Profit-linked pay breaks the chains: Relating reward to performance has tax advantages that are proving popular in a recession, writes Brian Friedman

PROFIT Related Pay (PRP) is rapidly becoming the reward phenomenon of the 1990s.

When it was introduced in 1987 companies were somewhat dismissive, saying it presented too many legislative restrictions and administrative burdens.

But in the recession employers and employees alike are seeing the attractions of tax-free pay.

Many employers are struggling to offer their staff pay rises as low as 1 and 2 per cent and are naturally attracted to any scheme which gives its employees a much larger projected pay rise while reducing payroll costs.

Inland Revenue statistics show that in the year to September PRP registrations increased by 130 per cent. But the three months to December is the busiest quarter for PRP (as many companies have 31 December year-ends) and the rise will almost certainly become even more marked.

Inland Revenue workers at the PRP Unit at Cumbernauld in Scotland have recently been working evenings and weekends to meet the demand from companies seeking to register before the 31 December deadline, which must be the clearest example yet of the Revenue's commitment to customer service.

So why is PRP taking off so dramatically? Apart from the combined impact of the recession and low inflation, the enhanced tax relief bestowed in the 1991 Budget has given it a boost. Before 1991 only half of PRP was tax-exempt. In 1991, tax relief was extended to cover the entire PRP up to a maximum of pounds 4,000, or 20 per cent of salary if that was lower.

PRP is not designed to be a bonus or an incentive scheme. It is intended to allow companies to relate pay to profits. The theory is that if pay can fluctuate, to a limited extent, with profits, then companies may be able to maintain productive capacity during a recession. But if PRP were simply a means of relating pay to profits, employee resistance would be strong; in fact, employees tend to welcome PRP. The reason, not surprisingly, is tax relief.

Consider Joe, a clerical worker earning pounds 10,000 per annum. If he sacrifices pounds 2,000 of pay for PRP which is planned to be equal to pounds 2,000, he will have substituted tax-free pay for taxable pay. As a result, he will be better off to the tune of pounds 500 (tax at 25 per cent on pounds 2,000). This represents a net increase in pay of 6.7 per cent.

Clearly any mechanism that can increase the net pay of employees by more than 6 per cent without costing the employer anything is highly attractive in a recession.

For higher-paid tax-payers, the savings can be more substantial. The maximum amount of PRP that can be paid tax-free is pounds 4,000, which at a marginal rate of 40 per cent represents a tax saving of pounds 1,600 a year.

Some companies are going one step further and using PRP to reduce payroll costs. This can be achieved, for example, by asking staff to sacrifice 22 per cent of salary in return for 19 per cent back by way of PRP. Because the PRP is tax-free, the employee will still receive an increase in net pay of 3 per cent; the employers will have reduced their payroll costs by 3 per cent.

While some linkage between pay and profits is often to be welcomed, excessive fluctuations are likely to be a source of concern for employer and employee. Fortunately the legislation allows stringent limits to be placed on the degree of profit fluctuation.

PRP is being enthusiastically supported by Government ministers. In the words of the Financial Secretary to the Treasury, Stephen Dorrell: 'Employees whose pay is dependent on profits have a real personal interest in the success of the business. And business benefits from a better motivated workforce. So I hope that employers without schemes will seriously consider introducing them.'

Mr Dorrell certainly practises what he preaches. He recently announced that PRP had been introduced in his family business - the Faithful Group, which manufactures industrial clothing.

The profit pool (known as the distributable pool) may be distributed to employees either by setting aside a fixed percentage of profits, or taking a fixed sum which is then increased or decreased in line with profits.

Under either method profits do not have to be distributed equally per employee, but should be distributed to employees on similar terms, for example in proportion to level of pay or length of employment.

Scheme rules must be drawn up and submitted to the Inland Revenue for registration prior to the start of the first profit- related-pay period. These 12 months should, for reasons of cost, be aligned to the accounting year.

The writer is managing director of Stoy Benefit Consulting.

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