One step ahead of the taxman

This affront to tradition is causing much pain and anguish, but the banks are fighting back.

In remuneration committees across the City of London, the search is on for new strategies to maximise pay in these straitened times and see off the Inland Revenue as well. They have always come up trumps in the past.

Since the UK government lifted the ceiling on National Insurance paid by employers in 1986, banks have avoided paying it and other taxes by using any number of ingenious strategies.

First they paid bonuses in gilts, then in gilts wrapped inside unit trusts. Then they moved to gold bullion (avoiding VAT if it was held abroad), then gold coins and then platinum sponge, which is used inside precision instruments.

Chris Oates, a tax expert at the accountant Ernst & Young, says: "At one point there was more platinum sponge in bonus schemes than actually existed in the world."

The banks have always stayed one step ahead of the government, moving on to a new vehicle every time the tax loophole on the last one was closed.

Now they face an assault on one of their latest schemes - employee benefit trusts (EBTs). These are vehicles for bonuses that allow staff to avoid paying National Insurance and sometimes income tax. In November, Gordon Brown, the Chancellor, abolished tax breaks enjoyed by the firms themselves when they use EBTs in this way.

The Inland Revenue was already arguing that employees should pay tax on EBTs anyway. It says the government's new rules will apply to a wide variety of schemes, includingloans made in foreign currencies, such as the Turkish lira.

These have been in use in London for two or three years, according to Mike Warburton, a tax expert at the accountant Grant Thornton.

The idea is that the bank lends a large amount of lira to an employee, who changes it immediately into sterling.

If all goes to plan, the lira then depreciates over the next year, allowing the loan to be repaid with cash to spare. This cash is in effect a bonus, but arguably attracts no tax as the whole transaction looks like a loan.

Many accountants have doubts about the scheme. Sarah Hyde at Ernst & Young says: "What if the lira appreciates? It doesn't seem so clever to me."

But they also doubt that Brown's changes will necessarily end the scheme's tax advantages.

Many banks treat such schemes warily, as they are not good public relations. They attract not only the wrath of the Chancellor but of newspapers in love with tales of City excess.

Warburton says: "Firms like ours are not a hotbed of dodgy ideas for not paying tax. I come across different ideas all the time, but if they are a bit smelly I don't touch them."

He says his firm has not taken part in the lira scheme.

Another difficulty faced by those who structure bonuses is that the attraction of share options has plummeted. Options have become increasingly common in recent years, even for quite junior staff, and together with deferred shares they now account for more than half the bonus of many senior bankers.

Options currently face a triple handicap from weak prospects for equity prices, changes in accounting rules and a widespread feeling that there is something sleazy about them.

Richard Cockman, a tax expert at the consultancy Watson Wyatt, says: "Not only have options become linked with greed and malpractice, but they also are not providing much incentive and may actually be demotivating to participants."

Two months ago the International Accounting Standards Board (IASB) called for options to be treated as an expense in the profit and loss account. The proposal is likely to become law in the UK and other European countries in January 2004, Cockman believes. Options granted after November last year could be caught by the new laws.

The change is significant. So far options have not needed to be treated as an expense, making them more attractive from the employer's point of view.

But there is still plenty of room for manoeuvre by clever tax experts. "The IASB says options are an expense, but it doesn't say how options should be valued. I suspect there is a little industry building up here, aimed at valuing them as low as possible," Cockman says.

A starting point for valuing options is 35% to 40% of face value, he says. But there are many variables, including dividends, share price volatility, length of exercise period and the possibility that an employee will leave the firm before the options vest.

Most tax experts agree that share options will remain an important part of pay packages. But increasing weight is likely to be given to deferred payment in shares, often granted in accordance with the performance of an individual or the company. Deferred payments of cash could also become more popular.

Whatever strategies banks employ, they are constrained in the short term by low profits, or no profits at all. In a survey of nine investment banks the headhunter Armstrong International estimated in November that 2002 bonuses would be down between 30% and 50% in most sectors compared with last time.

But the most useful staff can still expect to be well looked after as banks focus resources on them at the expense of the mediocre. Managers in credit derivatives might pull in as much as $2.2m (€2.2m), while in credit marketing some might earn $2.8m, according to Armstrong.

They might be wise not to ask for much of it in Turkish lira. Since August, the currency has strengthened against the pound.

Staff with lira loans to pay off will be hoping that foreign exchange traders do not drive it up further.