How to know if a bonus deferral scheme is right for your Financial Services business

After facing heightened budget concerns for so long through this cost-of-living crisis, and now with a change of government adding to uncertainty, financial services businesses need resourceful ideas for how to ease pressure on their balance sheets.One possibility for employers is to apply a bonus deferral scheme. In this set-up, regulation from the Prudential Regulation Authority (“PRA”) and the Financial Conduct Authority (“FCA”) requires deferral of a proportion of variable remuneration for certain roles, though some employers also operate voluntarily, to promote best practice. Bonus deferral can apply to both companies and LLPs as employers.

Bonus deferral can have a positive effect on a business by incentivising longer-term success over shorter-term results. The employer may also enjoy cash-flow benefits that it can use to invest in the business. 

What are the options?

Bonus deferral in most cases takes one of the following forms:

• Cash-based deferral
• Share options
• Units in managed funds

Key design points

Whilst a well-designed deferral scheme can offer benefits, the scheme design should consider the following:

1. What form will the deferral take?
2. Who will be included?
3. How will it be taxed?

With these key questions in mind, below we consider some pros and cons of the most common forms of bonus deferral.

Cash-based

A cash-based scheme is the simplest deferral mechanism. A proportion of an individual’s bonus is deferred, and later paid out in cash. Payment is subject to ongoing employment, typically with some narrow conditions for clawback. The cash payment can either be fixed (based on the bonus deferred) or can be variable, by tracking an index during the deferral period, such as the company’s shares or a fund the individual is managing.

These types of schemes can provide certainty of outcome for the participant, assuming the deferral period is completed. They are also easy for participants to understand as they don’t involve equity investment; whilst also making it easy for employers to forecast cash outflows.

On the other hand, it is important to note the cash cost they bring to the business, and the employer NIC cost they carry.

Option-based

For an option-based scheme, a proportion of the bonus is converted to the equivalent value of company shares, with an option granted over these shares, exercisable as the deferral period(s) end.

This set-up is less demanding from a company cashflow perspective. It also provides an incentive during the deferral period to increase the share value.

These advantages must be balanced against the complexities involved. For instance, regarding determining the share price at which the bonus is converted to options (this is made easier if the shares are listed). 

Option-based schemes can also lead to shareholder dilution, and require tax analysis to ensure the exercise of options qualifies as corporation tax deductible.

Unit-based

Finally, for unit-based schemes, a proportion of the bonus is converted to the equivalent value of units in the fund that the employee may be managing. There will be restrictions around ability to sell the fund units and potentially also forfeiture of the fund units if employment ceases or there is reason for clawback. 

Unit-based schemes are most appropriate for employees who have influence on the performance of the fund. This is because they provide an incentive during the deferral period to increase the fund value. They also offer potential flexibility to defer the bonus on a pre-tax or post-tax basis.

As above, though, tax analysis will be required to implement these schemes, in this case to establish if a corporation tax deduction is due. Designing the schemes can also be made more complex if fund units are subject to forfeiture provisions.

Expected tax position

Provided structured correctly, deferral should result in the associated income tax and NIC liability being deferred until the eventual cash payout, exercise of share options or release of fund units to the employee. 

There is, however, potential for the tax-point to be triggered early, if structured poorly. For example, if the deferral scheme is facilitated by an entity other than the employer, the ‘disguised remuneration’ rules can impose income tax/NIC on earmarking of the awards instead of at end payout.

Similarly, if set-up correctly, you can expect a corporation tax deduction in line with the amount on which income tax is paid. However, tax inefficiencies can again arise if these deferral schemes are incorrectly structured. For example, where deferring into an option scheme, a corporation tax deduction may be blocked if the shares are in a subsidiary company. In such a case, it may be more appropriate to use a cash-based scheme.

Tips for setting up a bonus deferral scheme

To make the bonus deferral scheme successful requires time investment. It is important that all aspects are carefully considered, including the regulatory, tax and legal position as well as any other factors relevant to the employer. Implementation might typically include the following:

1. Check regulatory position – determine the extent to which deferral is required, who must it apply to and over what deferral period. 
2. Design of deferral plan – this should be commercially driven, with tax advice taken to ensure no tax leakage.
3. Employee communication – this may take the form of Q&A documents, webinars or in-person presentations. 
4. Legal implementation

Clearly, then, there is much to consider when it comes to evaluating the benefits of a bonus deferral scheme for your business. But with careful analysis of the different types of schemes, and a meticulous approach to implementation, many in the financial services sector will find there is much to be gained from this approach.