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Markel Tax

07 Jul 2020

HMRC Loses Corporation Tax Deductions Case in Court of Appeal

On 21 May the Court of Appeal handed down its judgment in the latest round of litigation in HMRC v NCL Investments Limited & Smith & Williamson Corporate Services Limited [2020] EWCA Civ 663.

The factual background to the case is involved and is set out in our article on the Upper Tribunal decision which can be found here.

In brief, share options were granted to employees of entities within the Smith & Williamson group.  Under IFRS 2 (which is echoed by Section 26 of FRS 102) the employer companies recognised debits in their income statements that reflected the value of the options. Where options lapsed the employer companies were unable to reverse the accounting entries, which meant that the profit of the companies, for accounting purposes, was reduced even though shares had not been acquired by employees.

Following Finance Act 1998 (now enacted in CTA 2009, s 46) a company’s profit for tax purposes is to be calculated in accordance with Generally Accepted Accounting Practice (“GAAP”) unless there is an adjustment required by law to the profit calculated in accordance with GAAP (the prime example being the write-back of depreciation and substitution of capital allowances).

When employees exercised their options the employer companies could claim a corporation tax deduction under Part 12 Corporation Tax Act 2009, but there is no statutory relief where an option lapses. The employer companies amended their open returns and claimed the debits that had been made under IFRS 2 as deductions.

At the Court of Appeal HMRC reprised their arguments in the Upper Tribunal:

  • that the use of the word ‘incurred’ in CTA 2009, s 54 means that a deduction should only be made if there has been an actual cash payment made;

  • that the making of the debits in the employer companies’ accounts was made to comply with GAAP and not wholly and exclusively for the purposes of the employer companies’ trades;

  • that the debits were capital in nature; and/or

  • that the grant of options constituted ‘employee benefit contributions’, because shares were held under the terms of the option for delivery at a future date, therefore the options fell within the scope of the legislation in Part 20 CTA 2009 that prevents contributions to EBTs from being deducted until the employee receives a benefit.

Lord Justice David Richards made short work of these submissions in his judgment:

  • sections 46 and 48 CTA 2009 together define allowable expenses as debits made in accordance with GAAP and do not require any further examination of whether such accounting debits were “expenses” – if HMRC’s submission on section 54 was correct, then the whole basis for basing taxable profits on a company’s accounts would be fundamentally undermined;

  • the purpose of granting the options was to remunerate the group’s employees, the accounting entries were an unavoidable consequence of remunerating the employees;

  • the debits were required to be made in the taxpayers’ profit and loss accounts because they represented the consumption of services provided by the employees to the taxpayers for the purposes of their trades, they were clearly revenue in nature, not capital; and

  • the benefit received by an employee was the option – the acquisition of shares on exercise of the option was not the benefit received by the employee, but the fulfilment of an existing contractual entitlement, the options clearly fell outside the scope of Part 20 CTA 2009.

For these reasons the appeal was refused.

Even though the law has changed, so that deductions cannot be claimed for the accounting entries relating to lapsed options, the case is still of interest; as it highlights that a company’s accounts form the basis for calculating taxable profits unless there is a very clear statutory provision to the contrary.  In doing so it rejects the obiter dicta in Ingenious Games LLP v HMRC [2019] UKUT 226 (TCC), which suggested that one should look beyond the accounts to the economic consequences of a transaction.

The case is also interesting because it shows a certain consistency in the courts’ approach to arguments that fixate on a single word or overly literal readings of legislation: the courts do not tolerate this approach to legislative interpretation when it is taken by tax-payers to avoid tax; there is no reason that they should do when HMRC takes such an approach.

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Tagged Employment taxes and share scheme
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