The Arrangement
Mr Y was the sole shareholder and director of 'Cyclops Electronics', a firm which specialised in the purchasing and selling of niche electronic components which were either obsolete or hard to find.
In 2004 a company named Davissa Ltd was registered, again with Mr Y as its sole shareholder and director. The new company had intended to commence a new branch of Mr Y's electronics reselling but that never eventuated.
In 2004 Davissa issued £400,000 of loan notes to Cyclops. Cyclops then transferred those loan notes to Mr Y as payment of his salary for the past two years.
The loan note redemption clauses were quite strict and generally at the discretion of Davissa (unfavourable to the note holder, meaning that the 'market value' was quite low for tax purposes). The other point of interest was a 'survival clause' which noted that in the event of Mr Y's death, the loan notes would revert back to the ownership of Cyclops, meaning that the estate of Mr Y would not be entitled to the funds. The survival clause was to last 365 days and was a critical aspect of the tax planning outlined below.
The Issue
Ordinarily these securities would form part of Mr Y's taxable income for the year, being earnings made from his employment as a director. However, Mr Y was planning to utilise s.425 of the ITEPA 2003 to exempt the acquisition of these loan securities from tax. At the time s.425 provided a tax exemption for 'restricted employment related securities'. It was agreed between all parties that the loan notes were employment related securities, however the case hinged on whether or not the loans were 'restricted' employment related securities as per s.423(2)(a), which defined 'restricted' securities as those for which:
"there will be a transfer, reversion or forfeiture of the employment-related securities...if certain circumstances arise or do not arise"
It is the latter half of that definition which was carefully analysed in this case. At face value the section requires a condition to be placed on the security which places on it some form of risk. The 2015-16 CCH British Master Tax Guide implies that the conditions would typically be business performance provisions which incentivise employees to succeed in their career. Provisions like restrictions on the sale of those securities for a number of years, or a restriction on the share price which had to be achieved before a sale of those shares would be permitted, are typical examples of restricted securities. These 'restrictive' provisions effectively render those securities worthless upon acquisition (at that point in time), thus not taxing them until later makes sense.
The key question in this case was whether or not the 12 month 'survival clause' was enough to satisfy the forfeiture risk requirements of s.423 when looking at the loan note arrangement as a whole.
The Contentions
The HMRC argued that Supreme Court precedents require employee security issues to have some kind of commercial purpose.1 It argued that the legislation's purpose was to exempt from tax those security options which have genuine commercial restrictions (similar to the Master Tax Guide's comments). To achieve this end the HMRC raised the 'Ramsey Principle', a principle which courts can invoke to remove tax benefits obtained by non-commercial behaviour where parliamentary intention supports that approach. Further to the HMRCs case was the fact that Mr Y was a director of all entities involved and thus all 'restrictive clauses' were not really that restrictive if Mr Y could simply change the clauses at a later date. In its view the issue of loan notes was an ordinary wage payment and taxable on the day of issue as per usual under the Income Tax and National Insurance regimes.
Council for Mr Y (Mr Sherry) took a much broader view of the legislation, judicial precedents and parliament's intention. He contended that s.423 required a 'circumstance' of the security to be conditional, and that the survival clause was precisely that. Thus in his view s.425 was satisfied and the loan notes were not to be taxable upon acquisition by the taxpayer. Judicial precedents referring to a 'commercial purpose' were in his view quite broad and were met by the fact that Davissa had a business plan set in place which would put the funds to a commercial use. Lastly, in his view parliament intended for a degree of flexibility in claiming the exemption and thus he rejected the HMRCs approach.2
The Decision
Firstly, the Tribunal ruled that the 'survival clause' was insufficient:
"There was no business or commercial purpose for including the forfeiture provision in Clause 9.1 of the Davissa Loan Note. That forfeiture provision was commercially irrelevant and designed only to secure the benefit of the tax exemption in s425 of ITEPA. I have reached that conclusion because Mr Y accepted in cross-examination that he had no independent reason (whether as a director of Cyclops or in his personal capacity) for wanting the forfeiture provision to be included and it was included purely on Charterhouse’s advice. Mr Edmond’s evidence did not suggest any business or commercial purpose for the forfeiture provision and, in cross-examination, he explained that the forfeiture provision was essential if the planning was to have the desired result (as it was the forfeiture provision that enabled the Davissa Loan Notes to be “restricted securities”). Moreover, there was no evident link between the forfeiture provision and any aspect of the commercial activities of Cyclops, Davissa or Mr Y."3
In regard to the nature of the payment and whether or not it was taxable, the Tribunal agreed with the HMRC and likened the creative form of payment to Mr Y to a typical deposit into an employee's bank account, and thus ruled (quite philosophically) that the loan note issue was taxable under general Income Tax and National Insurance legislation, see below.
