27 July 2020

For a tax lawyer, one of the least satisfactory parts of advising clients on the sale of a fast growth business is discovering that the founders or management team have not been able to afford professional support at an early stage of the business growth, or have been poorly advised. Often this means that the implications of the employment related securities (ERS) regime for shares, options and other securities they hold have not been properly considered, and relevant elections have not been made.

Being the bearer of bad news is never a welcome part of being a professional adviser, and the recently released decision of the Upper Tier Tribunal in Commissioners for HM Revenue & Customs v Vermilion Holdings Limited [2020] UKUT 162 will increase the number of cases in which bad news has to be delivered.

The root of the difficulty here is that the main policy objective underlying the ERS regime was to ensure that awards of shares, options, or securities were not being used as a tax planning device to escape normal income tax. However, they are extremely broadly drafted and often seem to act as a trap for unwary key stakeholders in owner-managed businesses. The Upper Tier Tribunal decision will make no improvement in this situation, and in some cases will remove scope for a reasonable interpretation which imposed some practical limits on the scope of these rules.

Where shares, securities or options are awarded to employees at less than their market value, it is generally well understood that there is a potential employment tax charge on their grant, exercise and/or disposal as appropriate. However, the following points are less widely known to many clients:

  • Because they were originally drafted as anti-avoidance measures, they potentially catch a wide range of transactions outside the issue, grant or acquisition of securities, including certain disposals, variations, reorganisations and even the falling away of certain restrictions, regardless of whether the events are tax motivated or purely commercial.
  • There are a number of chapters or 'sub-codes' within Part 7 which do not always work well together – so the same transaction may be caught under one chapter, when a definition or an exclusion may take it safely outside the scope of another chapter, even though as a matter of policy the same treatment would be expected to apply under both chapters. Similarly, the amount of tax at stake under different chapters may be radically different.
  • Critically, all the provisions start from the question of whether a person acquires the right or opportunity to acquire the securities 'by reason of an employment of that person or any other person' (emphasis added). This wording, already very wide, is further extended by the scope of a deeming provision considered below. For this purpose, 'employment' includes directorship, which is again a trap for the unwary, as many shareholders or early stage investors who act as non-executive directors do not think of themselves as employees.
  • It is sometimes assumed that, very broadly, if shareholders are dealing with their company on an arm’s length basis, or their share interests are treated on the same terms as those of other shareholders who are not directors or employees, they cannot be caught by these rules. This is a reasonable assumption in policy terms, but there are a number of circumstances in which it is not correct. There also seems to be an urban myth that the rules do not apply to business founders or certain investor/directors, but there is no general exemption for 'founder shareholders' or angel investors. There are some circumstances in which, particularly right at inception of a business, it may be possible to argue the rules do not have a significant adverse impact, but this comes down to valuation.
  • The 'restricted securities' provisions, while designed to catch shares where the value has been manipulated, in fact apply to many cases due to typical restrictions on, for example, the freedom of transfer in the articles or the way certain voting rights can be exercised, which create difficult questions of valuation. If the amount paid for the shares or carry is not the unrestricted market value (a purely hypothetical amount) and this materially exceeds the actual market value, and an appropriate election is not made, potentially a proportion of the growth in value of the shares can be subject to income tax (sometimes including PAYE) and NICs on certain triggering events (known as chargeable events). The result can be a total tax cost which may be up to 60 per cent on a proportion of the gain (income tax at 45 per cent plus employee national insurance of 2 per cent plus employer national insurance of 13 per cent) realised on such a chargeable event, when company and shareholder were expecting this would be a chargeable gain for the shareholder only, and subject to 20 per cent tax accordingly.

An additional complication is that where the issue is not identified until the pre-sale stages of a transaction, it often concerns not just the vendors but the purchaser, because typically by that stage, on disposal of the relevant shares or securities these will have become readily convertible assets (RCAs), giving rise to a potential obligation to operate PAYE on the share or security disposal proceeds and both an employee and employer NICs liability for the company. There may also be penalties at stake, including penalties for the company if it has failed to comply with previous filing obligations. It is therefore an issue which concerns purchasers as well as vendors, and which if discovered as part of due diligence will probably be excluded from any normal insurance cover for tax warranties and indemnities.

In Vermilion the dispute related to a grant of share options, but the principles set out by the Upper Tier Tribunal will be equally applicable to acquisitions of shares or other types of securities. The exact factual details in Vermilion will not be of wide interest, but in essence an individual had been granted a share option in a private company in exchange for consultancy services provided. A short time later, the company ran into serious financial difficulties. As part of a rescue package agreed with shareholders, it was agreed both that the option holder would become executive chairman of the company under a 12 month contract and that his original share option should be replaced by a new share option on different terms. The existing shareholders were being diluted and the reason for the grant of the successor option appears to have been that the shareholders wanted option holders to suffer a broadly equivalent value dilution. The original option was very clearly not an employment related security: the question for decision on the appeal was whether the successor option was caught by the employment related securities rules. The First Tier Tribunal, in a detailed and closely reasoned judgment, had held that it was not.

HMRC appealed against this decision. Since the amount at stake seems to have been just under £387k, this may indicate determination by HMRC to establish a principle. Typically, the amounts at risk where there are employment related securities issues on sales of successful growth businesses are much larger.

