08 March 2010
If you sell shares for more than their market value, then there may be a charge to income tax and NICs on the overvalue. However, the meaning of "market value" has never been entirely clear. The question was recently addressed by the Supreme Court in the case of Gray's Timber Products. This briefing examines the Supreme Court's decision, and whether employee shareholdings involving "ratchet" arrangements need to be restructured as a result of the judgment.
Gray's Timber Products was the first reported case on the "employment-related securities" regime, and has now become the first tax case to be heard by the Supreme Court. Historically, one of the main aims of employee remuneration planning has been to allow employees to realise profits in connection with their employment which are chargeable to CGT, rather than to income tax and national insurance contributions. The employment-related securities regime contains a number of provisions designed to counter planning of this type. Gray's Timber involved an employee selling shares and arguing that the profit should be subject to CGT. HMRC argued that the profit was chargeable to income tax and NICs.
Facts and legislative background
Although the employment-related securities legislation is complex in places, the provision under consideration, Chapter 3D, is relatively straightforward. It applies where employment-related securities are sold for more than their market value. In this situation, the amount of the overvalue, less a deduction for expenses, is chargeable to employment income tax and NICs.
"Market value" is defined for these purposes, in relation to any assets, as "the price which those assets might reasonably be expected to fetch on a sale in the open market." This is a statutory definition, which applies to the whole of the employment-related securities regime. The test which has often been applied by the courts is: what would an hypothetical purchaser in the open market pay to "stand in the shoes" of the vendor?
The facts of the case were as follows. Gray's Timber Products had appointed Mr Alexander Gibson as managing director. Mr Gibson paid £50,000 to take up 6% of the shares in Gray's Timber's parent company, Gray's Group Ltd. He and other shareholders in Gray's Group entered into a shareholders' agreement which entitled him to a disproportionately large share of the sale proceeds on a future sale of Gray's Group. He was entitled, under the terms of the shareholders' agreement, to put his shares onto Gray's Group or a third party purchaser on an exit for an enhanced price. The reason for these special rights was set out in the shareholders' agreement, which explicitly described the rights as a way of rewarding Mr Gibson if performance targets were met.
When Gray's Group was sold, Mr Gibson received just over £1.4m, rather than the £0.4m to which he would have been entitled without the benefit of the shareholders' agreement. The shares were "employment-related securities", and HMRC sought to tax the difference between these two figures under Chapter 3D.
The issues were:
(i) Should Mr Gibson's rights under the shareholders' agreement be taken into account when determining his shares' market value?
(ii) If so, what effect would this have on the valuation process?
Counsel for the taxpayer argued that:
(i) the rights which Mr Gibson had under the shareholders' agreement were close enough to being class rights, attached to the shares, and an hypothetical purchaser would have benefited from those rights, and
(ii) even if they did not, "market value" should include personal rights, as it should be given a consistent definition throughout the employment-related securities regime, and other Chapters had clearly been drafted on the basis that "market value" should include personal rights.
The court did not accept the first point, holding that it turned on a company law case which had not been referred to in the submissions of either side.
The court appears to have found the second point difficult to decide. Lord Walker's speech states that "I am left in real doubt as to whether Parliament has, in Part 7 of ITEPA 2003, enacted a scheme which draws a coherent and consistent distinction between intrinsic and extrinsic rights." Lord Hope's speech makes clear that, even though "market value" has the same statutory definition for all Chapters of the employment-related securities regime, it does not have a consistent meaning across all the Chapters. This is an odd conclusion, and although it must now be taken to be law, Lord Walker clearly found the position to be unsatisfactory. His speech concludes by stating that "I express the hope that Parliament may find time to review the complex and obscure provisions of Part 7 of ITEPA 2003."
Furthermore, HMRC's argument on this point was clearly at odds with their previous published guidance. This raises questions about whether taxpayers will be able to trust HMRC guidance in the future.
It was held that Mr Gibson's rights would have been personal to him even if they had been set out in Gray's Group's articles of association, and so had attached to his shares. They were expressed to benefit Mr Gibson personally, not simply any holder of the shares. This was clear from the drafting of the shareholders' agreement, which, in the words of Lord Walker, "made it plain that Mr Gibson was to get a special price for his shares, not because the shares themselves had a special value, but in recognition of his personal services as managing director." A hypothetical purchaser would not have paid anything extra to acquire rights which could only benefit Mr Gibson.
Lord Hope, who gave the only other speech, also found that Mr Gibson's rights under the shareholders' agreement should not be taken into account in determining the shares' market value, even if those rights attached to the shares. However, his speech has a different emphasis. Lord Hope focuses on the fact that Mr Gibson's shares were not worth any more in the hands of the purchaser than any of the other shares in Gray's Group. In the view of Lord Hope, "in estimating the market value attention must be focussed on the asset that requires to be valued. In this case it is the rights attached to the shares acquired by the purchaser, no more and no less...[the put option rights], which were extinguished by the payment which Mr Gibson received, were not part of the assets acquired by the purchaser." The determining factor to Lord Hope appears to be whether or not the put option rights transmitted to the actual purchaser (as distinct from the hypothetical open market purchaser). As they did not, they should not be taken into account in determining the shares' market value.
Tax planning in the future
On the strength of the decision of a lower court, some tax advisers had felt that the taxpayer in Gray's Timber could have avoided Chapter 3D if the put option rights had been non-personal and had been contained in the company's articles of association, even if those rights were extinguished by the sale to the third party purchaser. This view probably cannot stand with the speech of Lord Hope. According to Lord Hope, since the put option rights were extinguished by the transaction, they should not be taken into account in determining the shares' market value. The same would have been true even if the rights had attached to a separate class of share and had not been personal to Mr Gibson.
Lord Walker does not focus on this point to the same extent, but he was also influenced by the fact that the actual purchaser did not inherit Mr Gibson's special rights. He states at paragraph 38 that "Jewson agreed to buy Group for £6m less a retention, and all the ordinary shares which it acquired were of equal value to it. It was not concerned with the division of the sale price between the vendors...The same would have been true of any other open-market purchaser."
Remuneration structures involving "proceeds only" ratchets (such as in Gray's Timber) may need to be restructured as a result of the judgment.
Where an employee has entered into put option arrangements similar to the arrangement in Gray's Timber, but with the put option rights drafted as non-personal rights which attach to the shares in question, it may still be possible to avoid a Chapter 3D charge on an exit. It might be possible for the employee to achieve this by selling his shares to an investor who is not an employee for a price which takes into account the put option rights, immediately before the exit. That investor could then put the shares onto the third party purchaser for the same price. Provided the put option rights transmit from the employee to the purchaser, Chapter 3D (arguably) should not apply to the employee shareholder.
In terms of future tax planning, taxpayers should ensure that any enhanced employee rights attaching to shares survive when those shares are acquired by a third party purchaser. This would be the case with growth share arrangements, where a class of shares held by employees "flowers" if performance targets are met. Such arrangements should be unaffected by the Gray's Timber decision, because a third party purchaser would inherit the enhanced rights. Similarly, ratchet arrangements under which shares not held by employees convert into worthless deferred shares if performance targets are met – enhancing the value of employees' shares – should also be unaffected. Again, the enhanced value of the employees' shares would not be extinguished by a third party sale and would transmit to a third party purchaser.