HMRC has won a long-running case against a software company after the Supreme Court ruled that a share option given to a director should be taxed as employment income
The appellants, Vermilion Holdings (Scotland) Limited, were disputing a tax bill for PAYE in the sum of £285,148.76 and £100,709.98 in National Insurance contributions, totalling £385,850.
The liability for the tax rested with an individual taxpayer, software engineer Marcus Noble, who was a co-founder and director of Vermilion Software and had received a share option in the company following a rescue funding package.
HMRC argued that the option was an employment-related securities option, subject to income tax.
The appeal to the Supreme Court was the last chance for Vermilion Holdings to resolve the tax dispute after hearings at the First Tier Tribunal in 2019, Upper Tribunal in 2020 and Court of Session (Scotland), the latter decision which was appealed by HMRC.
The case revolved around the meaning of section 471 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA), which sets out when an option to acquire securities or shares in a company is granted ‘by reason of employment’ and therefore subject to income tax rather than capital gains tax.
In 2006, Vermilion Holdings Ltd granted an option to Quest Advantage Ltd to acquire shares in Vermilion. By the end of 2006, it became clear that Vermilion was underperforming. As part of a rescue funding package, Vermilion and Quest agreed to amend the 2006 option. In July 2007, Vermilion and Quest entered into a new option agreement (the ‘2007 option’), under which Quest subscribed for a new class of shares in Vermilion and the 2006 option expired.
In 2016, Quest transferred the 2007 option to Noble. Quest asked HMRC to confirm that this transfer was subject to capital gains tax. HMRC disagreed, informing Quest that it was subject to income tax as it had been granted to Noble because of his employment as a director of Quest.
On 18 November 2016, accountancy firm French Duncan acting for Noble and Vermilion, submitted a non-statutory clearance request to HMRC. In that request, the agent asked for HMRC’s agreement that the gain, in the sum of £636,238 on the exercise of the 2007 option by Noble, was liable to capital gains tax.
On 14 December 2016, HMRC confirmed its view that the option granted on 2 July 2007 was an employment-related securities option, since the grant of the option is not an excepted option covered under s 471(3) ITEPA.
HMRC argued that the exercise of the option was a chargeable event within s477 ITEPA, and the taxable amount of the gain on acquiring the securities counts as employment income of Noble in the relevant year.
The Supreme Court unanimously allowed the appeal.
The judgment stated: ‘Subsection (3) creates a bright line rule: if a person’s employer (or a person connected to that person’s employer) provides the employee the right or opportunity to acquire a securities option, that right or opportunity is conclusively treated as having been made available by reason of the employment of that person. This involves a straightforward examination of the agreement or transaction to ascertain who conferred the right or opportunity.’
The ruling went on: ‘That is what has occurred in this case. The 2006 option was cancelled, not varied. Vermilion conferred a new option, over a different and new class of shares, on Quest. In so doing Vermilion fell within the deeming provision.’
The Court also cited Lord Briggs in the Fowler case that s471(3) should ‘not be applied so far as to produce unjust, absurd or anomalous results, unless the court is compelled to do so by clear language’. The judge disagreed with the First Tier Tribunal’s opinion that HMRC’s position ‘produced an absurd, anomalous or unjust result’, saying this was an ‘error of law. It put the cart before the horse: the purpose of the deeming provision is to avoid the decision-maker having to carry out the section 471(1) assessment. There is no anomaly here’.
The Court concluded that applying section 471(3) produced no such result in this case.
It added: ‘What Parliament has done in enacting section 471(3) is to make clear that if an employer makes available, in this case confers by contract, a securities option, that option is treated as being an employment-related securities option.’
The Supreme Court ruled that under s471(3) ITEPA 2003, Noble was deemed to have acquired the securities option because of his employment as a director of Quest and it is therefore subject to income tax.
An HMRC spokesperson told Accountancy Daily: ‘We welcome this win, which protects £385,000 in tax and confirms our position that the 2007 option was an employment-related securities option.’