UK government crackdowns against what are called employee benefit trusts makes it tough for financial firms to comply with new regulatory codes on deferrals of bonuses - a sorry example of a lack of joined-up thinking.

The wealth management industry in the UK and some of its clients face a dilemma in how to comply with new rules on bankers' pay as these laws clash with the taxman’s crackdown on remuneration deferral schemes. That this dilemma exists at all demonstrates sloppy thinking among policymakers.

Under European Union rules and the Financial Service Authority’s own regulations (“Remuneration Code”), financial services institutions in the UK – not just the top 26 banks and building societies – are subject to rules requiring firms to defer some or all of the bonuses that are paid to staff.

The idea behind this reform is to discourage the sort of short-term risk-taking that policymakers claim was a key cause of the 2008 financial smash. The issue was sensitive particularly as a number of banks, such as Royal Bank of Scotland and Lloyds Banking Group, were rescued by the taxpayer. (Of course, some might argue that central banks and governments bear heavy responsibility for the bust).

The idea of deferring bonuses has hit a problem in the form of the current UK government's crackdown on forms of tax avoidance. Starting from late last year, it has removed some of the tax benefits from what are called employee benefit trusts (EBTs). In the broadest terms, EBTs are discretionary trusts set up for employees, from which payments can be distributed at a later date, often in a highly tax-efficient manner. The decision effectively means that new EBTs will not be established. Existing ones are likely to fall into disuse.

These issues are not totally settled, but banks, investment houses and other financial players have lost key freedoms to set pay. On one hand, if firms defer bonuses, then their employees cannot use EBTs, or as much as they did before, to mitigate tax. On the other hand, firms cannot now pay bonuses straight away because of the FSA’s pay regulations. Another problem is that the legislation requiring firms to defer bonuses seems to be drawn up with listed firms in mind – but the situation as faced by private partnerships, for example, is unclear.

The issue creates an example of how different parts of a government machine – regulator and tax collector – can move in diametrically opposite directions. But many wealth managers and other institutions may decide they cannot be bothered to wait for clarity and migrate elsewhere to friendlier climes. Harvey Knight, a partner at Withers, the law firm, recently told me of how serious this problem now is.

“It [the tax changes] encourages a move to the East. If you don’t have a family to worry about, then life in the East is more financially attractive. Young traders and fund managers are more likely to move to places like Hong Kong and Singapore than in the past,” he said.

Claw-back

A key issue is the possibility of “claw-back”, said Knight. Bonuses paid out could be later clawed back in the event of a problem at a company that was not known at the time when payments were made.  This is no longer a theoretical concept, either. It is being actively considered by the Remuneration Committee of the Lloyds Banking Group in the wake of the Payment Protection Insurance scandal and the compensation that has had to be paid to the mis-sold consumers, Knight points out. It is unclear and unlikely that any tax paid on such claw-backed bonuses would be credited back by HMRC to the affected individuals, he said.

“The fact is that at some point, no matter how long a period of time that a payment is deferred, tax has to be paid,” said Knight.

Knight’s colleague, Colin Smith, also pointed out how wide the scope of the FSA’s Remuneration Code is, highlighting that a broad swathe of firms, including boutique wealth managers, could be caught in the net, as well bulge-bracket banks.

“The extent of the new FSA Remuneration Code is wide: even for institutions such as hedge funds and other firms that fall into the lowest 'Tiers' of the Code. Whilst these firms are able to dis-apply some of the rules that apply to Tier 1 firms such as the largest banks (such as deferral of bonuses and payment of at least half of bonuses in shares), such organisations may take the safety-first option of applying some deferral and retention elements to their remuneration policies,” Smith said.

“This would enable them to demonstrate to the FSA that their remuneration policy does not encourage excessive risk-taking and is aligned with the long-term objectives of the firm,” he said.

Tiers

His reference to “Tiers” needs some explaining. There are, for the purposes of the Code, four of them:

Tier 1: the largest banks and building societies with capital resources of over £1 billion;

Tier 2: smaller banks with capital resources exceeding £50 million;

Tier 3: small banks with a capital base of less than £50 million, and

Tier 4: firms with limited permissions from the FSA (e.g. firms without permission to accept deposits, this will include most hedge funds and asset managers).

A difficult issue, as Knight said, is to know precisely which “tier” a firm falls into. However, while the rules on big firms kicked in at the start of this year, all firms must comply with the Code by 1 July. Time is short.

“My real concern is that the smaller firms that are included within the scope of the revised FSA Remuneration Code have breathed too large a collective sigh of relief when it was announced just before Christmas that it would be applied in a proportionate way and the more onerous provisions could be dis-applied,” said Knight.

“Some firms may have gone so far as thinking it does not really apply to them. This is a very real problem with the 1 July 2011 deadline for compliance rapidly approaching. The FSA has a tendency to adopt a “one box fits all” approach and smaller firms could be in for a nasty shock when the FSA starts to probe their compliance with the spirit of the Code,” Knight continued.

Smith adds that another problem is the requirement for firms in Tiers 1 and 2 to pay at least 50 per cent of bonuses in shares or equivalent instruments. This is not such a difficult issue for publicly-listed banks (although it still gives rise to administrative issues).

However, not all firms subject to this requirement have listed shares: some are LLPs or mutual societies. Even private companies face substantial difficulties in awarding bonuses in the form of shares (not least because there is not necessarily a market for such shares).

In recognition of this, the FSA has extended the transition period for firms in this position until 1 July 2012. However the watchdog has said that it would expect firms in this position to put in place “appropriate arrangements” during the transitional period to manage the risks raised by their inability to comply with the "shares or other instruments" requirement.

All in all, this regulatory-tax dilemma is a sorry commentary on the ability of governments to think through how their actions will work. Is it too much to ask for policymakers to frame laws that are coherent, for once?