Commissioners for HM Revenue and Customs v Vermilion Holdings Ltd

Heard on 7 February 2023

Lord Hodge ( with whom Lord Lloyd-Jones, Lord Leggatt, Lord Burrows and Lady Rose agree):

This appeal is concerned with the correct interpretation of section 471 of the Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”). This section, with its related sections, imposes a liability to income tax as employment income in relation to gains made on the exercise of a share option if it is treated as an employment-related securities option.

I can state the background facts briefly as their detail is not relevant to the outcome of this appeal. I make this summary from the uncontested findings of fact of Dr Heidi Poon in the First-tier Tribunal (“FTT”). There were two witnesses, Mr Marcus Noble, a corporate adviser and mergers and acquisition specialist, and Mr Kevan McDonald, who was, before his retirement, a partner in the corporate law firm of Dickson Minto WS. The FTT found both witnesses to be credible and reliable. Thus, I take it that, unless the context were to suggest otherwise, when the FTT summarised or quoted what a witness said, it was finding as a fact the content of that statement.

Vermilion Software Ltd was incorporated in 2003 principally to market a software product for the fund management sector and provide support and servicing of the product. In 2006 the business arranged further equity funding from new investors. This exercise involved the creation of a holding company, Vermilion Holdings Ltd (“Vermilion”), which is the entity that HM Revenue and Customs Commissioners (“HMRC”) found liable to pay tax in connection with a further fund-raising exercise in 2007 as explained below. Vermilion was the appellant before the FTT.

The 2006 funding exercise involved the carrying out of due diligence on Vermilion Software Ltd and approaching credible investors. Quest Advantage Ltd (“Quest”), a company owned by Mr Noble and Mr Scott Carnegie, a chartered accountant and business adviser, was brought in to produce a business plan and financial projection and Dickson Minto was recruited as legal adviser for the 2006 exercise. As the costs of the 2006 exercise exceeded its budget, Vermilion granted a “supplier option” to each of Quest and 22 Nominees Ltd (Dickson Minto's nominee) to acquire ordinary shares in Vermilion representing up to 2.5 per cent of that company's share capital. The contract between Vermilion and Quest provided for the option to be exercised within ten years of the date of the agreement.

Unfortunately, by the end of 2006 it was clear that the business was underperforming. By January 2007 income was not coming in and Vermilion was running out of working capital. Mr Noble's assessment was that Vermilion “was going to go bust”, that in any rescue the management and administration would all “take a bath” and that everyone, including the option holders, was “to get diluted”. In other words, there had to be what the FTT described as a “rescue funding exercise” which would reduce the entitlements of existing stakeholders. In February 2007 an outline plan to refinance Vermilion was prepared, which involved among other things Quest and Dickson Minto amending their supplier options to reduce their entitlements.

The rescue funding exercise involved as preconditions the departure of the managing director, and the reduction of the entitlements of the existing shareholder directors. The directors' A Shares were to be replaced by non-voting shares, their equity interest would be diluted by the new investment of share capital, and their remuneration would be reduced. It was also a precondition of the further investment of funds that Mr Noble be appointed as executive chairman of Vermilion. It was another precondition of the further investment of funds that the supplier options were to be varied by reducing the amount of equity which would be available under the options. Dickson Minto and Quest conceded this as their options would have become worthless if the rescue funding exercise did not proceed.

In the event, agreements to vary the supplier options were not prepared and, instead, new option agreements were executed. The option agreement between Vermilion and Quest, which was executed on 2 July 2007, gave Quest an option to subscribe for a new class of shares – F ordinary shares – in such numbers as would represent up to a maximum of 1.5 per cent of Vermilion's issued equity share capital. No consideration was paid for Vermilion's grant of the option, but it was provided that the 2006 option agreement would lapse from the time the new option agreement was executed.

Moving on nine years, in June 2016, in the context of a proposed sale of Vermilion's shares to another company, a novation agreement was entered into whereby Quest was replaced by Mr Noble as the holder of the 2007 option. Mr Noble exercised the option. In November 2016 Mr Noble and Vermilion submitted a non-statutory clearance request to HMRC seeking their agreement that the gain in the sum of £636,238 on the exercise of the 2007 option by Mr Noble was liable to Capital Gains Tax. On 14 December 2016 HMRC gave their decision that the 2007 option was an employment-related securities option. The decision was that the exercise of the option was a chargeable event and the taxable amount of the gain on acquiring the securities counted as employment income of Mr Noble in the relevant tax year.

HMRC assessed Vermilion in the tax year 2016–17 in the sum of £285,148.76 under Regulation 80 of the Income Tax (Pay as You Earn) Regulations 2003 (SI 2003/2682) and for National Insurance Contributions in the sum of £100,709.98 under section 8 of the Social Security Contributions (Transfer of Functions, etc) Act 1999. Vermilion appealed those assessments. As the FTT recorded in its decision, Vermilion has an indemnity from Mr Noble for any tax consequences arising from the exercise of the option. Vermilion is the appellant, but Mr Noble has the economic interest in the outcome of Vermilion's appeal.

Part 7 of ITEPA is headed “Employment Income: Income and Exemptions Relating to Securities”. Chapter 5 of that Part relates to securities options. The critical section for this appeal in that chapter is section 471 which provides (so far as relevant):

“Options to which this Chapter applies

(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 –

(a) the person by whom the right or opportunity is made available is an individual, and

(b) the right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person. (Emphasis added)

(4) …

(5) In this Chapter –

‘the acquisition’, in relation to an employment-related securities option, means the acquisition of the employment-related securities option pursuant to the right or opportunity available by reason of the employment.

‘the employment’ means the employment by reason of which the right or opportunity to acquire the employment-related securities option is available (‘the employee’ and ‘the employer’ being construed accordingly), and

‘employment-related securities option’ means a securities option to which this Chapter applies.”

Section 471(1) asks whether a securities option is available “by reason of an employment of that person …”. This raises a question of causation which the Court of Appeal of England and Wales discussed in relation to analogous statutory provisions in Wicks v Firth [1982] Ch 355: see Lord Denning MR at p 363 and Oliver LJ at pp 370–371. That case concerned the taxation of university scholarships which ICI provided by means of a discretionary trust to children of its employees or certain of its subsidiaries' employees. The relevant statutory provision was section 61(1) of the Finance Act 1976, which taxed fringe benefits of higher-paid employees. Lord Denning stated that the fact of employment must be one of the causes of the benefit being provided: “It is sufficient if the employment was an operative cause – in the sense that it was a condition of the benefit being granted.” Oliver LJ stated (p 371):

“One is directed to see whether the benefit is provided by reason of the employment and in the context of these provisions that, in my judgment, involves no more than asking the question ‘what is it that enables the person concerned to enjoy the benefit?’ without the necessity for too sophisticated an analysis of the operative reasons why that person may have been prompted to apply for the benefit or to avail himself of it.”

As the decisions of the tribunals and opinions of the Inner House in this appeal demonstrate, ascertaining the reason why a right or opportunity to acquire a securities option has been made available can give rise to disagreement. In the House of Lords ( [1983] 2 AC 214) the relevant point in ...