PROFIT-RELATED PAY - The fatal hour

One adviser calls it ‘the greatest tax wheeze of a generation’.

It has saved millions of pounds – at the expense of the Treasury – for employers and employees alike. But profit-related pay (PRP), or rather its extraordinarily generous tax relief, is being phased out. In July, Chancellor Gordon Brown confirmed the death sentence passed in Ken Clarke’s swansong Budget eight months earlier.

The demise of PRP leaves employers with a serious dilemma. How can they afford to compensate employees who will lose out? And can they afford not to, especially where workers have substituted PRP for pay rises or even part of their existing pay so that they and their employers can benefit from the tax break?

More than four million people in the UK stand to lose out from the scrapping of PRP relief. Introduced in 1987, the initial take up was slow but by March this year there were 14,553 registered schemes. Tax incentives were intended as a ‘pump-priming’ measure to encourage the use of PRP which, the government hoped, would motivate workers and enable them to share in their employers’ success without ratcheting up pay rises which could not be reversed in less prosperous periods.

Research carried out by the Inland Revenue in 1995 showed that without the tax breaks at least one-in-three employers would not have introduced their PRP schemes. Not surprisingly, ‘tax efficiency’ ranked high as motivation although ’employee involvement’ came top. Productivity and pay flexibility were not high on the list of perceived benefits.

Riding the PRP bandwagon

From the mid-1990s, PRP snowballed as the tax advantages became clearer and more schemes were set up on a ‘salary sacrifice’ basis. This meant that because basic pay was actually reduced both the employer and employee shared the benefits. A priority for many schemes was to create a de facto guarantee to the employee that the PRP element of his salary was not at risk, thus undermining one of the central objectives of the measure.

The Treasury was not alone in being sceptical about the merits of PRP.

Chris Giles, senior research economist at the Institute of Fiscal Studies, argues: ‘It was turning into a tax avoidance scheme rather than a means of influencing company performance.’

In a PRP scheme, up to #4,000 or 20% of an employee’s total salary (whichever is the lower) can be paid tax free. For a basic rate taxpayer that represents an annual saving of #920; in the higher band, that figure goes up to #1,600. Under the measures announced in Ken Clarke’s last Budget, the #4,000 ceiling will be halved for profit periods starting on or after 1 January 1998, and cut again to #1,000 the following year. From 1 January 2000 the relief will be scrapped entirely.

While in opposition, the Labour party had called for even more Draconian measures which would have outlawed any new ‘salary conversion’ schemes.

Employers and their advisers breathed a sigh of relief when Clarke’s timetable for the PRP wind-down remained untouched. That confirmation was the signal for companies to start looking in earnest at their alternatives, according to Caroline Scott, a senior manager in Arthur Andersen’s human capital services division. ‘It has cleared the air. People know where they stand now,’ she says.

Scott is author of Andersens’ report Beyond PRP which looks at the exit strategies open to companies faced with a bigger tax bill and potentially disgruntled workers. It is a prospect the CBI views pessimistically. CBI policy adviser Diane Sinclair says: ‘It will put upward pressure on earnings and could have a substantial effect on labour costs.’

Taking factors such as employers’ NICs into account, it could cost industry up to 8.4% more on the wage bill to make good the lost tax relief. And that is exactly what the TUC is already calling for. Whether employers will play ball is another matter. According to Ian Nichol, head of PRP services at Coopers & Lybrand: ‘Many businesses will take the attitude “we always said it was a one-off tax saving – you’ve had it good for a few years but now we’ll return you to where you were before, with annual pay rises taken into account”. How the burden is shared will vary widely between industries and companies.’

In its survey of FTSE 350 companies, Andersens found that while 12% planned to match take-home pay on a monthly or annual basis, as many as 34% intended to revert to pre-PRP arrangements. A more detailed breakdown shows that those running salary conversion or salary sacrifice schemes, where PRP is used simply to reduce the tax liability on existing pay, were far more likely to revert. Where it had been introduced as a genuine bonus scheme, however, nearly half said they would either keep the scheme – even without the tax relief – or introduce a share-based bonus scheme.

Taking what Andersens’ Scott calls the ‘hard-nosed’ approach and allowing the burden to fall on the employee need not involve reneging on any commitments but it would prove extremely unpopular. The workforce could be up to 6% worse off in net terms. Such a resolution might upset the present balance of the labour market and make recruitment and retention difficult, to say nothing of the effect on morale of those who remain.

Coming up with alternatives

There is no ‘son of PRP’ – the easy tax savings it offered cannot be reproduced by any other scheme. But probably the nearest to it is the range of share-based remuneration schemes still available. Of these, perhaps the most effective is the approved profit-sharing scheme (APSS). Under such a scheme, employees can be awarded shares in their own company up to the value of #3,000 (or 10% of annual earnings, whichever is less) free of income tax. The award is linked to company profits, although the detailed provisions for this are less complex than for PRP. To escape a tax liability, the employee must wait for three years before realising the value of the shares but can retain the shares even if he leaves the company before then.

