UK: TAXMAN TO THE RESCUE - PROFIT RELATED PAY.

UK: TAXMAN TO THE RESCUE - PROFIT RELATED PAY. - Profit related pay is not a new idea but recent simplification of the rules and changes in tax relief should make it attractive enough to be used for its intended purpose - as a trade-off for part of basic

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Last Updated: 31 Aug 2010

Profit related pay is not a new idea but recent simplification of the rules and changes in tax relief should make it attractive enough to be used for its intended purpose - as a trade-off for part of basic pay. By Nigel Hawkins.

A remarkable idea is in the air in Britain again. It is that employees should give up part of their basic pay in return for the promise of a bonus related to the profits of the business in which they work. That's the idea behind tax relief on profit-related pay (PRP). But so remarkable is it that for a long time no one took it seriously; not the employers nor the unions - nor even, it seemed, the Government which gave birth to it. The regulations affecting PRP were far too complicated. Above all, the tax relief offered to employees was insufficient to compensate for the risks involved.

When PRP was introduced in the 1987 Finance Act, Norman Lamont, then Financial Secretary to the Treasury said that the target was to have one million employees covered by registered schemes by 1989. The then Paymaster General, Peter Brooke, predicted that two million employees would be affected by that time. However, more than two million would be needed to have the desired macroeconomic effect on inflation and unemployment. And according to the Revenue count at the end of June 1991 only 354,000 employees were covered by PRP schemes well into the current year. The squib has been very damp.

Now times may be changing. The Government is undoubtedly taking PRP seriously, and it's time that more employers and trades unions did so too. With the simplification of the rules in 1989, followed - in the 1991 Finance Act - by complete exemption for bonus payments up to the statutory limits, the Government has made PRP look sufficiently attractive to be used for its intended purpose - as a trade-off for part of basic pay.

The core requirements of PRP schemes are unchanged. A PRP scheme can apply to a company, division or any smaller unit for which a profit and loss account can be prepared. The bonus pool must relate to the profit of that unit, and be calculated according to Method A or Method B as defined in the Taxes Act. (More about this later.) At least four-fifths of the employees in the unit who are working full- time and have at least three years service behind them must be eligible - on similar terms - although all employees can be brought into the scheme. Lastly, the scheme must be registered with the Inland Revenue office in Cumbernauld before the start of the first profit period. As long as these requirements are met, no tax will be due on the profit-related pay of any participant up to £4,000 or 20% of total salary (ie inclusive of PRP) - whichever is the lower figure.

Until now PRP has been used largely to gain extra tax relief by companies which have been in the habit of paying out widespread bonuses in any case. A common technique has been to establish a PRP scheme in parallel with the existing bonus scheme, and set off PRP payments against those due under the existing scheme. By calculating the pool so that it is lower than the sum that would willingly be paid out under the existing scheme - and by allowing a generous margin of error - the employer can ensure that he will not lay out any more in the future than he does already.

Parallel plans can still be used in this way, but there is now an incentive for management, and for employees of their representatives, to use the scheme in the way originally intended - as a substitute for some part of fixed pay, or for a pay increase.

It's easy to imagine the scene. After weeks of talking, the annual pay negotiations have reached deadlock. The union representatives are demanding 10%. Management refuses to consider a penny more then 6%. The union might possibly be persuaded to compromise at 8%. But management fears that there could be a fall in profits, and doesn't feel able to budge. Then, just before the meeting is about to break up, someone mentions a profit-related pay scheme. At the next session management puts forward the following proposals. The company will increase pay by 2% across the board - and it will introduce a PRP scheme which will pay out the equivalent of 5% of the wages bill if profits are held at the same level as in the current year.

A 2% pay rise? They have got to be joking. The union representatives are on the point of rejecting the offer out of hand when the junior management negotiator (the one who tossed the idea of PRP into the pool last time, and who has since studied the subject in some detail) reminds them that it is take-home pay which counts, and emphasises that the offer really is worth further consideration. Indeed it is - thanks to the tax relief.

