Ken Moody warns about the possible application of special tax rules for employment related securities in normal company transactions.
This article is intended to tackles the vexed subject of the application of Chapter 3D of the employment-related securities (ERS) rules to normal company transactions, and hopes (probably in vain) for some relaxation to this very onerous legislation.
The relevant legislation (ITEPA 2003, Pt 7, Ch 3D) applies, simply, where ERS are disposed other than to an ‘associated person’ for a consideration which is greater than ‘market value’.
What is ‘market value’?
The HMRC guidance on Chapter 3D in the Employment Related Securities Manual at ERSM80000 is not very helpful in practice. It harks back to the purpose of earlier legislation regarding ‘stop-loss’ arrangements by employers to protect employees from a fall in the value of their shares. There is some commentary at ERSM80110 about employee share plans involving employees disposing of their shares to their employer for ‘fair value’, which it notes could be greater than market value.
The guidance at ERSM80130 goes on to explain in some detail the decision in Gray’s Timber Products Ltd v HMRC [2010] UKSC 4, which is one of the few decisions concerning the 2003 ERS rules and in particular the meaning of ‘market value’ as it applies for the purposes of Chapter 3D. In that case, the company’s MD had been allotted shares in the group’s holding company on terms which entitled him to a greater than pro-rata share of the proceeds on the sale of the holding company. HMRC assessed the excess proceeds under Chapter 3D, which was ultimately upheld by the Supreme Court.
Market value is defined (in ITEPA 2003, s 421) by reference to the capital gains tax (CGT) statutory open market basis, underpinned by about a century of case law. However, we also know from Lord Walker’s obiter dicta in Gray’s that while the section 421 definition was intended to apply consistently throughout Pt 7, Chs 2-5 in practice, there is a degree of fluidity in the interpretation depending upon which chapter is involved.
Gray’s, of course, concerned a company sale to a third party in a real open market, whereas the CGT definition postulates a sale between hypothetical parties in an open market which does not exist in reality. And therein lies the major inequity of Chapter 3D.
Company purchase of own shares
It is not uncommon, for example, on a company purchase of own shares (PoS), that the price for the shares will be calculated by reference to the whole company value (i.e., without minority discounts etc.). That price is therefore likely to exceed the statutory open market value which would apply discounts for the size of the holding, marketability etc. So, while in Gray’s, an employee shareholder receiving their pro-rata share of the sale proceeds would be accepted as having received market value (no argument there), consideration calculated similarly under a PoS or perhaps a management buyout (MBO) may be challenged as being in excess of market value. It is unclear why the shareholder in the latter situation should be considered to have received an employment reward, though obviously, it may depend upon the circumstances.
Several years ago, HMRC’s Employee Shares Schemes Unit (ESSU) confirmed to me that provided the price for the shares on a PoS had been freely negotiated between the parties, they would not seek to apply Chapter 3D. In practice, such assurance is, of course, worthless (and the ESSU no longer exists).
There might be some argument that Grays did not support a strict application of the open market principle, but that is a matter for a share valuation specialist.
Practical tip
Clearly, the employee and the company in a PoS or an MBO should be advised of the risks of HMRC seeking to apply Chapter 3D to part of the sale consideration and of the consequences. The company might also be advised to seek an indemnity from the employee in those circumstances for any PAYE or National Insurance contributions payable.
