ITR July 2015 Marital discrimination in the tax code

Tax Treatment of Married Persons: Time to Dust off the Murphy Case

Background

The Murphy case was a seminal 1980 income tax case in which the Supreme Court held that under the Constitution a married couple should not pay more tax than a cohabiting couple. The plaintiffs were Francis and Mary Murphy, who were both primary school teachers employed in different schools. At the time, if a married woman was working, her income was added to her husband’s income and taxed as if it was his. While there were some additional allowances to which a married man was entitled but a single person was not, the net effect was that a married couple living together would pay more tax than a cohabiting couple. In essence, because they were married they paid an additional IR£250 in tax.

Under the system in place at the time, a married woman could not elect for single assessment, and the husband was automati-cally the assessable person. The offending provisions of the Income Tax 1967 were ruled to be repugnant to the Constitution. Subsequently, each spouse was permitted allowances and rate bands equivalent to single person’s, which were transferable between spouses. The system was subsequently modified in Finance Act 1999, which introduced the current system of tax credits and individualisation.

The purpose of this article is to illustrate some aspects of the tax code where married couples are at a disadvantage compared to a cohabiting couple in similar circumstances. Each of these instances of discrimination applies regardless of whether the couple is jointly, separately or singly assessed.

PAYE Tax Credit: Proprietary Director
The employee tax credit (or the PAYE tax credit) is available to individuals in receipt of emoluments taxed under the PAYE system. Emoluments of a proprietary director and/or the spouse/ civil partner of the director that are paid by the company are excluded from the credit. Many Irish individuals are employed by companies in which their spouse is a proprietary director in circumstances where if they were not married they would benefit from the credit. Likewise, the emoluments paid by self-employed persons to their spouses/civil partners are excluded from the credit. Again, it would not be unusual for traders, either sole or in partnership, to employ their spouse. In each of these cases the credit would be available to a cohabiting partner in similar circumstances. It is difficult to reconcile the Murphy case with operation of the PAYE credit.

Company Buyback of Shares: Substantial-Reduction Requirement and Connection Test

The company buyback of shares provisions essentially enable a qualifying individual to avail of CGT treatment on the repurchase of his or her shares. There are many conditions to be met by both the company and the individual to obtain CGT treatment.

One condition is that the individual and his or her associates must have substantially reduced shareholding in the company after the buyback. The definition of associate includes a husband and wife living together. This provision may potentially preclude one spouse from obtaining CGT treatment where the combined marital shareholding is not reduced to 75% of the pre-buyback holding. Take the example of a company that is owned 75%:25% by a husband and wife, respectively, where the latter wishes to retire and have her shares bought back by the company. She intends to claim retirement relief on the redemption proceeds, for which all of the other conditions are met. In this instance, however, the substantial-reduction test would not be met as the wife’s associate’s shareholding, that of the husband, would be aggregated with hers to determine whether the 75% substantial reduction had occurred. Before the buyback the married couple own 100% of the company, and after it they still own 100%, on the basis that the wife’s associate’s shareholding is included. This would not be an issue/difficulty for a cohabiting couple.

The loss of retirement relief on the buyback proceeds could represent a considerable amount of tax, dwarfing the amounts involved in the Murphy case, even with inflation taken into account. With the prevalence of family-owned businesses in Ireland, such a situation would not be unusual. This provision may have the effect of deferring the passing on of a corporate family business to the next generation. In this example it would be only the acquisition of greater than 25% of the combined shareholding of the husband and wife, subject to the connected rule considered below, that would satisfy the substantial-reduction test after the granting of a shareholding to an adult child. This may not be commercially viable on either business or financial grounds.

An additional requirement for CGT buyback treatment is contained in s180 TCA 1997, which states that a vendor cannot be connected with the company after the buyback. Defined in s186 TCA 1997, a connected person is one who has more than a 30% interest in the capital, the voting power or the assets of the company. The powers and rights of a person’s associates are aggregated to determine whether the person is connected. Similar to the substantial-reduction test, a husband and wife living together are treated as associated with one another, and thus their collective shareholding must be below 30%.