The Upper Tier Tribunal overturned the First Tier Tribunal decision, and held that the relevant option was indeed acquired by reason of the option holder’s employment and the tax was due. The detail of its reasoning was particularly concerning. Effectively, there were two lines of argument put for HMRC – first, that the acquisition of the second option was 'by reason of' the holder’s employment; second, that if this were not the case, it was caught by a deeming provision which extends the scope of the charge. This deeming provision provides, broadly, that where the option (and by extension the security) is made available by a person’s employer or a person connected with that person’s employer, it is to be regarded as available by reason of employment, unless the person by whom the opportunity is made available is an individual and the opportunity is made available in the normal course of the 'domestic, family or personal relationships' of that person. There are number of question marks about the scope of the exclusion for 'domestic, family or personal relationships'. This wording was not addressed in Vermilion, so the scope of this exclusion will remain uncertain except in the most obvious cases.

However, the UTT took issue with the fact that the First Tier Tribunal decision had not, in its view, actively considered whether the acquisition of the option was 'by reason of' the employment, although it did specifically allow HMRC permission to appeal on this point. The First Tier Tribunal had, however, found that, as a matter of fact, the employment was not the 'causa' of the option award. It is not quite clear what was meant here by 'causa' but it probably meant causa causans, or operative/actual cause.

The Upper Tier Tribunal held that whether the option was granted 'by reason of' employment was in fact a question of mixed fact and law, and therefore, by implication one it was entitled to consider on appeal. It then relied on comments of Lord Denning in Wicks v Firth that the employment need not be the sole or dominant cause of the grant for this to be 'by reason of' employment. Applying these comments, it held that since the appointment of the option holder in this case as executive chairman was linked to the grant of the new option, the option was by reason of employment. There was no need, in the Upper Tier Tribunal’s view, even to consider the deeming provision to conclude the appeal in favour of HMRC. The judgment notes expressly that the same commercial outcome could have been achieved by amending the existing option, rather than replacing this with a new option, but considered this irrelevant on the facts.

From a legalistic point of view, this is startling. The judgment of Lord Denning in Wicks v Firth was in 1981, and formed part of a Court of Appeal decision overruled by the House of Lords (as it then was). Further, in the House of Lords, Lord Fraser expressly refused to decide the question of whether the benefit in point (scholarships for employees’ children) would have been 'by reason of employment' independently of a deeming provision which was applicable on these facts. Lord Bridge took a consistent approach, following the reasoning of Lord Templeman on the construction of the deeming provision, and disregarding the question of whether the amounts would, absent this deeming provision, have been 'by reason of employment'. It is strongly arguable that this involved an implied overruling of Lord Denning’s statements, on the basis that, had the scholarships been 'by reason of employment', there would have been no further need to consider the deeming provision on which all three substantive judgments in the House of Lords focused. So this is highly dubious ground from which to extrapolate a broad principle that 'by reason of' should be read as meaning not only 'are (to any extent) by reason of' but also 'are interconnected'.

In Vermilion, while the individual’s appointment as director was seen as a critical element of the restructuring package, it was far from clear that the grant of the new option was, in the ordinary sense 'by reason of' this appointment. On the facts, the reason the new option (or an amendment of the old one) was required seems to have been that the other equity holders were determined that the option holders (the relevant individual and a legal firm) would not escape the consequences of dilution. Insofar as there was causation, the need to restructure the company and put it on a sounder financial footing appears to have caused both the appointment and the new option grant, rather than the option grant (on less favourable terms) being caused by the appointment or vice versa.

We understand that the taxpayer has appealed the decision to the Court of Session and it is to be hoped that this will be an opportunity to reconsider the scope of these provisions. As a minimum, there should need to be a direct causal connection between the employment and the grant of securities to satisfy the ‘by reason of’ test. A further appeal may also offer scope to reconsider the scope of the deeming provision which was addressed by the First Tier Tribunal.

Unfortunately, in the meantime, it will be prudent to make a worst case assumption in any instance where securities are acquired and there is any connection with an office or employment. In fairness to the Upper Tier Tribunal in Vermilion, the reason this point matters is arguably due to flaws in the statutory drafting, which ought to be resolved as a policy matter. However, with current pressure on parliamentary time this type of technical amendment is most unlikely to be treated as a Finance Bill priority.

For now, this also reinforces the importance of making section 431 elections in the case of restricted securities (sometimes on a precautionary basis) and considering valuation issues carefully for certain other types of transaction. The benefit of a section 431 election is that, in exchange for paying either unrestricted market value of shares/securities up front, or paying a relatively small amount of tax (sometimes negligible) up front when shares are acquired (calculated by reference to the difference between the amount paid and the unrestricted market value of the shares), the whole of gain on a subsequent sale remains subject to tax under the CGT regime. But the 14 day time limit for making s.431 elections is very tight, and there is no way of putting the genie back into the bottle once the deadline has expired – or the company is brought to market for a high value a few years later.

We have included some illustrative examples of the problems resulting, indicated here.

Contributed by Rebecca Arthur.

Key contact

Jim Aveline

Jim Aveline Partner

  • Private Client Services
  • Family Offices and Family Businesses
  • Food and Farming

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