Side-stepping complexity: tax on termination of employment

In a decision published on 10 August 2015, the FTT ruled partially against HMRC in the case of Sjumarken v The Commissioners of Her Majesty’s Revenue and Customs [2015] UKFTT 0375 (TC), which concerned the tax treatment of share awards received by an employee on being made redundant.

The case is of interest, as it reiterates the proper treatment of employee share options and casts light on the evidential requirements for an employee to demonstrate that shares are restricted shares, but also because of a point that HMRC failed to raise, the restricted securities regime.

Background

The background to the case is that Mr Sjumarken was employed by BNP Paribas (“BNP”) and had entitlements under two of BNP’s share schemes, one entitled the 2004 Share Incentive Plan (“the SIP”) and a second which consisted of long dated options over 3,000 BNP shares (“the Options”).  The Options could be exercised up to ten years following their date of grant, which was March 2003.  Mr Sjumarken also had entitlements under the company’s Cash Incentive Plan, which was a form of long term bonus arrangement.

Mr Sjumarken’s employment with BNP came to an end in 2006 and, under the terms of a compromise agreement, Mr Sjumarken’s SIP shares were transferred to a trading account in his name, a cash payment of £56,863 in respect of his interest in the Cash Incentive Plan and a cash termination payment of £117,450. BNP operated PAYE at basic rate on these amounts and also on the value of the SIP shares, which it calculated as being £144,632, based on the listed price of the shares.

Under the rules of the SIP, a redundant employee was entitled to receive their SIP shares and would be free to sell them immediately.  In practice, Mr Sjumarken found that he was unable to sell the shares for a number of years, as the company regarded him as being bound by restrictions on the right to transfer the shares until certain time periods had elapsed.

In his tax return, Mr Sjumarken initially did not include anything for the SIP shares, as he was under the mistaken impression that the SIP was an approved share scheme under the SIP Code of ITEPA 2003. As there was a manifest disparity between the amounts returned by BNP and the numbers in Mr Sjumarken’s tax return, HMRC enquired into his return and claimed tax on the difference between the amounts returned by BNP and by Mr Sjumarken.

The appellant’s case

In the case before the tribunal, Mr Sjumarken made two arguments: that the value of the SIP shares that was subject to tax should be reduced because the shares had restrictions attaching to them; and that the Options were valuable and, by giving them up, he was giving valuable consideration for the termination payments that he was receiving, with the result that the amount subject to tax should be reduced by the value of the Options.

The Options

On the Options, HMRC argued that the options had lapsed by the operation of the rules of the option scheme, not by reason of any conscious act on the part of Mr Sjumarken – their lapse was an inherent characteristic of the Options.  In the alternative HMRC argued that the rules on employment-related securities options in chapter 5, Part 7 ITEPA 2003 meant that if Mr Sjumarken had released the Options for consideration or if he had received consideration for allowing them to lapse, then that consideration would, itself, be treated as a receipt of taxable employment income: Mr Sjumarken would not be able to reduce the amount of tax payable by advancing this argument.

The tribunal found in favour of HMRC on this point.

The SIP shares

On the SIP shares, HMRC argued that these were quoted shares and the rules of the plan said that they would be transferred to a leaver without restrictions; there was no basis to discount the shares to reflect the restriction upon them.

The tribunal held that Mr Sjumarken had adequately demonstrated that the SIP shares did carry restrictions, notwithstanding the rules of the SIP, because he had attempted to sell the shares and his request to do so was refused on the basis that there was an unexpired holding period on them.

Citing Commissioners of Inland Revenue v Crossman [1937] AC 26, the tribunal held that the restrictions on the shares should be taken into account in valuing them and instructed HMRC to remit the case to Shares and Assets Valuation to agree a suitable valuation.

Analysis

The decision of the tribunal in respect of the Options is clearly correct: Mr Sjumarken’s options were employment-related securities options that were clearly within the scope of chapter 5, Part 7 ITEPA 2003: any value that had accrued in the Options was always going to be treated as taxable employment income; even if the tribunal had accepted that the Options had not simply lapsed and were released in consideration for an element of the payment that he received under the compromise agreement, the charging provisions in chapter 5 would still have treated the amounts received as taxable employment income.

The decision in respect of the SIP shares is more problematic, as a key element of the employment related securities legislation was not referred to in the judgment and does not seem to have been raised in argument by either of the parties: the rules on restricted securities set out in chapter 2 of Part 7.

Absent the restricted securities rules, s 421 ITEPA provides that the market value of a security is to be determined in accordance with Part VIII TCGA 1992. Where a share is a quoted share, then s 272 TCGA provides that the value of that share will be the price set out in the Official List.  The only exception to this rule is where “…in consequence of special circumstance prices quoted in that List are by themselves not a proper measure of market value…”, typical examples being where shares are very thinly traded, which can mean that the price quoted on the official list may represent trades that took place a period of time in the past or may reflect other market distortions, like “fat-finger” trades.  The valuation methodology in Part VIII TCGA explicitly excludes any rights or restrictions that are personal to a particular shareholder and not to all shareholders.  On this basis, the tribunal would have been wrong to look to Crossman (which considered the value of a freehold tenanted estate) and should have disregarded the restrictions.

However, chapter 2, Part 7 ITEPA provides that where an employee suffers a restriction on his rights to dispose of shares, an employee will only be taxed on the restricted value of those shares when he or she becomes entitled to them.  The quid pro quo for this relief is that the employee will then be treated as being in receipt of taxable employment income when the restrictions are lifted.  The amount subject to tax on the lifting of the restrictions will be a proportion of the market value of the shares when the restrictions lift calculated by reference to the value effect of the restrictions: if the effect of the restrictions when the shares were originally released to Mr Sjumarken was to depress their value by 10%, then 10% of their value when the restrictions lapsed would be treated as taxable employment income.  It is possible to elect out of this regime and be taxed in full up-front, but there was no evidence in the reported case that this was considered.

Because of the way that charges under the restricted securities regime are calculated, if the share price goes up during the period that the restrictions are lapsing (as the BNP price did between 2006-2008, the restricted period for Mr Sjumarken’s shares), then an employee can end up paying a higher tax-bill than he would otherwise have done if his shares were not restricted when he originally acquired them or if he had elected out of the restricted securities rules.

It seems strange that the restricted securities rules were apparently not raised by either party to the case or referred to in the judgment, as they are such a central part of the regime in Part 7 ITEPA: although the judgment seems to get to the right position for tax year 2005/06, it seems to do so without reference to the law as it currently stands and it ignores the possible future liabilities that Mr Sjumarken would have faced in subsequent fiscal years.

As was said at the outset, the case is of interest because it highlights the proper treatment of employment related shares options – many employees and some advisers are under the impression that option gains can be treated as capital or that selling on or releasing share options can be a way to escape the income tax rules.  The case also rams home the point that the rules on employment-related securities apply irrespective of the quoted or unquoted status of shares that an employee acquires and serves as a reminder that these rules need to be considered wherever one is advising an employee or a company on proposed transactions involving shares.

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