Ian Nichol says: ‘APSS comes reasonably close to being a replacement but it’s not the quick fix that PRP has been. And no-one can guarantee what the tax provisions will be in three years’ time.’

Because of the three-year time lag, an APSS set up now would benefit the employee in 2000, dovetailing neatly into the end of PRP. The scheme could also be combined with an interest-free loan (up to #5,000), using the APSS-allocated shares as security. Then, the benefit would be immediately available as part of the employee’s monthly salary – a particularly useful option if this is how PRP is currently paid out.

Among the other share-based schemes available is Sharesave where the employee opens a regular savings account which accumulates tax-free interest.

He is also granted an option to buy shares in the company. At the end of a fixed period (typically, three-to-seven years), the employee can either take the cash or exercise the share option, with any gain since the option was granted free of income tax. Using a personal equity plan, future capital gains could be protected too.

Share options can also be granted more simply under an approved company share option scheme (COSOS) – the options can be exercised tax-free after a three-year holding period. Unlike PRP, the same terms do not have to be offered to all or most employees. Alternatively, an unapproved scheme used as part of a long-term incentive plan offers even more flexibility, though without the same tax savings. Options are not just for ‘fat cat’ directors: some companies – like supermarket group ASDA – operate an ‘executive’ share option scheme for a large number of their staff. As David Atkins, a consultant with remuneration advisers the Monks Partnership puts it: ‘”Executive” share option schemes are a misnomer. They are, essentially, discretionary schemes.’

But there are some difficulties with shares and share options. Options present a degree of risk for the employee which PRP doesn’t. The value of shares can go down as well as up and options which are not backed by a cash alternative could end up worthless. Proposing such a scheme as an alternative to a ‘safe’ PRP arrangement could be tough to sell to employees.

Another problem is that share-based schemes will only be open to a relatively small number of employers, namely the larger quoted companies. Partnerships and the public sector are excluded, and so are companies where there is no ready market for their shares. That means that, for many employers, offering a more effective remuneration package without adding unacceptably to the wage bill needs a little more imagination.

If easy tax savings are no longer possible, one alternative is to bring in a range of flexible benefits so that the remuneration package can be tailored to fit the requirements of the employee. In this way, the theory goes, spending on pay and benefits will be more effective because employee satisfaction will be higher. At its simplest, this could simply entail a choice between, say, cash or a company car. But the complete ‘cafeteria’ approach – where employees can choose from an extensive menu of benefits – is still more common in the US than here in the UK.

One of the largest in this country is the Flex scheme operated by Price Waterhouse, involving more than 6,000 employees and some 18 options. PW introduced it at the start of this year. David Thompson, a senior tax manager with PW responsible for advising on flexible benefit packages, says: ‘We felt it should be rolled out straight away to everyone.’

Employees can choose between, for example, a range of insurance and financial services benefits, child-care or shopping vouchers, a better company car – or just plain cash. The most popular was longer holidays. While the choice may be complex, according to Thompson, administration is simple.

Flexible benefits can also help to integrate different businesses’ packages following a merger or acquisition. And they can be cheaper to provide than cash. For example, the purchasing power of a large organisation means retailers’ vouchers can be bought in bulk at less than their face value.

The same is true of, say, health insurance. There is also a tax saving since vouchers which are not exchangeable for cash do not attract a national insurance liability. This is set to change over the next few years, however, given the increasing convergence between NICs and income tax.

In fact, looking for new wheezes to avoid tax on remuneration is getting harder, says Monks’ David Atkins: ‘It is getting to the point where it’s a waste of time even looking for loopholes.’

The status of payments in kind, using such exotic means as platinum sponge, are currently a matter of dispute between tax advisers and the authorities.

For a minority of employees, schemes such as assigning trade debtors to an individual member of staff or paying a bonus for employees to sign a restrictive covenant (typically agreeing not to work for a competitor within a certain period of leaving) may avoid some tax. But these are marginal and not appropriate for the majority of staff – who did benefit from PRP.

Stressing individual and team performance

Duncan Brown, head of rewards practice at consultants Towers Perrin, argues that the decreasing emphasis on tax saving schemes helps to focus attention on more effective reward packages based on individual or team performance rather than the more remote measure of company or group profit: ‘People want something that provides a genuine incentive,’ he says.

Whatever the route a company takes, it is going to involve a change for the staff involved. And in many cases it will mean they are either worse off or subject to a greater degree of risk than they were before. PRP was intended to be a flexible element in the pay package but most individuals in schemes have come to rely on it. According to Andersens’ Scott, tax planning is only half the story when it comes to planning an ‘exit strategy’.

She says: ‘Communicating with employees is as tough as the decision itself and it needs to be thought through.’

Scott expects to see a renewed burst of activity by companies this autumn, with many announcing replacement schemes by the end of the year. In the meantime, some companies are still setting up new PRP schemes, even though their lifespan is necessarily limited. The ultimate tax wheeze has some life in it yet.