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TaxationWeb by Burges Salmon LLP

Burges Salmon LLP outline recent legislative changes regarding employment related securities, and highlight a potential quirk in the rules.

Employment Related Securities – Finance (No 2) Act 2005 changes

The rules relating to employee share acquisitions were completely rewritten in Schedule 22 to the Finance Act 2003 in an attempt to put a stop to the use of arrangements involving shares and securities as a way of avoiding income tax and NIC on what were, in commercial terms, payments of remuneration.

However a number of loopholes in Schedule 22 have been highlighted by the new regime for the disclosure of tax-avoidance schemes. In an attempt to prevent this exploitation, Finance (No 2) Act 2005 introduces a number of detailed technical amendments to Schedule 22 and also a number of more general anti-avoidance tests.

These tests introduce a requirement that the purpose (or one of the main purposes) of the arrangements under which the right or opportunity to acquire the employment-related securities is made available is not the avoidance of tax or national insurance contributions. They have been inserted throughout Schedule 22 and the consequences if they are satisfied should be carefully considered. Some examples are as follows:

1. Certain securities normally outside the scope of the restricted securities regime will be brought within it, for example, securities which are forfeitable on cessation of employment for misconduct.

2. If the securities are restricted, a section 431 election will be deemed to have been made with the result that there will be an automatic upfront market value tax charge by reference to the unrestricted market value of the securities.

3. The tax liability on the acquisition of convertible securities must be calculated with reference to the right to convert, when usually it would be ignored when valuing the securities.

4. The normal notional loan rule is disapplied where securities are acquired at an undervalue or not fully paid up, and instead, an amount equal to what would normally have been the notional loan is treated as employment income in the year in which the acquisition takes place.

A further very important development in this area was the Paymaster General's statement on 2 December 2004 in which she stated,

"I am therefore giving notice of our intention to deal with any arrangements that emerge in the future designed to frustrate our intention that employers and employees should pay the proper amount of tax and NICs on the rewards of employment. Where we become aware of arrangements which attempt to frustrate this intention we will introduce legislation to close them down, where necessary from today."

This clear announcement of the intention to introduce retrospective legislation to 2 December 2004 should be kept in mind together with the new anti-avoidance tests whenever schemes involving employee shares are being considered.

S 425 ITEPA - Oddity or Opportunity?

Now that the dust is starting to settle on the provisions of FA 2003, Sch 22, which inserted Income Tax (Earnings and Pensions) Act 2003, Part 7 (references in this article to Chapters are to Chapters of Part 7), various oddities in those provisions are starting to emerge. Chief among those oddities are the provisions now contained in s 425 ITEPA 2003.

The starting point in understanding these provisions is the general rule that if an employee acquires shares for less than their market value, he or she normally pays income tax on the difference. For instance, if an employee pays £2,000 for 2,000 ordinary £1 shares, but their market value is actually £10,000 then normally the employee will pay income tax on the £8,000 difference. This was decided in the case of Weight v Salmon (1935) 19 TC 174.

Overlaying this general rule, the restricted securities provisions (Chapter 2) now force employees not only to pay market value for their shares, but to pay ‘unrestricted market value’ or UMV. If an employee fails to pay UMV then either part of the eventual sale proceeds will be subject to income tax, or the employee can elect to pay income tax upfront (a ‘s 431 election’).

But here is the oddity. If an employee acquires restricted securities and certain other conditions apply, the employee can pay nothing at all for those securities, and yet pay no upfront income tax charge either. This relief is granted by s 425.

Section 425 is an oddity because, not only does it save the employee from having to pay UMV, it also saves the employee from having to pay bare market value.

It might be imagined that a relief like this comes hedged about with conditions. But strangely, the conditions are minimal. The shares must be restricted securities because of a forfeiture provision. And that forfeiture provision must fall away within 5 years.

Presumably the Government's thinking here is that when the restriction falls away, this will be a ‘chargeable event’ and a big income tax charge will arise at that point on the uplift in value. This is confirmed by the fact that s 425 contains its own election regime akin to s 431 elections.

However, the definition of ‘chargeable event’ has yet to be fully tested and it may be that chinks emerge in it. If so, then having obtained s 425 treatment at the outset, may prove to be very worthwhile indeed. We suspect that it is for this reason that the Finance Act 2005 introduced a bona fide commercial purpose test into s 425. Time will tell whether this is effective.

But why include such a provision in the legislation in the first place? It appears that the policy rationale behind s 425 is to enable US-style restricted stock plans to be taxed in the same way as share-options. Under such restricted stock plans, the employee may acquire shares on day 1 but have to forfeit them if he or she leaves within a set period. Economically it is difficult to distinguish such plans from a share option for the same period. Section 425 was presumably included in the legislation, therefore, to give such plans parity with share options.

Corporation Tax

It is when one comes to consider the corporation tax position, however, that the opportunities inherent in s 425 start to become clearer.

If the s 425 securities are issued by the employing company itself then the corporation tax position is straightforward. Under FA 2003, Sch 23 para 22(5) there is no corporation tax relief unless and until a chargeable event occurs.

However, if the employing company gives s 425 shares in a subsidiary company to an employee, then there is an argument that corporation tax relief is available on general common law principles - assuming, of course, that the payment is made wholly and exclusively to benefit the employing company's trade. The anti-EBT provisions in Finance Act 2003 do not appear to apply as there is no third party to whom the employing company has transferred an asset to use on behalf of employees.

As mentioned above, if the obtaining of this corporation tax deduction is one of the main purposes of the arrangements, then s 425 will be ineffective to prevent an upfront income tax charge. Subject to that, however, s 425 seems to have re-opened the possibility - finally closed by Dextra - of obtaining a timing mismatch between corporation tax deduction and income tax charge.

Couple this with possible chinks in the definition of ‘chargeable event’ and s 425 begins to resemble a distinct opportunity.

Practical consequences

While great care is needed with s 425, the following practical opportunities may present themselves:

1. Consider whether to use restricted stock-plans rather than conventional share options.

2. Creating such plans in subsidiary companies may give an immediate corporation tax deduction.

3. Such plans may also be of interest to:

(a) Owner-managed companies wishing to reduce headline profits,

(b) Companies for whom a formal demerger is not suitable, using the five year deferred tax break offered by s425 as an alternative to distribution treatment.

Disclosure of Tax Avoidance Schemes

The above description of s 425, being general in nature, does not in our view constitute "making available" of a tax scheme within the provisions of FA 2004, Part 7. However, we have nonetheless made provisional disclosure of these opportunities to HMRC under those provisions and obtained a scheme reference number for them.

January 2006

Burges Salmon LLP


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