Indemnity Insurance – Government acts to close a tax loopholeMonday, January 26th, 2009
If an employer pays an employee’s liabilities arising out of legal action or provides indemnity insurance against such liabilities, the employer’s costs are a taxable benefit to the employee and must be reported on form P11D. However, where the liability arises out of the employment, for example, because the employee is obliged to pay it as holder of the employment, the employee may make a business deduction claim to offset some or all of the tax charge arising from the benefit being reported on form P11D (unless they arise in respect of criminal acts). These provisions are to be found in sections 346 to 348 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA) and, in respect of employees who have left the employment, in sections 555 to 559.
For example, directors may face legal action in respect of alleged or actual wrongful acts or omissions in their capacity as directors or employees. The employer may provide indemnity or liability insurance to cover the damages and legal expenses that arise from such claims. If a payment qualifies for a tax deduction, it is also disregarded for the purposes of Class 1 NICs.
On 12 January 2009, the Government announced that it will be introducing legislation to block a tax and NICs avoidance scheme that takes advantage of these provisions for tax relief.
For example, in order to shelter a large employment payment from tax, the promoters of the scheme arrange for the employee to take up separate employment, the duties of which include entering into financial arrangements, such as stock lending, with another party. During the course of this employment, the employee deliberately defaults with regard to some aspect of the financial arrangements and, as a result, becomes liable to pay damages to the third party. The employee borrows money to pay the damages under arrangements that do not involve having to repay it. Nevertheless, as the damages arose out the employment, the employee makes a business deduction claim of the amount of the damages, to be offset against general earnings for the tax year.
In order to close down such schemes, the Government will introduce measures in the 2009 Finance Bill which will apply retrospectively to payments of damages that are made on or after 12 January 2009. The proposed legislation will deny any deduction under section 346 or section 555 of ITEPA where the liability in respect of which the deduction would otherwise be due has been paid in connection with arrangements of which the main purpose, or one of the main purposes, is the avoidance of tax.
However, the blocking amendments will not affect the use of the tax relief provisions for the purposes for which they are intended, where the tax deduction does not have as its purpose the avoidance of tax.
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