Share Options

Introduction

Share options had been granted to two directors. The company did not pay PAYE in respect of the tax due on the exercise of the options. Legislation provided that in such a situation the employer was entitled to seek the PAYE from the employee. Where the employee did not provide the funds within 30 days, the employee was subject to tax as a benefit.

The Facts

The company, a private limited company, was incorporated in February 2000. The day after incorporation, the two taxpayers were appointed directors. Each of these directors subscribed for 5 20p shares as at that date having sub-divided the normal 2 £1 subscriber shares into 10 20p shares. Further shares were issued in April of that year. Options were also granted at that date. Finally, on that date an Unapproved Executive Share Option Scheme was entered into.

In March 2001 the entire issued share capital and options in the company were exchanged for shares and options in another company. The two directors exercised their options (over the new company) later in 2001. The company did not deduct any PAYE, employer's or employee's national insurance on the exercise of the options in 2001, on the grounds that they believed the options obtained by the two directors were not obtained by reason of employment.

In submitting their income tax returns for the relevant tax years, one of the directors included the gain on the exercise of the options while the other did not. The director who had not included the gains wrote to HMRC requesting that the return be amended to include the gain. The company sent a letter to HMRC later in the year advising that it had paid the taxes and NICs due on the exercise of the options.

HMRC commenced an enquiry into the affairs of the taxpayer who had included the gain in his tax return. Subsequent to correspondence and discussions, HMRC issued a closure notice to the taxpayer amending his return, resulting in additional tax due of £174,459.60. A Regulation 80 Determination was issued to the other taxpayer. Both taxpayers appealed.

The Issue

The issue was whether tax paid by an employee in respect of the options outside of the 30 day period should still be treated as a benefit in the hands of the employee.

The Decision

According to HMRC, the correct legislative position was that the exercise of these options should have resulted in the company remitting the PAYE tax and secondary (but not primary) National Insurance Contributions at the time of exercise. It would then have been for the company either to have obtained repayment of the PAYE tax from the individuals within the stated time limits, or to declare the benefit.

Appellants Arguments

The company had ultimately accepted that the options over shares had been granted by reason of the directors’ employment. The options had been granted at the time of issue of shares in the first company. The directors and the company had considered that there was a respectable argument that the options had been granted to the directors as “promoters”, but the company did not want to embark on expensive litigation to establish this.

It was accepted that the notional gains were subject to PAYE by the employer. The company as employer had been unable to operate PAYE, because of the absence of funds. If the employer was unable to deduct, this meant that the employer had to go to the employee for the balance due. The two returns showed this to be the case.

It was not appropriate in the present case to apply the benefit legislation, which was considered anti-avoidance, on the basis that this was not a case where HMRC would have failed to receive, either from the employer or from the employees, the tax arising on the exercise of the options.

HMRC Arguments

As the taxpayers had not reimbursed to their employer the Schedule E tax payable on the notional gains within 30 days of the date when those gains had arisen, a tax charge under the benefits legislation did apply to them in respect of the tax not reimbursed within that time.

Where an employer was required to operate PAYE in respect of a notional payment such as the notional gain arising on the exercise of a share option, it was impossible for the employer to deduct tax in the conventional manner associated with PAYE. The deduction should first be from actual payments made in respect of such income at the same time or later in the income tax period in which the notional payment occurred. If the employer was unable to deduct a sufficient amount to cover the PAYE tax due, the employee had to account for the balance.

The Special Commissioner dismissed the taxpayers’ appeals.

The basis on which the benefits legislation was framed was considered clear by the Special Commissioners. It suggested a normal expectation that there would be a prompt reimbursement within the relatively short period of 30 days.

The judgment is available online at http://www.bailii.org/uk/cases/UKSC/2008/SPC00727.html.