The fine line between employment related securities and shares from employment

The phrase ‘conventional wisdom’ is often credited to J K Galbraith. In The Affluent Society, he uses the term to describe ‘ideas which are esteemed at any time for their acceptability’. Conventional wisdom exists in taxation, as it does in many other fields. As in other fields, it is not always right.

Take the case where an employee acquires shares in the company that employs him, giving consideration for them that is less than their market value. Conventional wisdom will tell you that in nearly every case there is a charge to income tax on the acquisition under the basic charging rules: that is, a charge under ITEPA 2003 s 62. The main exception might be where the shares are gifted by a close family member.

So far, so conventional. But this is worth examining.

‘From’ or ‘by reason of’ employment?

Section 62 charges tax on anything that is an ‘emolument of the employment’. By contrast, ITEPA 2003 Part 7, dealing with ‘employment related securities’ (ERS), applies where a right or opportunity to acquire securities (or an interest in securities) is made available ‘by reason of’ a person’s employment.

The difference is not mere semantics: that the expressions are not synonymous is explicitly accepted by HMRC (albeit in the context of benefits in kind rather than share acquisitions) in its Employment Income Manual (at EIM20503):

‘It is important to understand the distinction between Section 62 on the one hand, and Sections 70(1) and 201(2) on the other hand. Section 62(1) applies to earnings “in relation to an employment”, including anything that is an “emolument of the employment” (Section 62(2)(c)). Section 70(1) and Section 201(3) apply to expense payments and benefits provided “by reason of the employment”. Section 62 is based on what was previously Section 19 ICTA 1988, which charged to tax emoluments “from an employment”. Case law shows that the phrase “by reason of the employment” has a wider meaning than “from the employment”. The words “from the employment” are not reproduced in Section 62 but earnings chargeable under that section include emoluments “of the employment” and in this context “of the employment” has the same meaning as “from the employment”.’

It is therefore undoubtedly possible, in principle, that shares may be acquired ‘by reason of’ employment and yet not be earnings ‘of’ (or, in pre-ITEPA terms, ‘from’) the employment.

Something will be received ‘by reason of’ employment if the employment is what Denning MR described in Wicks v Firth [1982] STC 76 as ‘an operative cause’ of the receipt. The case concerned scholarships provided by ICI (or, to be strictly accurate, by an educational trust established by ICI) to certain children of its higher-paid employees. Denning MR set out the point with characteristic succinctness:

‘It is sufficient if the employment was an operative cause–in the sense that it was a condition of the benefit being granted. In this case the fact of the father being employed by ICI was a condition of the student being eligible for an award. There were other conditions also, such as that the student had sufficient educational attainments and had a place at a university. But still, if the father’s employment was one of the conditions, that is sufficient. If two students at a university were talking to one another – both of equal attainments in equal need – and the one asked the other “Why do you get this scholarship and not me”. He would say “Because my father is employed by ICI”. That is enough. The scholarship was provided for the son “by reason of the father’s employment”.’

To be ‘from’ an employment requires a much closer connection. It is not quite right to say that something is ‘from’ the employment only if it is explicitly intended to be a reward for particular services or even for undifferentiated general services (though if it is, it will certainly be ‘from’ the employment). But it will be necessary that the receipt arises from the existence of the employer-employee relationship and from that alone. The words of Lord Radcliffe in Hochstrasser v Mayes (1956-1960) 38 TC 673 remain a helpful way of stating the requirement:

‘while it is not sufficient to render a payment assessable [under what is now s 62] that an employee would not have received it unless he had been an employee, it is assessable if it has been paid to him in return for acting as or being an employee.’

Thus, in Hochstrasser v Mayes, the employer had established a scheme under which employees who were required by the employer to relocate were compensated for any resulting loss on the sale of their home. An amount received under the scheme was held not to be taxable under the predecessor of s 62 as an emolument ‘from’ the employment. It was not received by the employee ‘for acting as or being an employee’ but because of his ‘personal embarrassment in having sold his house for a smaller sum than he had given for it’.

How does this apply to employee shares?

What, then, if we apply this distinction to the acquisition by an employee of shares in a company that employs him? Will the value of the shares inevitably be something that arises ‘from’ the employment?

Unfortunately, at this point HMRC’s published guidance confuses the position, wrongly implying that the s 62 charge applies where shares are acquired ‘by reason of’ (rather than ‘as earnings from’) an employment:

‘It is important to remember that where shares or other securities are acquired by reason of employment for less than their market value, then there will normally be a general earnings charge on the money’s worth of those securities, less anything paid for them.’ (HMRC’s Employment Related Securities Manual at ERSM700010)

In some circumstances, shares will indeed be earnings ‘from’ an employment. For example, a public company may establish and fund an employee share trust. The trust acquires shares in the market and from time to time awards shares to employees in accordance with the terms of an employee share scheme. It could not seriously be doubted that, in such a case, the receipt arises only from the employer-employee relationship; they are given to an employee ‘in return for acting as or being an employee’.

