In 2006, Vermilion Holdings Ltd (“Vermilion” or “the Company”) carried out a funding exercise as part of which Quest Advantage Limited (“Quest”) was appointed to produce a business plan and financial projections and Dickson Minto was appointed as legal advisor to assist with the fundraising. Vermilion granted a “supplier option” to each of Quest and 22 Nominees Ltd (Dickson Minto’s nominee) to acquire ordinary shares in the Company in consideration for the services provided by Quest and Dickson Minto. The “supplier options” were not considered to be employment-related securities options within the meaning of Income Tax (Earnings and Pensions) Act 2003, s 471(5).
By January 2007, it transpired that the Company was not generating any income and was running out of working capital. Mr Noble (a director of Quest) highlighted that the Company needed another fundraising round to continue trading. The 2007 fundraising round had notable pre-conditions:
- to appoint Mr Noble as executive chairman of the Company; and
- to amend the “supplier options” held by Quest and Dickson Minto to reduce their respective share entitlements.
However, the Company did not vary the terms of the existing options, but instead granted each of Quest and Dickson Minto a new option on 2 July 2007. The option granted to Quest was now over F ordinary shares over a maximum of 1.5% of Vermilion’s issued share capital. It was a condition of the new option that the 2006 option would lapse on the grant of the 2007 option.
Almost a decade later, in the context of a proposed sale of the Company, the 2007 option was novated by Quest to Mr Noble who then exercised the option. Shortly thereafter, Mr Noble and Vermilion sought confirmation from HMRC that the gain realised on the exercise of the 2007 option and sale of the resulting shares was subject to capital gains tax (rather than income tax/NICs). HMRC determined that the exercise of the option was a chargeable event pursuant to Part 7 of ITEPA and that the option gain therefore counted as Mr Noble’s employment income for the purposes of ITEPA and, accordingly, HMRC assessed Vermilion to the resulting tax and NICs under PAYE (which Mr. Noble had indemnified the Company for).
The relevant legislation
For the purposes of this appeal, the critical legislation is set out in ITEPA, s 471, which provides that:
“(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—
- 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.”
Accordingly, there are effectively two tests set out in ITEPA, s 471, which, if either is satisfied, will result in the exercise of a securities option being subject to income tax rather than capital gains tax. The first test, in subsection (1), is a test of causation, asking whether the right or opportunity to acquire the securities option “is available by reason of employment of that person or another person”. The second test, in subsection (3), purports to eliminate the need to establish a causal link where a person’s employer makes a right or opportunity to acquire a securities option available to the employee, in which circumstances the causal link is deemed to exist.
The lower courts considered and applied the tests set out in ITEPA, s 471 in a slightly different manner, thereby reaching a different conclusion each time but, in each case, either focussing on, or giving material weight to, the operative cause of the grant of the 2007 option. However, the Supreme Court’s decision took a very different approach to the interaction of s. 471(1) and s. 471(3), determining in favour of HMRC on the basis that, once the deeming provision in s. 471(3) was engaged, there was no need to then qualify or test this by looking at the operative cause of the grant of the relevant option.
The First-tier Tribunal held in the favour of the taxpayer. It determined that the scope of the deeming provision should be limited “where the artificial assumption from deeming is at variance with the factual reason that gave rise to the right to acquire the option”. It concluded that the grant of the 2007 option was ‘made available’ by Mr Noble’s surrender of his 2006 option and he did not as a matter of fact acquire the 2007 option ‘by reason of his employment’ and accordingly the 2007 option should not be treated as an employment-related securities option.
The Upper Tribunal overturned the decision of the First-tier Tribunal and held in favour of HMRC, finding that the FTT had erred in law. The Upper Tribunal decided that Mr Noble’s employment (i.e., his directorship of Vermilion) was an operative cause of the grant of the 2007 option as it was a condition of the grant of the 2007 option that Mr Noble would become a director. As such, pursuant to ITEPA, s 471(1), the 2007 option was an employment-related securities option. Given this conclusion, the Upper Tribunal had no need to consider the application of the deeming provision set out in subsection (3) and did not do so.
The Court of Session Inner House, by majority, reinstated the First-tier Tribunal’s decision finding in favour of the taxpayer. It stated that the 2007 option had been made available by the existence of the 2006 option and that Mr Noble’s directorship of Vermilion was not a sufficiently operative cause of the 2007 option being granted to engage ITEPA, s 471(1). Further, Lord Doherty considered that it would be “anomalous, absurd and unjust” to treat the opportunity to acquire the 2007 option as being made available by reason of Mr Noble’s employment so as to engage ITEPA, s 471(3). The Court of Session further stated that it was an error to categorise ITEPA, s 471(3) “as a separate and distinct route to taxation” which is available even if it has been established that ITEPA, s 471(1) has no application (i.e. there is no direct causal link between the relevant employment and the option being made available).
