In this week’s budget, Chancellor George Osborne announced that he intends to introduce measures to close tax loopholes for companies, making it harder for them to avoid paying tax in the UK. Just a week before the budget, the Supreme Court issued its decision in a long running case about the validity of schemes set up by investment banks designed to avoid bankers paying income tax on their bonuses. It did not go well for the banks.

‘In our society, a great deal of intellectual effort is devoted to tax avoidance,’ said Supreme Court Justice, Lord Reed, at the start of his judgment, ‘the most sophisticated attempts of the Houdini taxpayer to escape from the manacles of tax....include elements which have been inserted without any business or commercial purpose...’  Unfortunately for the banks, his lordship went on to say that tax avoidance schemes that lack commercial purpose will not be protected even if they meet the strict letter of the tax legislation, thereby slamming shut the door on schemes which have ‘no commercial rationale beyond tax avoidance.’

Collectively UBS and Deutsche Bank had a bonus fund of £182 million which was payable to their respective employees. But payment of the bonuses by means of salary would have given rise to large income tax liabilities. The Income Tax (Earnings and Pensions) Act 2003 provides income tax exemptions for certain types of shares known as ‘employment related restricted securities’. That, as the catchy name suggests, is a share awarded to an employee which has to be forfeited if, for example, the employee fails to meet future performance targets. Dismissal for misconduct may be one ground for forfeiture.

Since at the time of the share award there is no guarantee that employees will receive the benefit of the shares (since they might have to be forfeited) it would be unfair for employees to be taxed on the value of such shares at the time of the share award. The 2003 Act therefore provides that no income tax is chargeable then; it is chargeable later on. This made sense to Lord Reed. It was clear to his lordship that the purposes of the restricted security exemption in the 2003 Act were to protect employees who receive shares conditional on future events, and to encourage employee participation in share schemes, but only in ways that did not diminish tax receipts for HMRC in the event the shares were not later forfeited. It is in respect of those purposes that the banks’ schemes had to be judged.

As it then stood (it has since been amended to remove the loophole), the 2003 Act exempted certain types of employment related restricted securities from the payment of income tax altogether – both when the shares were awarded and later on.

To make use of this exemption, the banks incorporated companies in Jersey and the Cayman Islands; created a special class of share in them (the restricted securities), purchased the shares with the bonus funds and allocated the beneficial interest in the shares to the employees, with the employees having the right to redeem the shares later on. No liability for income tax arose and, providing the employee waited long enough, the structure was also capital gains tax efficient. On paper, the schemes worked.

The problem, however, was that the schemes looked artificial to the Supreme Court because there was no realistic prospect of the shares ever being forfeited. The key element of a ‘restricted security’, namely the risk of forfeiture, simply wasn’t there. As the bonuses had actually been earned and awarded, it was not in the interests of the banks or their employees to see forfeiture happen. Unsurprisingly, the forfeiture provisions in the schemes were drafted so that the chances of forfeiture were extremely remote.

In the Deutsche Bank scheme, the shares were forfeited only if the employee resigned his or her employment within 8 weeks. Dismissal by Deutsche Bank, even on cause shown, was not a ground of forfeiture. Redundancy, death or disability also had no impact. The matter of forfeiture was therefore within the sole control of the employee.

In the UBS case, forfeiture was conditional on the value of the FTSE 100 index reaching a certain pre-defined level at the end of a three week period. Aside from being an arbitrary event that was highly unlikely to occur, UBS also hedged against the risk by obtaining insurance which would have paid out sums equivalent to the bonuses in the event the shares were forfeited.

Accordingly, the chances of either UBS or Deutsche Bank employees forfeiting bonuses, and suffering any losses, were remote. As a result, the court held that there were no ‘restricted securities’ because there were truly no contingencies – the shares were always going to be retained and the employees were always going to receive their bonuses - and thus the exemption could not apply. The court held that income tax was chargeable on the value of the shares at the time that they were awarded.

Although each case must of course be decided on its own facts, Lord Reed’s judgment (which was unanimously approved by all five justices) appears to lay down a marker for future cases. We can expect to see tax avoidance schemes more routinely unpicked by the courts. As Lord Reed put it:

‘There is nothing in the background to suggest that Parliament intended that [the exemption] in section 423 (2) [of the 2003 Act] should apply to transactions having no connection to the real world of business, where a restrictive condition was deliberately contrived with no business or commercial purpose but solely in order to take advantage of the exemption.’

There are further big tax cases coming up, most notably the liquidators of Rangers FC’s attempt to persuade the Supreme Court to accept the validity of the Employment Benefits Trusts (EBTs) the club used to pay some of its high profile players from 2001 – 2010. Watch this space.