Are share options always employment related?

The Employment Related Securities (ERS) legislation in Part 7 of Income Tax (Earnings & Pensions) Act 2003 (‘ITEPA 2003’) was described by Lord Walker in Grays Timber Products v HMRC [2010] UKSC 4 as “complex and obscure”, a point that has been highlighted by the decision of the First-Tier Tribunal in the case of Vermilion Holdings Limited v HMRC [2019] TC07077, which was handed down by Judge Heidi Poon on 8 April 2019.

Vermilion Holdings Limited (“VHL”), a privately held company registered in Scotland, was the holding company of a group of software companies.  In 2006, VHL undertook a capital-raising exercise and engaged the law firm Dickson Minto and a corporate finance advisory company, Quest Advantage Limited (“Quest”) to assist.  As is common in the tech sector, both Dickson Minto and Quest were paid through the grant of share options.  Quest’s option entitled it to acquire 2.5% of the share capital of VHL.

By early 2007, it became clear that VHL was struggling and would go out of business unless further capital was raised.  As a consequence of the refinancing, it was agreed that all of the existing shareholders, including the supplier option-holders would suffer dilution.  A condition of the refinancing was that Mr Marcus Noble, the main shareholder of Quest, should be brought in as chairman of the Company, to be a representative of the investors.

New option agreements were drawn up for both Dickson Minto and Quest to reflect the reduction in their entitlement to the capital of VHL.  On 9 June 2016, a novation was signed on behalf of Quest in favour of Mr Noble, shortly before he exercised the option and subsequently sold the shares in VHL.

Following the exercise of Mr Noble’s options and sale of VHL in 2016, a non-statutory clearance request was made by VHL regarding the tax status of Mr Noble’s options.  HMRC raised a tax and NIC assessment for around£386k on the basis that his options fell within the provisions of s.471 ITEPA 2003 to be treated as ERS options for tax purposes.

VHL, on behalf of Mr Noble, appealed HMRC’s decision on the basis that the 2007 option did not relate to Mr Noble’s position as a director of the Company, but was instead a re-grant of the option that Quest had held.

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:
    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
  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)

“Employment-related securities option” means a securities option, to which this Chapter applies.

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 ERS option 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 relationships of that person.

In considering the issues, Dr Poon did not consider the wording of s471 to be obscure or ambiguous and did not allow the appellant to refer to parliamentary material in their interpretation of the statute. Citing ERSM20210, she stated:

“…it seems to me that the purpose of the provisions under Part 7 of ITEPA is not in doubt: it is to bring into the income tax regime the award of securities or securities options which is employment-related.”

It was held that, as a matter of fact, the options were granted by reason of the 2006 option grants, which were granted for the same reason as the Dickson Minto options: payment for professional services, not by reason of Mr Noble’s subsequent appointment to the board as part of the 2007 refinancing.

 

“The set of facts in the present case is ‘unusual’. Had the Company not gone into difficulties that resulted in the rescue funding exercise in 2007, Mr Noble would have kept his Supplier Option granted in 2006 and would not have to litigate to have his tax liability assessed as capital gains. Had Mr Noble not happened to be the right person to steer the Company out of the difficulties, he would not have been caught by the deeming provision even if his 2006 Option had to be replaced by the 2007 Option.”

Dr Poon’s judgment emphasises the material reality: that the 2007 option granted to Mr Noble was demonstrably not granted to him because of his chairmanship of VHL.  In Dr Poon’s view, the legal fiction created by the deeming provision in section 471 is subordinate to that material reality.

The case is significant, as it is the first to examine the effect of the deeming provisions in Part 7 ITEPA 2003 and section 471 is echoed by the wording in section 421B that 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 advisors 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, leaving Dr Poon to bridge a gap in the statutory regime.

This decision should be treated with caution by advisors: it is a First Tier Tribunal decision and we should expect HMRC to appeal; the facts in the case are quite unusual and it was very clearly demonstrable that Mr Noble’s appointment to the board of the Company was the result of him holding the options, not the other way round. The decision, if it stands, does not reopen the door to “founders’ shares” arguments.

What the decision does show is that the courts are willing to ameliorate the effect of the deeming provisions where the result would, otherwise, be unjust.

For further information on this matter, please contact Thomas Dalby, James Lindon or Liam Hawkins on 0845 4900 509, or email us on taxdesk@gabelletax.com.