Decision of the Supreme Court
The Supreme Court upheld HMRC’s appeal, finding that the 2007 Option was an employment-related securities option. In a surprisingly short judgment, which leaves a number of key questions unanswered, the Supreme Court has given some direction on the interpretation of ITEPA, s 471(3) and the circumstances in which it applies. Lord Hodge who gave the only judgment (with which Lord Lloyd-Jones, Lord Leggatt, Lord Burrows and Lady Rose agreed) stated (at ):
“.. the purpose of section 471(3) is to circumvent the difficult issues that can arise in the application of section 471(1). The statutory provision makes it clear that if an employer makes available to an employee a securities option, that option will be treated in the employee’s hands as an employment-related securities option and taxed accordingly.”
It was noted that, in interpreting ITEPA, s 471, the lower courts had focused on the meaning of “by reason of employment” in subsection (1) to try to establish a “causal” connection, thus requiring them to grapple with difficult questions of causation and, perhaps unsurprisingly, coming to different conclusions. Instead, the Supreme Court found that ITEPA, s 471(3) creates a straightforward ‘bright line rule’, being that if an employee is granted an option (or, more precisely, if the right or opportunity to acquire the option is made available) by their employer (or a person connected with the employer), that option is conclusively treated by ITEPA, s 471(3) as an employment-related securities option. That, in the view of the Supreme Court, reflects Parliament’s specific intention behind the insertion of the deeming provision, i.e., avoiding the need for the courts to consider complex questions of causation raised by ITEPA, s 471(1) where the deeming provision in ITEPA, s 471(3) applies. Therefore, the only point on which the Supreme Court considered it necessary to opine, to determine whether HMRC’s appeal should be upheld, was whether Vermilion (as employer) made the 2007 option available to Mr Noble whilst he was a director (and hence deemed for income tax purposes to be an employee) of Vermilion. The answer was, in the view of Lord Hodge, a rather simple yes on the facts and, as such, HMRC’s appeal was allowed.
The Supreme Court cited with approval its previous guidance given in the case of Fowler v Commissioners for Her Majesty’s Revenue & Customs  UKSC 22 on the application of deeming provisions in legislation. Lord Briggs in that case stated that:
“(1) The extent of the fiction created by a deeming provision is primarily a matter of construction of the statute in which it appears.
(2) For that purpose, the court should ascertain, if it can, the purposes for which and the persons between whom the statutory fiction is to be resorted to, and then apply the deeming provision that far, but not where it would produce effects clearly outside those purposes.
(3) But those purposes may be difficult to ascertain, and Parliament may not find it easy to prescribe with precision the intended limits of the artificial assumption which the deeming provision requires to be made.
(4) A deeming provision should not be applied so far as to produce unjust, absurd or anomalous results, unless the court is completed to do so by clear language.
(5) But the court should not shrink from applying the fiction created by the deeming provision to the consequences which would inevitably flow from the fiction being real.”
The Vermilion judgment removes any ambiguity in circumstances where an employee receives a share option which is made available by their employer (or a person connected with their employer). Given that Vermilion had granted the 2007 option at a time when Mr Noble was a director of the Company, the Supreme Court was satisfied that the option was made available to Mr Noble by his employer and therefore the exercise of that option rightly fell within the ambit of income tax.
The “who” test
In overturning the decision of the Court of Session Inner House, the Supreme Court decision tells us not to “put the cart before the horse”; the correct approach to applying the deeming provision in ITEPA, s 471(3) is to ascertain ‘who’ conferred the right or opportunity for the employee to acquire the share option in the employer company rather than ‘why’ that person conferred such right or opportunity. If the right or opportunity is made available by the employer (or a person connected with the employer), the option is correctly treated as being an employment-related securities option and, in those circumstances, there is no need to consider the (sometimes difficult) questions of causation posed by ITEPA, s 471(1). The Supreme Court opined that this sequencing in which the statutory provisions should be considered, and the consequent absence of any requirement to consider actual causation if the deeming provision in ITEPA, s 471(3) applies, reflects the intention of Parliament in enacting the deeming provision.
In dealing with this point, Lord Hodge stated (at ), “That is what 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 did not opine on whether the outcome would have been different if the terms of the 2006 option were varied instead of the Company granting a new option in 2007, but the implication from Lord Hodge’s comments referred to above is maybe that it would have done. (It is, of course, a separate question as to whether an amendment to the number of shares and the class of shares would, as a matter of law, have amounted to a surrender and re-grant rather than a variation of the 2006 option in any event.)