Take, as an example, Company X, which has three shareholders – A, B, C – who own 50, 30 and 20 shares in the company, respectively. B and C are married to each other, and C wishes to have his shares bought back by the company. In this instance the substantial-reduction test is met, as B now holds 37.5% of the company (30 shares out of 80) and the collective shareholding of B and C has been reduced to 75% of its pre-buyback holding. However, C is still connected with the company because C is associated with B, who holds more than 30% of the shares. Again, this would not be an issue for a cohabiting couple. If B and C were merely cohabiting, they would not be associated, and the CGT treatment on redemption would be satisfied.

Section 817 TCA 1997: Avoidance Provision to Counter Cash Extraction

Section 817 of TCA 1997 is a complex anti-avoidance provision that seeks to prevent schemes that extract cash from close companies from availing of CGT treatment. It has the effect of treating the disposal proceeds from the sale of shares as an income distribution unless the disponer shareholder has significantly reduced his or her shareholding.

Take, as an example, A and B, who are married and equally own a trading company. B wants to retire from the company and have his shareholding acquired with the resources of the company. The company share buyback route may not be available for some reason (e.g. the trade-benefit test is not satisfied). Although the company has sufficient distributable reserves and cash to acquire the shares indirectly, in order to avoid distribution treatment B must ensure that his shareholding is sufficiently reduced for the s817 substantial-reduction test. This test aggregates the shares of the disponer shareholder and those connected with him or her. Connected persons include spouses. Because A and B are married, their shareholdings are aggregated, and B does not pass the test. This is another clear example where a married couple may end up having a significantly higher tax burden than a cohabiting couple in similar circumstances.

Interest Relief Restriction: Married Couples

The Case V rental-income provisions contain a restriction on interest deduction where the funds are borrowed to acquire a rental property from a spouse18 There is no similar restriction on interest deductibility where the property is acquired from one member of a cohabiting couple.

Close Company: Associate of Participator

The close-company rules contain, inter alia, provisions on how shareholders and others may interact with their companies. Because the majority of Irish companies are family-held close companies, these rules have a potentially significant impact on the Irish business landscape.

The close-company rules contain restrictions on participators’ expenses, interest paid to directors and loans to participators. Section 436 TCA 1997 treats certain expenses paid to a partici-pator as a distribution. Section 437 treats most interest paid to a person with a material interest (greater than 5%) as a distribution. Section 438 treats a loan made to a participator as an annual payment and requires income tax at the standard rate to be deducted and paid over to the Revenue Commissioners. In each of these instances these provisions are extended to associates of partici-pators/those with a material interest. An associate, in relation to a participator, is defined in s433(3) and includes a relative or partner of the participator. A relative includes a husband, wife or civil partner.

Each of these close-company provisions therefore has the potential to apply to a spouse of a participator but would not apply to a person who is cohabiting with a participator. This is another clear example where tax provisions are being applied to a spouse purely because they are married to a participator.

To Put This in Perspective

It is worthwhile putting this in perspective, especially now that we are coming up to an election and there would appear to be indicators about putting the self-employed on a more equal footing with employed persons for tax purposes. This is despite the fact that there are so many features (some listed above) that discriminate against married couples (who have constitutional protection) in the tax code and that there is no constitutional protection per se for self-employed persons.

In many micro-enterprises, both spouses are employed by the business, so this is a very practical issue rather than a hypothetical one. Ireland has 185,000 20 small and medium-sized enterprises, meaning that businesses with 250 or fewer employees employ 68% of the workforce, or 1.2m people. Approximately 90% of these businesses are micro-enterprises, with 10 or fewer employees, which equates to 168,000 businesses employing 323,500 people. On average, 47%21 of the population aged over 15 are married, and applying this average to the business owners equates to 79,000 married micro-enterprise owners. This means that there are 79,000 spouses of owners of micro-enterprises who are affected by the (arguably unconstitutional) tax provisions restrictions (e.g. no PAYE credit) that apply solely because of the taxpayers’ married status. Legally and logically, as well as economically, it would seem to make more sense to address the discrimination in the tax code between married and cohabiting persons rather than employed and self-employed persons.

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Remove the roadblocks to employee equity

One of the most intriguing nuggets in the recently published Irish Software Association’s Digital Technology Index (DTI) is that, despite everything we are being told and that we know from anecdotal evidence, ironically finding finance is now easier than finding key staff. More than 60 per cent of respondents were positive about the availability of money, but only 49 per cent were positive about being able to hire talent.

