Employment-related securities – tax charges on conversion

On 14 October 2014, the First Tier Tribunal decision in the case of Bruce-Mitford v HM Revenue & Customs [2014] UKFTT 954 (TC) was released, a ruling on the application of the employment-related securities rules in Part 7 ITEPA 2003 to shares that acquired by a company’s founder before the extensive changes to the law made by Finance Act 2003.

The case involved Mr Bruce-Mitford, the founder of VFB Holidays Limited.  In 2002 a new holding company was inserted above VFB Holidays Limited, VFB Group plc, which eventually went on to be renamed Travelzest plc.

On 31 January 2003 Mr Bruce-Mitford increased his holdings in the company by subscribing for 270,000 deferred shares at their par value of 2p each.  The deferred shares had extremely limited share rights, but included a mechanism by which they would be redesignated as ordinary shares if, on the application of the shareholder, the auditors of the company certified that a transaction had been undertaken that met conditions set out in the rights of the shares.

In October 2005 Travelzest made a substantial acquisition and floated its shares on AIM at 126p per share.  Mr Bruce-Mitford applied to the auditors for their certificate that the transaction met the requirements of the articles of association and his deferred shares were redesignated as ordinary shares on a 1:1 basis.  Mr Bruce-Mitford went on to sell the shares and to report the gains that he had made as taxable under the CGT rules on his tax return.

Before the changes made by Finance Act 2003, the rules on employees’ shares only imposed income tax charges when shares were converted from one class into another because an employee had an immediate or conditional entitlement to convert them.  Mr Bruce-Mitford argued that he did not have an entitlement to convert the deferred shares into ordinary shares, only the right to ask the auditors if the conditions had been met for the conversion to take place and, therefore, his shares would not have been caught under the old rules.

After the changes made by Finance Act 2003, c.3 Part 7 ITEPA 2003 imposes a tax charge whenever securities of one description are converted into securities of another, irrespective of whether or not the conversion takes place because the employee has exercised an entitlement to make the conversion occur.

HMRC raised an assessment on the basis that Mr Bruce-Mitford should have been treated as having received taxable employment income on the difference between the 2p per share nominal value of the deferred shares and the 126p per share at which the ordinary shares were trading.

Finding for HMRC, the First Tier held that the redesignation of the deferred shares as ordinary shares constituted a conversion for the purposes of the revised version of c.3 Part 7 ITEPA 2003. In addition the decision strongly suggests that the tribunal would have come to a similar conclusion if the original version of the legislation was in point.

Moreover, the tribunal confirmed that it does not have jurisdiction to determine whether HMRC should use apply the discretionary practice set out at ERSM40040 and not pursue Mr Bruce-Mitford for tax.

The case serves as a useful reminder of a number of points:

  • The rules on employment-related securities encompass founders and business owners who are also employees or directors – there is no ‘founders’ exemption’;
  • With the exception of the rules on restricted securities, the employment-related securities regime applies to shares and other securities acquired before the rules were changed in 2003;
  • As was the case here, a right written into a company’s articles can give rise to tax charges under the employment-related securities rules; and
  • That the Tribunal has no jurisdiction over HMRC discretionary powers as set out in their manuals.

For further information please contact the TaxDesk on 0845 4900 509 and ask for Thomas Dalby.