Companies often issue shares or share options to retain, reward, or incentivise their employees. Where employees receive shares or other forms of securities from their employer by reason of their employment, the money’s worth of the shares less any amount paid is normally taxed as earnings.
The employment-related securities regime is outlined within the Income Tax (Earnings and Pensions) Act 2003. The objective of the provisions is to combat avoidance of income tax and NICs.
All shares and securities acquired in connection with an employment come within the scope of the employment-related securities regime. This includes those received by Directors, officeholders, and employees.
‘By reason of employment’?
Throughout the legislation, a similar application is made that contains both a causal test and a deeming provision to consider whether the acquisition is, “by reason of employment”.
The causal test applies as follows:
Applies the provisions of the relevant chapter to securities/interest in securities/securities option acquired by a person where the right to acquire the securities/interest in securities/ securities option is available by reason of employment of that person or any other person.
The deeming provision applies as follows:
A right or opportunity to acquire securities/an interest in securities/securities option is made available by a person’s employer, or by a person connected with a person’s employer, is to be regarded for the purpose of the causal test as available by reason of an employment of that person unless:
- the person by whom the right or opportunity is made available is an individual; and
- the right or opportunity is made available in the normal course of the domestic, family or personal relationship of that person.
This exemption from the deeming provision (set out at 1 and 2 above) is often referred to as the friends and family exemption.
The application of these tests has been looked at in detail in the case of Vermilion Holdings Ltd v R & C Commrs. This was recently considered by the Supreme Court and overturned the previous decision of the Court of Appeal and finding in favour of HMRC that share options were deemed to be granted “by reason of employment” due to the deeming provision (described above).
As Lord Hodge noted in his judgment, the inclusion of the deeming provision (in this instance included within s.471(3) of ITEPA 2003), provides a “bright line rule” that will result in the security being treated as having been made available by reason of the person’s employment, unless the friends and family exemption applies.
The facts of Vermilion
In 2006, Vermilion granted an option to Quest Advantage Ltd (‘Quest’), which was owned by Mr Noble, to acquire up to 2.5% of the company’s shares. This was part of a supplier option granted in exchange for the production of a business plan and financial projections.
In 2007, as Vermilion was underperforming, and, as part of a rescue funding package in which the other shareholders would suffer dilution, the option was to be varied to reduce the entitlement of Quest. A new option agreement was entered into that replaced the 2006 agreement, which reduced the entitlement of Quest to 1.5% over a new share class.
One of many preconditions of this rescue package was that Mr Noble be appointed as an executive chairman of Vermilion. When the prospect of a sale of Vermilion to a US company arose, a novation agreement was entered into by which Mr Noble replaced Quest as the holder of the 2007 option.
On the sale that took place in 2016, Mr Noble exercised his option and sought clearance from HMRC that the gain made on the option — being £636,238 — would be subject solely to capital gains tax. HMRC’s opinion was that the 2007 option was an employment-related securities option, and that the taxable amount of the gain would count as employment income of Mr Noble in the relevant tax year. Moreover, as the shares were readily convertible assets this was assessable via PAYE. So, HMRC had assessed Vermilion for £285,148.76 of income tax payable via PAYE and for £100,709.98 of National Insurance Contributions.
The Supreme Court held that the causal test did not even have to be considered here as the deeming provision should be the first consideration. It was held that in this case, Vermilion did grant the option to Quest while Mr Noble was its employee, and as such, it should be treated as an employment-related security.
Further, whilst First Tier Tribunal and Inner House both considered that the application of the deeming provision in these circumstances produced an absurd, anomalous, or unjust result, as it reached a different conclusion to the conclusion they had reached when considering the causal test. In his judgment, Lord Hodge stated that in doing so they “put the cart before the horse”, given the deeming provision was included by Parliament to avoid considering the causal test.
What does this mean for me?
The Supreme Court’s ruling is very clear: where a director, officeholder, or employee receives securities from their employer, these will fall within the employment-related securities regime. The actual motivation behind the receipt of the securities is irrelevant.
This ruling highlights the importance of taking advice when issuing any type of security or securities option to employees. This is to avoid walking the individuals into significant income tax charges and creating potential liabilities for the company later down the line. The value of any security being issued or exercised should be considered carefully to calculate the tax consequences.
Another point to note from this case is that, despite the share option being granted to Mr Noble’s personal service company, albeit it was later novated to Mr Noble personally, he was still deemed by the Supreme Court to have received this by reason of his employment at Vermilion. As such, it would seem where personal service companies are involved, the owners of the personal service company and the individual are viewed as one. Using a personal service does not, therefore, enable individuals to escape the employment related securities regime.
Things to consider
Where employees are receiving securities, section 431 elections should be considered. Private companies’ shares are usually ‘restricted securities’ for tax purposes due to restrictions on transfer or disposal within the company’s Articles, which affect the value of the shares. Where these restrictions exist, an election known as a s.431 election, can be entered into jointly by the employer and employee within 14 days of the acquisition. This election opts the recipient of the shares out of the restricted securities taxing regime.
As a result, the employee will have a higher income tax charge on acquisition, as it is calculated on the higher unrestricted market value of the shares. However, on eventual disposal of the shares, the employee will only be subject to capital gains tax — no further income tax under the restricted securities regime will arise.
Should the disposal of securities arise on an exit, such as in the case of Vermilion, securities will be deemed to be readily convertible assets. If a section 431 has not been entered into, a further income tax charge would be payable via PAYE, along with National Insurance Contributions. As demonstrated in Vermilion, this can add up to a significant tax charge. And it’s also a key area considered during a due diligence process.
Company obligations
There are also reporting obligations on the company where a transaction falls within the employment-related securities regime — an ERS annual return must be filed with HMRC by the 6 July following the end of the tax year. Penalties are payable for failing to make these returns on time.
Taking advice at early stages
When high growth companies are in their infancy, issues often arise in relation to employment-related securities when advice has not been sought. While taking advice is a cost to start-ups — when budgets are often tight — the cost of not taking the correct advice can, in the long run, be significantly higher.
Author: Sarah Dobbs, CT: Entrepreneurial Tax