that in most of these cases employees will understand and accept the gradual cuts in take-home pay, but warns that in those companies which failed to explain matters properly, employees may be less accommodating. A recent study of FTSE-100 companies by the City University, revealed that most of those operating PRP schemes have indeed failed properly to communicate the underlying principles.

'There are going to be a lot of disgruntled employees out there next year when they first see the effect on their wage packets,' warns Nichol.

The answer, according to all the experts, is careful communication: 'Whatever they decide to do, most companies will need a very clear message,' says Watson Wyatt's Bartlett. 'They are going to have to say more than just "bad luck".'

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