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HMRC internal manual

Employment Income Manual

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Appendix 4: Not ordinarily resident employees: tax equalisation

(Adapted from an article in Tax Bulletin 59 – June 2002)

Sections 25 and 27 Income Tax (Earnings and Pensions) Act 2003 (‘ITEPA’)

An employee resident but not ordinarily resident in the UK is chargeable under section 25 ITEPA on general earnings in respect of duties performed in the UK (UK-based earnings). Section 26 ITEPA charges the foreign earnings of such employees but only to the extent that the earnings are remitted to the UK.

Paragraph 2 of Statement of Practice 5/84 (SP5/84) states that where the duties of a single office or employment are performed both in and outside the UK, an apportionment is required to determine how much of the earnings are attributable to UK duties and therefore liable to tax as UK-based earnings under section 25. Apportionment of earnings is essentially a question of fact and HMRC accepts time apportionment based on the number of days worked abroad and in the UK except where this would clearly be inappropriate.

In addition to salaries and benefits, employers may also provide their employees with the benefit of tax equalisation. This usually means that the employer undertakes to meet on the employee’s behalf any additional tax payable above the tax that the employee would have paid in his home country. It is well established that such payments made on behalf of employees form part of their earnings. But before 2002, there was a difference of view between the then Inland Revenue and a number of accountancy firms about the extent to which such tax equalisation payments represent earnings in respect of duties performed inthe UK.

The view taken by the Inland Revenue and subsequently by HMRC is that tax equalisation payments represent earnings wholly referable to duties performed in the UK where the underlying tax liability is similarly wholly referable to duties performed in the UK. Therefore, where an employer pays a tax liability arising under section 25 on an employee’s behalf, that payment will itself represent earnings wholly chargeable under section 25.

This view was approved by a Special Commissioner in 2001 in the case of Perro v Mansworth (SpC286). The Special Commissioner stated that it was an inescapable fact that the payment of tax by the appellant’s employer was an emolument (earnings) in respect of UK duties since that tax was only payable because of the performance of duties in the UK.

Ms Perro’s net earnings were time apportioned in accordance with SP5/84 in order to find the net attributable to UK duties as there was no specific attribution of salary or other benefits between UK and overseas duties. Following Perro, it has been accepted practice to gross up this net figure on the basis that the payment of tax on UK-based earnings represents additional earnings wholly referable to duties performed in the UK.

The Special Commissioner did not consider the treatment of reimbursement of tax on income other than employment income chargeable under what is now section 25. The employer of a tax-equalised employee may reimburse UK tax on investment income or capital gains. Employers may also pay foreign tax liabilities on the employee’s behalf. Following the decision in Perro, the Inland Revenue was asked to give its view on the treatment of such reimbursements.

When apportioning earnings between sections 25 and 26, it is necessary first to consider whether those earnings are wholly referable to UK or non-UK duties on the facts. Clearly if this is so, there is no need to consider time apportionment. If the earnings are not wholly referable either to UK or non-UK duties, then time apportionment will be necessary in accordance with SP5/84.

If an employer reimburses personal tax liability arising on non employment income such as bank interest, dividends or capital gains, then the first question is whether that reimbursement is a payment of earnings that relates wholly to either UK or non-UK duties. We do not consider that the physical presence of the employee in the UK in order to perform employment duties is sufficient justification for treating such reimbursements as wholly in respect of duties performed in the UK. In the absence of unusual facts, we believe that such earnings should be time apportioned. This will produce net section 25 earnings that will then need to be grossed up. The gross up will be on the basis that the payment of UK tax on earnings within section 25 is itself a payment of earnings wholly chargeable under section 25.

With regard to foreign tax payments, the attribution between sections 25 and 26 will depend upon the facts and circumstances. If the foreign tax relates solely to overseas duties, then the payment of that tax by the employer will comprise earnings wholly referable to duties performed outside the UK that cannot be charged to tax under section 25. Alternatively, the foreign tax may be charged on worldwide income so that time apportionment is likely to provide the only practical mechanism for determining the attribution between sections 25 and 26.

With regard to the treatment of employer payment / reimbursement of tax chargeable under section 26, SP5/84 states that provided the earnings chargeable under section 25 are arrived at in a reasonable manner; HMRC is prepared to accept that a charge under section 26 will arise only where the aggregate of earnings received in the UK exceeds the amount chargeable under section 25 for that year. The amount chargeable under section 26 is therefore restricted to the excess of the aggregate over the amount chargeable under section 25.

Where the employer meets UK tax liability under section 26, the payment of that tax to HMRC will clearly be remitted to the UK. It is logical that the payment of the section 26 liability will itself be a payment of earnings chargeable under section 26 and as the tax payment will be remitted to the UK, the related gross up will also be wholly chargeable under section 26.