If profits remain static, employees will take home more than they would have done if management had allowed itself to be talked up as far as the compromise solution of an 8% rise. If profits actually increase next year, employees could even do as well as they would with a 10% settlement. And if profits really do fall, their take-home pay will be an improvement on management's previous immovable position. Tables 1 and 2 show how it works. Under ordinary circumstances, ignoring PRP for a moment (also leaving aside National Insurance contributions, which apply to PRP as well as to normal bonus payments), an employee on £10,000 a year could expect to take home ah extra £750 a year if management acceded to the union's 10% claim. He would get £600 if the parties settled at 8%; and £450 if the union caved in and accepted management's earlier 'final offer'. He would have no chance of sharing in the company's profits, except in the unlikely event of management deciding to make an ex gratia bonus payment.

Now let's see what happens if the union accepts a 2% increase plus the PRP scheme. We'll also assume that the scheme is to be calculated according to Method B, as set out in the PRP regulations. Under Method B, the company decides on a 'notional pool': a sum which is written into the rules of the scheme, and which fluctuates with the rise or fall of profits during the year in question. For instance, if £100,000 is taken as the notional pool, and profits rise by 10% in the first year of the scheme, then £110,000 will have to be distributed among the eligible employees.

In our case, an estimate of 5% of the basic wages and salaries of all employees might be taken as the notional pool - which is to be increased or reduced in line with the profit of the unit. Table 2 shows what happens to net pay if profit rises or falls by 20% above or below the previous year's figure. A 20% improvement brings the £10,000-a-year employee exactly the same increase as the 10% rise in his gross pay which was originally demanded by the union. But note that it only costs the employer the equivalent of an 8% rise. Even if profits fall by 20% the employee still gets the equivalent of a 7.3% rise, but it costs the company 6% of salary - which was its last negotiating position.

Of course, profits may rise or fall by more then 20%. To protect their positions, both management and the union may wish to insert a 'percentage override' (or 'damper') into the scheme. Under this arrangement the PRP pool will rise or fall by some percentage between 0.5% and 1% (as stipulated in the rules) for every 1% increase or reduction in profit.

Say it's agreed that the pool should expand or contract by only 0.5% in response to a 1% shift in profits. In that case employees would continue to receive an increase in take-home pay equivalent to a 7.3% pay rise even if profits were to fall by 40%. By the same token, a 40% surge in profits would not increase management's payroll bill by more than 8%.

One of the problems that has to be faced in any negotiations involving PRP is the timing of payments. Salaries and wages are normally paid monthly or weekly. If PRP is to be paid in lieu of a larger increase, it's hardly likely that an annual - or even a quarterly - payout will be acceptable to employees. However tax relief - now that it applies to the whole of PRP - again comes to the rescue.

While the employee is likely to want his PRP paid monthly (if not more often), the employer, on his side, will need to be satisfied that he is not going to overpay. If he does overpay PRP, with its full tax relief, he will either have to recover additional tax from the employee or pay it over to the revenue out of his own pocket. It will be usual, therefore, for the employer to hold back a percentage of PRP payments for a time, against the possibility that profits fall below budget. In any event, PRP payments will always be based upon forecast profits at the time that the payment is made.

Under most gain-sharing plans and widespread bonus arrangements driven by an established formula - it is normal for the employer to retain about 25% of each payment. If this is done with a PRP scheme, the basic rate taxpayer will, in effect, take home the same amount at the end of every period as he would have received - after tax - if the PRP had been part of a fixed salary increase. At the end of the year he will receive the tax that has been retained, as a nice lump-sum payment.

Table 3 shows the effect of such retention on an employee earning £12,000 a year with a PRP pool estimated at 5% of salary - and compares this to what happens in the case of a straight 5% wage increase. Under the PRP scheme, the £150 retained by the company (£12.50 x 12) would be paid out as soon as the accounts were audited.