This fact – and the wider struggle that indigenous software firms face in recruiting and retaining key talent should be seen against the size of the wider technology sector. The broad sector employs 90,000 people across a range of companies with everything from start-ups and SMEs right to the Googles and Facebooks of this world.

And it’s these ‘big boys’ that can skew the market. Pitted against huge multinationals, with their seemingly unlimited resources, what can indigenous firms offer key staff as a recruitment and retention incentive? The simple answer: a stake in the company, offering the potential of a far higher upside than would be available with the large FDI employers. Equally importantly, it changes the employee’s status from ‘worker’ to ‘boss’ and that makes a difference to those people that can be far greater than its monetary value.

Providing some form of employee equity involvement could be the most powerful weapon for David’s slingshot against Goliath, in helping indigenous firms attract the highly skilled staff that they need.

We all know that without the correct staff and without the correct skill mix our native companies will not be able to reach their full potential and that there will always be a ceiling on their growth. That doesn’t just stop those companies growing.

By inference, this also puts a major tether on the economy as a whole.

In general, shareholders in technology companies, be they the original promoters or venture capitalists, have an exit strategy in mind when they sign up; by either trade sale or flotation. Employees who have a stake in such companies can have an obvious upside where the company is sold for a profit. On top of this it’s also an extra and extremely important incentive to join a company in the first place, to work hard and to stay with such company even if things are not going that well for a period. This is why staff turnover in employee owned companies is much lower than in traditionally owned businesses.

To whet the appetite, it’s estimated that at least 1,000 Facebook employees became instant millionaires (and more) when the company floated in May 2012. Such examples are a big motivator for getting key staff to work for smaller companies rather than opting for the larger initial salaries at larger companies. The government here has stated that it would love to grow the next Google or Facebook in Ireland. But this is highly unlikely to happen without effective equity incentives.

In the DTI survey the Irish Software Association says that up to 4,500 jobs are unfilled due to skill shortages. It’s also felt that those that can pay the best will get the best. This presents a major challenge not just for the IT industry but for the economy as a whole.

Some 72 per cent of respondents in the DTI survey said that deferring income tax on share options until the shares are disposed of would make it far more effective for their companies to attract and retain key staff. But there’s a massive problem with these share options as a substantial tax liability of 52 per cent is triggered when the options are exercised. This level of tax is tolerable but the big problem is that this tax could fall due even before the shares are actually sold. This leaves the employee with a substantial tax liability and most likely no way to finance it.

For many years the Irish ProShare Association has been calling for the tax liability on these share options to be deferred until the gain is actually realised and not just when the option is exercised. The immediate benefit of such measures is apparent to us and now nearly three quarters of the respondents to the DTI are saying the same thing. They say that it would be a significant advantage for staff recruitment and retention if the tax liability on these measures could be deferred, especially for High-Potential Start-Ups (HPSUs).

One of government’s roles is to enable businesses to be innovative and creative so as to encourage economic growth. However in its current form the legislation on employee equity incentives is actually restricting the ability of our indigenous companies. The upcoming budget should address this simple anomaly. There’s no loss to the exchequer in doing this because as things stand the incentives aren’t being taken up as taxwise it’s not worth it.

As any farmer worth their salt will tell you, ‘you need to have your duck before you can pluck it’. If addressed than it will instantly remove a major roadblock to innovation and enterprise.

Cormac Brown is a council member of the Irish ProShare Association; ipsa.ie

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Taxation of employee share incentives

he 2011 Budget, and following legislative enactments, saw significant amendments to the taxation of employee share awards and share options in Ireland. The changes impact all private and public companies providing any type share awards for employees.  Firstly the employer is now required to operate PAYE on most forms of employee share award. Secondly, PRSI and the Universal Social Charge (USC) now apply to share awards.

The first change has implications for how companies operate employee share schemes and has shifted the responsibility for the collection of the tax from the employee to the employer. The second change has significantly increased the marginal tax rate on share awards, resulting in companies having to look for more tax efficient alternatives to reward executives and employees.

Extension of PAYE to Share awards

From 1st January 2011 an employer is required to deduct PAYE, USC and employee’s PRSI on most types of share awards, but not share options, made to employees and pay it through the PAYE system.  Prior to 2011, the employee paid income tax on share awards directly under the income tax self-assessment system.