There can be significant practical difficulties in identifying whether earnings relate solely to non-UK duties and therefore fall within section 26. In such cases, HMRC would not generally dispute time apportionment between sections 25 and 26 on the basis of working days. If any earnings were allocated solely to section 26 as attributable wholly to non-UK duties, evidence should be available to justify the attribution, in the event of an HMRC enquiry.

Non resident employees

Some tax-equalised employees are not resident in the UK. They may perform substantive duties of their employment in this country. Unless the specific terms of a Double Taxation Agreement confer an exemption from UK tax on UK source employment income, such employees will be liable under section 27 ITEPA on earnings in respect of duties performed in the UK. Earnings for duties performed outside the UK will fall outside of the charge to UK tax on employment income. HMRC adopts the same approach to tax equalisation for non-resident employees as for those resident but not ordinarily resident employees whose earnings are apportioned between sections 25 and 26.

The following simple examples are intended to illustrate the basic approach to tax equalisation earnings described in this appendix. It is recognised that many cases will have much more complex facts and that the ensuing calculations will be similarly complex.

Example

Tanya has been sent to the UK to work at her employer’s UK branch for two years from 1 January 2005. She is resident but not ordinarily resident in the UK from the day of her arrival. In addition to her UK duties, her employer requires her to make regular and extensive visits to an overseas branch of its business in order to monitor an important project. Whilst assigned to the UK, Tanya is subject to her employer’s policy on tax equalisation which provides for her to receive the same net salary and benefits as if she had remained in her home state.

During 2005-06, Tanya performed the duties of her employment on 225 days. She spent 158 days working in the UK and 67 days working overseas. Net salary and benefits from her employment were £100,000 of which £60,000 was received in the UK. Her employer was obliged to pay her tax liabilities in accordance with its tax equalisation policy. For simplicity, all calculations assume that Tanya’s income is chargeable to UK tax at 40%

Scenario 1

Tanya’s only tax liability was incurred in the UK on the earnings from her employment.

Calculation of UK tax for 2005-06

Net salary and benefits 100,000
   
Less amount attributable to overseas workdays – 67/225 (30%) (30,000)
Attributable to the performance of UK duties 70,000
Gross up for UK tax at 4/6 46,666
UK-based earnings taxable under section 25 ITEPA 116,666
Tax at 40% 46,666
Remitted to the UK - 60,000 plus section 25 tax of 46,666 106,666
Section 26 ITEPA - SP5/84 Nil

Scenario 2

Facts as above but Tanya’s employer also paid UK tax liability of £5,000 on her investment income. As the £5,000 is not directly referable to the performance of duties inside or outside the UK, it falls to be time apportioned in accordance with SP5/84. Therefore, the £5,000 has been added to net salary and benefits before calculating and deducting the amount attributable to overseas workdays.

Calculation of UK tax for 2005-06

Net salary and benefits 105,000
   
Less amount attributable to overseas workdays – 67/225 (30%) (31,500)
Attributable to the performance of UK duties 73,500
Gross up for UK tax at 4/6 49,000
UK-based earnings taxable under section 25 ITEPA 122,500
Tax at 40% 49,000
Remitted to the UK - 60,000 plus section 25 tax 49,000 and other UK tax 5,000 114,000
Section 26 ITEPA - SP5/84 Nil

Scenario 3

Additionally, Tanya’s employer pays overseas tax liability of £5,000 direct to an overseas tax authority. The overseas tax is referable solely to the performance of duties outside the UK and is therefore excluded from the section 25 calculation.

Calculation of UK tax for 2005-06

Net salary and benefits 110,000
   
Less overseas tax payment (5,000)
Salary and benefits to be time apportioned 105,000
Less amount attributable to overseas workdays – 67/225 (30%) (31,500)
Attributable to the performance of UK duties 73,500
Gross up for UK tax at 4/6 49,000
UK-based earnings taxable under section 25 ITEPA 122,500
Tax at 40% 49,000
Remitted to the UK - 60,000 plus section 25 tax 49,000 and other UK tax 5,000 114,000
Section 26 ITEPA - SP5/84 Nil

Scenario 4

Facts are the same as in Scenario 2 except that £70,000 out of the £100,000 net salary and benefits has been remitted to the UK.

Calculation of UK tax for 2005-06

Net salary and benefits 105,000
   
Less amount attributable to overseas workdays – 67/225 (30%) (31,500)
Attributable to the performance of UK duties 73,500
Gross up for UK tax at 4/6 49,000
UK-based earnings taxable under section 25 ITEPA 122,500
Tax at 40% 49,000
Remitted to the UK - 70,000 plus section 25 tax 49,000 and other UK tax 5,000 124,000
Net section 26 ITEPA - SP5/84 1,500
Gross up for UK tax at 4/6 1,000
Foreign earnings taxable under section 26 2,500
Total taxable earnings (sections 25 and 26) 125,000
Tax at 40% 50,000