If it is clear that profits are set to rise above those of the previous year, the employer may wish to make additional interim payments of PRP. On the other hand, since profits could fall in the final quarter, he might once again choose to wait until after the auditors have been and gone. The real problem - which could become a sticking point in negotiations - arises when it becomes clear that profits are going to be less than last year's.

In our example, we have assumed a 25% retention. Thus, if the damper applied, profits would have to fall by more than 50% before the employer had to review the monthly PRP payment. But once that point was reached he would either have to reduce the payments or be prepared to account to the Revenue for tax - at the employee's marginal rate - on all payments which turn out to be in excess of the PRP due under the formula.

This is in effect the same as a stop-loss provision. Under a stop- loss clause the employer promises that employees will not receive less than an agreed amount, however much profits might fall. Thus, if profits turn out to be lower than the sum required to provide the stated minimum, the company will have to make up the difference outside the scheme - i.e with fully taxable pay.

To return to our example, the employer might undertake that the after-tax pay of employees will not be lower than that which they would have received as a result of a conventional, annual 6% pay increase. But assuming, once again, that the damper was in place, profits would have to decline by as much as 80% before the company would find itself faced with an exceptional tax demand.

Stop-loss provisions are not mentioned in the PRP legislation, and they should not be included in the rules of any scheme. Indeed, they may be contrary to the Government's original intentions. The idea was that the profit-related part of the employee's pay packet should be allowed to shrink in direct proportion to the profits of the business, in order to help curb inflation and keep unemployment down.

Nevertheless, a stop-loss clause would seem the logical opposite to the cap on PRP, which can be inserted to protect a company against having to make extravagant payouts should profits suddenly take off. The statutory regulations allow the employer to ignore all profits exceeding 160% of the previous year's figure. So it's hardly surprising that the TUC Guidelines for Negotiation recommend the attachment of a stop-loss provision to any arrangement which includes PRP.

Another way of limiting cost to the company is simply to cancel the scheme. This can normally be done only from the start of the scheme year. In exceptional circumstances, however, the Revenue may permit cancellation in the middle of a period. Even though tax has been deducted under a PRP scheme for several months, the employer can still cancel the arrangement from the beginning of the profit period without incurring serious financial damage, provided that he has retained the tax relief at 25% and 40% - as appropriate.

Cancellation will of course be a last resort because it loses all tax relief, which doesn't help anyone. If a scheme appears in danger, therefore, the wise union negotiator is one who will agree to an increased retention, to prevent overpayment and so help to keep the plan on its feet.

If the employer is going to be put under pressure to make up payments in the event of a decline in profits, he is sure to insist on a cap being put on payments in the event of a sharp profits increase. Should the damper then apply, it could mean that the distributable pool is never more than 130% of the notional pool - or, in later years, of the preceding year's pool.

It's clear that the PRP formula offers no substitute for sensible wage bargaining. But it must also be clear that, with the recent improvements, PRP schemes can now have plenty to offer both employers and employees. Also that they can be used as they were meant to be: in lieu of part of basic pay.

TABLE 1

Wage increases and take-home pay

Employee on £10,000 pa

Pay increase (%) 10% 8% 6%

Pay increase (£) 1,000 800 150

Less tax at 25% (£) 250 200 150

Net pay increase (£) 750 600 450

TABLE 2

How pay varies with profits

PRP pool 5% of earnings

No

Profit change +20% change -20%

2% pay increase (£) 200 200 200

Less tax at 25% (£) 50 50 50

Add PRP (£) 600 500 400

Net Total 750 650 550

TABLE 3

Effect of retention

Employee on £12,000 pa, PRP pool 5% of earnings

Wage + 5% Wage

5% PRP increase

Salary (£) 1,000.00 1,050.00

Less Tax (£) 250.00 262.50

750.00 787.50

PRP (£) 50.00

Less retention (£) 12.50 37.50

Total (£) 787.50

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