But consider an unquoted trading company owned in equal shares by two unconnected individuals both actively involved as directors in running the business: what is sometimes described as a ‘quasi-partnership’ or a partnership in corporate form. Suppose the proprietors identify one of the employees as a ‘rising star’ and as someone ideally suited to join the management team and drive the next stage of the growth of the business. Someone who, if the business had been a partnership, would have been a candidate for admission to partnership. Suppose the proprietors appoint the individual a director and that they each transfer some shares to her for no consideration.

It is easy to see that the shares will have been acquired ‘by reason of’ the employment and will thus be employment related securities. It is rather harder to make the case on these facts that the shares have been transferred ‘in return for acting as or being an employee’. Rather, they have been transferred because the co-owners have identified the individual as someone with whom they wish to be ‘in partnership’. Indeed, the most cogent argument for saying that the shares are not in this case earnings ‘from’ the employment is that if the business had been a partnership and if the employee had been awarded an interest in the partnership, it is unthinkable that HMRC would have sought a charge to tax under s 62 by reference to the supposed value of the partnership interest. Put simply, if on these facts the acquisition of an interest in an unincorporated business would not have represented ‘earnings from’ the employment, the same must follow for an acquisition of an interest in an incorporated business.

The tax consequences

The absence of a charge to tax under s 62 does not, of course, mean that the acquisition of the shares has no tax consequences. On the premise that these are employment related securities acquired for no payment, ITEPA 2003 Part 7 Chapter 3C will apply. This provides that the employer will be deemed to make to the employee an interest-free loan of an amount determined by s 446T. On the facts postulated above, the loan will be for an amount equal to the market value of the shares on acquisition. This will in principle give rise to an annual charge to tax under the benefit in kind rules. However, if it is the case that if interest had been paid, the interest would have qualified for tax relief (as it would be on the facts postulated), s 178 takes the notional loan out of the charging provisions. There will thus be no annual charge to tax on the benefit of the notional loan. Under s 446U, the notional loan is treated as discharged when the shares are disposed of (among other circumstances) and there will usually be a charge to tax on the amount of the notional loan at that time.

Thus, if the acquisition of shares is ‘by reason of’ the employment but does not represent ‘earnings from’ the employment, the broad effect is to retain a charge to income tax on the market value as at the time of acquisition, but to defer recognition of the charge until the shares are disposed of. This is, obviously, rather more advantageous that that implied by the ‘conventional wisdom’ that a tax charge arises under s 62 at the time of acquisition.

A note of caution

There is, however, a note of caution to be sounded. Where the shares are ‘restricted securities’ the interaction between Chapter 2 and Chapter 3C of ITEPA 2003 Part 7 has an odd result. If there is no charge under s 62 on acquisition, the effect of the formula in s 428 is, broadly, that the full amount of the unrestricted market value will be charged to income tax on the lifting of restrictions or sale. This is because, although any amount charged under s 62 is a ‘deductible amount’, any amount treated as a notional loan under s 446U is not. This makes it especially important that, where restricted securities are involved, an election under s 431 should be made. This will not create a charge under s 62, but it will ensure that no charge can subsequently arise under Chapter 2, albeit at the cost of deeming the notional loan under Chapter 3C (and therefore the tax charge on sale of the shares) to be computed by reference to the ‘unrestricted’ value of the shares as at the time of acquisition.

It is also important to appreciate that what we’re talking about here is the acquisition of securities, or an interest in securities where the right or opportunity to acquire the securities or interest in them is made available by reason of the employment (or, as the case may be, where the acquisition represents earnings). Different rules will apply where shares are acquired pursuant to a ‘securities option’ (defined by ITEPA 2003 s 420 as ‘a right to acquire securities’).

Section 475 provides that there will almost never be a charge to income tax on the grant of a ‘securities option’, regardless of whether the option arises ‘from’ an employment or is made available ‘by reason of’ the employment. (The only exception is where a below-market value option is granted under a Sch 4 CSOP scheme, when a charge is imposed by s 526.) However, if the right or opportunity to acquire the securities option is made available by reason of employment, there will generally be a charge to income tax under s 476 on the occurrence of a ‘chargeable event’ (which includes exercise of the option) unless the option is granted under the terms of one of the approved schemes.

This produces an odd result in the case of ‘quasi-partnership’ companies of the kind considered above. As we have seen, if the ‘rising star’ is simply given shares, there is a very reasonable argument that there is no charge to income tax at the time of acquisition. If, however, the ‘rising star’ is instead granted an option to acquire shares, the right or opportunity to acquire that option will almost always be treated as having been made available by reason of employment (either because that is in fact the case or because s 471(3) deems it to be so) with the result that a charge to tax under s 476 will arise on the acquisition of the shares on exercise on the option. It is bizarre that the tax charge in respect of an acquisition of shares should in some circumstances differ according to whether an employee (a) is given shares outright or (b) takes up a right to acquire shares; but that seems indeed to be the case.