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Markel Tax

22 Jun 2020

HMRC v Vermilion Holdings (2020) – the UT’s decision

The Upper Tribunal (UT) in HMRC v Vermilion Holdings Ltd [2020] UKUT 162 (TCC) (published on 27 May 2020) found that the granting of a share option to a director, where that option replaced a previous option was an employment-related securities option.  This case reverses the earlier First-tier Tribunal (FTT) decision which found that the option in question was not an employment-related securities option.

The main issue before the UT was whether the gain on the exercise of a share option was chargeable to income tax.  This depended on whether the right to acquire the shares was made available ‘by reason of an employment’ and would, therefore, be treated as an employment-related securities option under s 471, Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). 

Principally this is a case about whether or not the grant of a share option was by reason of an individual’s employment.  If the grant of the share option was indeed so, then the profit on option exercise would be treated as employment income and, on the facts, chargeable to income tax and NIC pursuant to Chapter 5, Part 7 ITEPA 2003.  If it was not, then any gain on the subsequent disposal of the shares would be charged to capital gains tax, a substantially lower rate.

In brief, the background and facts before the UT were as follows:
Mr N (N) had provided consultancy services as part of an equity fundraising exercise to Vermilion Holdings Ltd (V). In return for those services, and in lieu of paying fees, V had granted an option over shares to N’s nominee company, (Q).  This option had originally been granted in 2006.  V subsequently came into grave financial difficulty and, as part of a rescue package with investors, N was appointed as a director and executive chairman of V. 

The rescue package had been conditional on N becoming director and chairman, and the cancellation or amendment of his 2006 option.  It was noted in submissions that the 2006 option was essentially worthless.  On N becoming a director, it was decided that his 2006 option be cancelled and a new share option was granted in 2007 to Q.  In 2016, Q novated the 2007 option to N personally.

Under N’s executive chairmanship from 2007 onwards, the performance of V (and the value of his 2007 option) both improved considerably.  N later exercised his 2007 option in November 2016 in anticipation of the sale of the entire issued share capital of V to a subsidiary of a major listed US corporation.  The gain on the exercise of the 2007 option was in excess of £630,000.

In August 2017, HMRC decided to assess V for income tax under PAYE and Class 1 NICs in relation to the 2007 option exercised by N in the tax year 2016/17.  This amounted to circa. £385,000.

The point of contention was the interpretation of s 471 ITEPA 2003:

471  Options to which this Chapter applies

(1)     This Chapter applies to a securities option acquired by a person where the right or opportunity to acquire the securities option is available by reason of an employment of that person or any other person.

(2)     For the purposes of subsection (1) “employment” includes a former or prospective employment.

(3)     A right or opportunity to acquire a securities option made available by a person's employer, or a person connected with a person's employer, is to be regarded for the purposes of subsection (1) as available by reason of an employment of that person unless—

(a)   the person by whom the right or opportunity is made available is an individual, and

(b)   the right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person.

(4)     A right or opportunity to acquire a securities option available by reason of  holding employment-related securities is to be regarded for the purposes of subsection (1) as available by reason of the same employment as that by reason of which the right or opportunity to acquire the employment-related securities was available.

(5)     In this Chapter—
“the acquisition”, in relation to an employment-related securities option, means the acquisition of the employment-related securities option pursuant to the right or opportunity available by reason of the employment,
“the employment” means the employment by reason of which the right or opportunity to acquire the employment-related securities option is available (“the employee” and “the employer” being construed accordingly), and
“employment-related securities option” means a securities option to which this Chapter applies.

In summary, a right or opportunity to acquire a security made available by a person’s employer, or a person connected with a person’s employer, is to be regarded as an employment-related securities option unless:

  1. the person by whom the right or opportunity is made available is an individual, and

  2. the right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person.

This deeming provision echoes the wording in section 421B, which determines whether shares are employment-related securities and within the scope of the charging regime in the rest of Part 7.  The effect of the deeming provisions is to treat almost all shares and options acquired by directors, including founder directors, as being employment-related, frequently to the frustration of advisers and business owners.

If this case had involved shares instead of options (i.e. that Quest/Mr Noble acquired shares long before his appointment to the board was in prospect and those shares were subsequently replaced or exchanged for a new shareholding), then section 421D would have treated the new shares as having been acquired for the same reasons as the old shares and the deeming provision in section 421B would not have been in play.  However, there is not an equivalent provision to section 421D in the rules governing options.

The FTT had previously considered that the 2007 option did not meet s 471(1) as the it was made available as a result of the surrender of the 2006 option and not as a result of employment.  The FTT had also, somewhat controversially, found that the factual background to the grant of the second option as over-riding the deeming provision in section 471(3). 

HMRC’s appeal had two limbs:

  • that the reasons for granting the option were a composite – the company was in recovery mode, the earlier options were worthless and a key element of the recovery package was the appointment of Mr Noble to the board – Mr Noble was, in part, granted the new option because he was joining the board and therefore fell within s 471(1); and

  • the deeming provision of s 471(3) cannot be over-ridden and will apply irrespective of the factual motivation for granting the option.

In allowing HMRC’s appeal, the UT found that the requirements of s 471(1), ITEPA 2003 were satisfied: the opportunity for N to acquire the 2007 share option was made available at least in part by reason of his employment with V.  The 2007 option had been granted to N both to replace the 2006 option, but also as part of a package of measures which included the employment of N. The 2007 share option was, therefore, an employment-related securities option. 

The UT did not consider that it was necessary to consider the parties’ submissions on the effect of s 471(3), the proper interpretation of which seems to have been left hanging by the FTT decision.

While not directly relevant to the exact facts of this case, advisers may ponder whether the same decision would have been reached by the UT had N decided to amend his 2006 option, rather than cancel it and accept the grant of the new 2007 option.

This case does highlight the difficulties that companies face when they are granting options and issuing shares to investors who subsequently take a position on the board, as often happens in start-up companies: they must always be mindful of the tax implications and the wide ranging tax avoidance legislation and it is important to take specialist advice before adjusting or replacing shareholdings or options.

Markel Tax are specialists in employment taxes and also advise a range of companies on their incentive arrangements.  

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