(Note, the decision was referring to Cyclops and 'Graceland' - the second appellant with the same scheme)
"If Graceland and Cyclops had paid cash into the Employees’ bank accounts equal to the principal amounts of their holdings of Loan Notes, there could be no doubt that they would have made a payment of cash to the Employees for both PAYE and NIC purposes. In legal form, if cash were paid into their bank accounts, the Employees would acquire a debt claim (or increased debt claim) against their banks. The credit balance of their accounts would be at the Employees’ disposal, but they might need to take certain steps to secure payment of that debt claim. For example, if they wished to withdraw cash from their accounts, they would need to give notice to their bank, would probably have to provide appropriate identification and might have to comply with daily transfer limits. If they wished to transfer the balance of their account to someone else as payment for goods or services, they would need to comply with the bank’s terms and conditions as to the manner in which they could deal with the debt claim represented by the credit balance on their accounts. Thus, in such a paradigm case of a “payment”, the Employees would in legal form be receiving a debt claim (or increased debt claim) which they had an immediate contractual right to turn into cash. However, they would need to take some steps before they could actually turn that debt claim into cash.
When the Employees received their Loan Notes they were not in any material respect in a different position from that set out [above]. On receipt of the Loan Notes, they had an immediate contractual right to require redemption of their Loan Notes at their face value and all of the issuers of the Loan Notes had sums on deposit that were sufficient to enable them to redeem the Loan Notes in full. The issuers of the Loan Notes had the contractual right not to pay the redemption proceeds for a period of time. However, that is not in any material respect a different position from a bank requiring a period of notice before sums can be withdrawn from an account. In any event, the Employees could use their influence as directors and shareholders of the issuers of the Loan Notes to ensure that payment was made immediately as I have found at [35] and [57] and, even after the First Redemption Period and Second Redemption Period expired, the Employees could still have ensured that their Loan Notes were redeemed immediately as I have found at [37] and [57].
...
Therefore, applying the approach that Lord Drummond Young set out in Aberdeen Asset Management, I consider that, when the Employees received the Loan Notes, the principal amount of those Loan Notes was placed unreservedly at their disposal. Therefore, they received “earnings” in the form of cash and the measure of those earnings was, accordingly, the principal amount of the Loan Notes. “Payment” of those earnings was made for PAYE purposes when the Employees received those Loan Notes.
Even without Lord Drummond Young’s extensive analysis in Aberdeen Asset Management, I would have reached the same conclusion based on DTE Financial Services. Given that the concept of “payment” is a “practical, commercial concept”, I would have no hesitation in concluding that, when the Employees received the Loan Notes, taking into account the totality of their rights as shareholders and directors of the issuers of those Loan Notes, they received “earnings” in the form of cash and that “payment” of those earnings was made when they received their Loan Notes."4
Current Law
The legislation in question has since been updated and now provides for a method of calculating reduced tax on just 'shares' as opposed to all 'securities'. The tax exemption for restricted shares is now found in s.426.
Notes
Case [2016] UKFTT 0487 (TC): http://www.bailii.org/uk/cases/UKFTT/TC/2016/TC05237.html
1. p68
2. p69
3. p32
4. p96, 97, 99 & 100
Legislation
2. p69
3. p32
4. p96, 97, 99 & 100
Legislation
Income Tax (Earnings and Pensions) Act 2003
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