The taxation of share options is unchanged with the additional requirement that the employee now pays PRSI and USC on the gain. The employee pays tax directly to the Revenue within 30 days of the exercise of options. The tax is paid under the RTSO system (relevant tax on share options) together with USC and PRSI.

The table sets outlines the position for 2013.

Award Type PAYE Income Tax PRSI Employer PRSI Employee USC
Share Y N N Y Y
Options N Y N Y Y

The general position, save for share options, is that it is the vesting or settlement of the share award that creates the employee tax liability (i.e. when the employees receive the shares and not a promise or entitlement to them).   Different provisions apply for tax approved SAYE and APSS schemes.

Where the employee has insufficient net salary to pay the tax liability the employer is nevertheless required to pay over the tax and subsequently recoup it from the employee.  The Finance Act 2012 introduced a provision which enables the employer to withhold and sell shares to meet the employee’s tax liability.  As a matter of practice U.S. and U.K. plans generally contain a provision allowing for such a sale and it recommended that plans be amended to give employers this right.

In Tax Briefing 02/11 (April 2011) the Revenue allow an additional 60 days in which tax should be paid. The purpose of this extension is to provide an additional period in which the employees may dispose of sufficient shares to cover the income tax and related liabilities.

PRSI

The situation regarding PRSI  on share awards has changed quite significantly since its initial  introduction in January 2011.  The current position is:
•    No employer’s PRSI arises on share awards or options.
•    No employee’s PRSI will apply to awards exercised or allotted in 2011where the award or option was granted prior to 1 January  2011.
•    Shares awards or options granted in 2011 and exercised in 2011 are liable to employee’s PRSI.   All 2012 and later awards or exercises attract employee PRSI regardless of grant/allotment date.
•    Employee PRSI arising on share options exercised after 30th June 2012 is paid through RTSO.

Specific issues arising from changes

For private companies share valuations, in the absence of a market in the shares, can present particular issues.  Employers are now required to use a best estimate of a shares value to calculate the income tax and other deductions required on the grant or allotment of a share.  There are different share valuation methods and the Revenue have accepted that there is no one correct method of share valuation.  Tax Briefing 02/11 states “Where a bona fide ‘best estimate’ is used and documented to show that all reasonable efforts were made to determine the taxable benefit for a tax year, the employer will not be required to make any adjustments after the end of the tax year.”

For international assignees coming to Ireland care should be taken to ensure a senior executive is not transferred at a time when a large share entitlement attributable to employment activities exercised outside of Ireland, vests or settles. Where this is likely to occur it should be investigated to see if vesting can be structured in such a way so that no Irish tax liability is created.   Tax equalisation programs that apply to share incentives could significantly increase the cost to the company of moving an employee to Ireland when a 52% marginal tax rate is taken into account.  SARP may also have relevance here.

Tax efficient arrangements

The extension of PRSI, introduction of the USC and a marginal income tax rate of 41% now gives a marginal tax rate of 52% on share awards. There is a significant difference in the capital gains tax rate (currently 33%) and a 52% income tax rate.  This has seen an increase in firms (private and public) looking at tax efficient share plans which would tax any profits on share disposal as a capital gain as opposed to income. The aim of such plans is that the employee holds the share while it increases in value and that this increase, on a sale, is liable to CGT and not income tax.  The downside is that the allotment of the share to the employee/executive triggers an income tax liability.

In order to substantially reduce the income tax liability on the allotment of shares to employees a restricted share or “clog” scheme can be used.  This involves an agreement between the employee and the company whereby the employee agrees not to dispose of the share for a period of between 1 and 5 years.

For example, where it is agreed that the share will be held, and not sold, for more than 1 year a reduction of 10% of the taxable value is allowed.  This reduction in taxable value increases to 60% where the share is required to be held for a period of greater than 5 years. This scheme does not require Revenue approval and can be structured with existing restricted stock arrangements.

Conclusion

In conclusion, the extension of the PAYE system to share awards should not result in any additional cost for the employer provided the correct procedures and protocols are in place.   Existing arrangements should be reviewed to see if a greater level of  tax efficiency can be achieved.

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