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PA contributed £25m to an employee benefit trust ("EBT") in 1999. The EBT established a Jersey company (with its shares issued to nominees of the trust) and transferred almost all of these funds to the company. Employees who were eligible for an "award" were granted a beneficial interest in the shares of the Jersey company. A dividend (funded from the capital contributed to the Jersey company by the EBT) was then declared.

HMRC contended that the dividends were in reality bonuses and liable to be taxed as employment income under Schedule E.  The First-tier Tribunal found that the payments were received by reason of the employees' employment, but that as they took the form of dividends, they fell to be taxed under Schedule F. Section 20(2) of the Taxes Act 1988 gave priority to tax under Schedule F. However, as there was no similar provision under the legislation governing NICs, the payments were emoluments liable to NICs under the social security rules. The Upper Tribunal came to the same conclusion.

HMRC appealed the decision, relying largely on a "Ramsay" anti-avoidance argument. PA cross-appealed the decision that the payments were liable to NICs.

The Court of Appeal were required to consider whether or not the payments could be classified both as emoluments and dividends (and if so, did Schedule F have priority by virtue of s20(2), precluding taxation under Schedule E).

The Court of Appeal considered the principle in Fry v Salisbury House Estate Ltd that the schedules of income tax are mutually exclusive; interestingly, that case predates the introduction of Schedule F and its priority rule. The Court of Appeal decided that the Upper Tribunal had erred in law in its analysis of the payment: once the source of a payment has been found to be an emolument of employment (with sufficient connection to give rise to a charge under Schedule E), no further consideration need be given to other Schedules. If Schedule E applied, Schedule F could not apply, so the Schedule F priority rule was not relevant.

The Court of Appeal found that the payments were emoluments of employment, so found in favour of HMRC and rejected PA's cross-appeal. The court did not give significant consideration to HMRC's Ramsay argument (which, given the first finding, was not needed for HMRC to win the case).

This decision may be correct in law, but will cause concern in employee share planning because it moves away from the more straightforward approach of the Upper Tribunal. This is even more the case because the schedular system has been abolished, and the present system gives little guidance on the priority of different income tax charges. Deciding the case on the basis of the Ramsay principle (which is the approach HMRC seemed to favour) might have shed more light on the limits of acceptable employee share planning.

A copy of the judgment can be obtained here.

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