The Supreme Court appears to have assumed that, if Vermilion granted the 2007 option to Quest, then it necessarily follows that Vermilion was the person which made the right or opportunity to acquire the 2007 option available to Mr Noble (in respect of whom it stated that Quest was a mere “nominee” – see further below on this nominee point). That will not always be the case (as is clear from the exception to ITEPA, s 471(3) which applies where the person who makes the right or opportunity is an individual. On the facts of Vermilion, it is far from clear that Vermilion (or any person connected with Vermilion) made such right or opportunity available to Mr Noble.
Absurd, anomalous, or unjust
Lord Hodge emphasised that, in determining whether the tests in ITEPA, s 471 apply, one should begin by seeking to apply the deeming provision in subsection (3) before trying to establish a causal link under subsection (1) and that the First-tier Tribunal and the Court of Session Inner House were incorrect in considering that the application of the deeming provision produced an “absurd, anomalous, or unjust result”. He states (at ) “There is to my mind no anomaly, absurdity or injustice in giving effect to the deeming provision of section 471(3) in this case.” Unfortunately, what Lord Hodge did not address in any detail is his reasons for this conclusion; accordingly there is no clarity as to the circumstances which may create an anomalous, absurd or unjust result so as to prevent the application of the deeming provision in ITEPA, s 471(3). Clearly, one reason why the lower courts had grappled with this question was because the outcome did seem unfair. The inference from the Supreme Court must, however, be that the bar will be set quite high on this question.
The bank customer and employee
The Supreme Court referred to the case of Price & Ors v Revenue and Customs Comrs  UKFTT 297 (TC) in which Judge Hellier gave a hypothetical example of a large bank making available to all its customers a securities option where some of such customers were also employees of the bank. Would that result in all options granted to customers, even those who were not its employees, falling within the deeming provision? It is clear from the judgment in Price that Judge Hellier was not considering whether the customers who were also employees would be caught by the deeming provision in subsection (3), he was merely concerned with the meaning of the words “a person’s employer”, as he goes on to state that:
“the purpose seems to us to be the provision of an automatic link to employment if the recipient of the opportunity is an employee and in other cases the requiring of an investigation as to whether or not there is in fact a link between the employment and the opportunity. As a result we regard (3) as limited to the making available of an opportunity to an employee by that employee’s employer (or person connected with that employer)”
Lord Hodge considered that the decision in Price gives no support to the arguments put forward by Vermilion. The Supreme Court did not consider in detail the impact of the deeming provision on the options granted to those customers who are also the bank’s employees, but the implication was clear that, by virtue of the deeming provision, those options would be employment-related securities options. That is notwithstanding the apparent anomaly and injustice (and possible absurdity) that the options granted to customers who are not employees would be taxed differently (and much more generously).
The Supreme Court decision removes any ambiguity in circumstances where it is the employee which acquires a share option. However, one of things which is not clear from the decision is the application of the deeming provision if the right or opportunity to acquire the option is made available to someone else, including a person connected with the employee (not being the employee’s nominee). Where an option is granted to a person connected with the employee (not as their nominee), it remains unclear whether legislation requires us to establish a causal link between the option and the employee’s employment and determine whether the option was granted to the person connected with the employee ‘by reason of [the employee’s] employment’.
Current or former employment
Whilst it is now clear that one should apply the deeming provision under ITEPA, s 471(3) first to determine whether an option is an employment-related securities option, it should be noted that the application of the Supreme Court judgment is limited to a situation where the option holder is an employee. It arguably does not apply where the recipient of the option is a former or prospective employee as ITEPA, s471(2) arguably only applies to the “causation test” set out in ITEPA, s471(1).
Employment Related Securities
The Supreme Court decision in relation to ITEPA, s 471 will also apply to the same tests set out in ITEPA, s 421B which relate to acquisition of employment-related securities (where shares are acquired outright) given that the wording of ITEPA ss, 421B(1) and 421B(3) is for all practical purposes identical to ITEPA ss, 471(1) and 471(3).
Whilst the Vermilion judgment provides some clarity on the application of the deeming provision in ITEPA, s471(3) and by extension ITEPA, s421B(3), it also leaves various ancillary points considered in the lower courts unanswered. Employers are now having to consider whether shares or options which were previously not treated as “employment-related”, whether on the basis of professional advice or otherwise, should now be considered to be “employment-related”. We now wait in anticipation for HMRC’s guidance to see whether any of the points considered in this article are dealt with in that guidance.
Read the full Vermilion judgment here.