Vermillion Holdings Ltd v R & C Commissioners

JurisdictionScotland
Judgment Date20 August 2021
CourtCourt of Session (Inner House)

[2021] CSIH 45

Court of Session (First Division, Inner House)

Lord President, Lord Malcolm, Lord Doherty

Vermillion Holdings Ltd
and
R & C Commrs

Simpson QC, Gilson Gray LLP appeared for appellants

Ghosh QC, R MacLeod; Office of the Advocate General appeared for respondents

PAYE & NIC – ITEPA 2003, s. 471 – Grant of share option to director – Whether by reason of an employment – No – Appeal allowed .

The Court of Session overturned the decision of the Upper Tribunal, effectively restoring the original decision of the First Tier Tribunal in determining that share options granted to a director were not “by reason of an employment” and thus not subject to PAYE and NICs.

Summary

An individual (Mr Noble) worked as a business advisor through his personal service company, Quest Advantage Ltd (Quest). In early 2006, Quest had been granted a share option in lieu of fees for work done in producing a business plan and financial projection for the appellant company (Vermilion).

Later in 2006, the company got into financial difficulty and a rescue package was agreed. The package was conditional upon Mr Noble becoming a director and executive chairman of the company and also upon either an amendment to or cancellation of the original option agreement. Vermilion and Mr Noble chose to cancel the existing option and in return, Quest was granted a new option in July 2007 under revised terms.

In June 2016, in anticipation of the forthcoming sale of Vermilion to an American listed company, Quest's option was novated to Mr Noble personally and subsequently exercised by him as the sale took place in November that year.

The issue was whether the new option agreement was “available by reason of an employment” under s. 471 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA). If it was, then PAYE and NICs would apply to the subsequent gain on exercise of the option. As the value of the underlying shares had increased by £636,238 the combined amount of PAYE and NICs at stake was £385,858.

Vermilion contended that the new option was simply a replacement of an option which had been granted at a time when Mr Noble was not a director and at that time it was not envisaged that he ever would be, therefore the new option should not be regarded as being by reason of his employment.

HMRC considered that the issue of the original option was not relevant and made two substantive arguments. Firstly, a new option had been granted at a time when Mr Noble was a director and the reason for granting it was at least partly because of his employment. Secondly, that even if the actual reason had not been because of the employment, s. 471 would deem it to have been so.

Initially, the First Tier Tribunal (FTT) had found in favour of Vermilion and HMRC appealed to the Upper Tribunal (UT). Vermilion now appealed that decision to the Court of Session.

Legislation and arguments

The question of whether there was an employment did not arise, as a director is an office holder and as such is treated as an employee by s. 5, Income Tax (Earnings and Pensions) Act 2003 (ITEPA).

The case hinged on clauses (1) and (3) of s. 471, ITEPA:

471(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.

471(2) For the purposes of subsection (1) “employment” includes a former or prospective employment.

471(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.

HMRC's arguments were that that clause (1) was satisfied, but even if the actual reason for issuing the option was not rooted in Mr Noble's employment, the wording of clause (3) meant that it would automatically be regarded as being “by reason of an employment” unless one of the two exemptions applied, which was plainly not the case.

Vermilion argued that clause (1) of s. 471 was not satisfied because the option was granted to replace an existing option which all parties agreed was not employment related. Furthermore, the replacement option was under less favourable terms and so it would be absurd to treat it as a reward of employment under clause (3), given that it represented a reduction in the option-holder's rights.

The reason that the original option agreement could not continue was that other investors involved with the rescue package considered it to be unfair because of its favourable (non-dilution) terms. Consequently, it was a fixed condition of the rescue funding that either the terms should be altered or that it should be cancelled and a revised option agreement issued. Mr Noble opted for cancellation rather than revision. Another condition of the rescue funding was that Mr Noble should be appointed executive chairman of the company.

The UT had found that the because the rescue package was dependent on both of these two conditions (amongst others), the issue of the revised option agreement was at least partly by reason of Mr Noble's employment. Following the precedent of Wicks v Firth (HMIT) (1982) 56 TC 318, the UT decided that it was not necessary for employment to be the sole or even the dominant reason. It was sufficient that Mr Noble's employment was a condition of the new option being granted.

Consequently the UT had held that clause (1) of s. 471 was met and it was therefore not necessary to go on to consider whether clause (3) would have applied.

Dismissing Vermilion's argument in respect of absurdity, the UT had found that although the original option was granted on more favourable terms, it had already become worthless because of Vermilion's financial difficulties. The company was going to fail without rescue funding. The new option was therefore not taking away value from Mr Noble, as there was no value to be taken.

Judgement

The Court of Session overturned the decision of the UT and allowed Vermilion's appeal by a majority verdict of 2:1.

Lord Malcolm

Lord Malcolm considered that the UT had made an error in attributing a causal link between the directorship and the option, finding that instead they were both conditions of the refinancing package, but neither was dependent upon the other. In addition, he agreed with the FTT that on a realistic view of the facts, Mr Noble was not acquiring something but was effectively giving something up, as the new option was on lesser terms. Consequently, the UT was wrong to find that clause (1) of s. 471 was met and therefore it was necessary to go on to consider whether clause (3) (the deeming provision) would have applied.

On this point, Lord Malcolm considered that the literal application of the deeming provision could be limited to prevent injustice, absurdity or obvious anomaly - referring to the situation posited in Price [2013] TC 02703 in which a bank employee was given an opportunity to acquire an option which was available to all customers, of which he was one. Clearly it would be unjust for such a case to be deemed “by reason of employment” as it was mere coincidence that the employment existed. The current case could be viewed similarly, in that although the literal words of s. 471(3) would have applied, the company was only facilitating the surrender of the original option, and doing so on less beneficial terms. To apply the deeming provision would be anomalous.

Lord Doherty

Agreeing with Lord Malcolm on the substantial points, Lord Doherty also addressed the UT's finding that that the original option had already become worthless because of Vermilion's financial difficulties and the new option therefore represented an additional benefit. On the contrary, he held that the original option had not become worthless, but would only become so if the rescue package was not granted. It was this rescue package that required Mr Noble to be a director. The new option was not caused by his employment but by the pre-existing option.

Lord President (Lord Carloway)

The sole dissenting voice, Lord Carloway saw no injustice, absurdity or anomaly and preferred the “plain and ordinary meaning” of the words in 471(3). He pointed out that the new option did not need to be structured in the way it was, but nevertheless it had been. As a result (as Vermilion had accepted in its original application for non-statutory clearance) on a literal view, the option would be caught.

Comment

A variety of issues emanate from this case, not least of which is that HMRC may well have been arguing the wrong case.

To take the existing case as presented, the rescue package contained a specific condition that Mr Noble should be appointed an Executive Chairman of Vermilion and, separately, that the existing options (not just those of Quest) should be cancelled or varied to ensure parity of dilution along with the other shareholders. It follows that the option was not dependant upon Mr Noble's continued directorship, but the rescue package was. To deem the option to be “by reason of the employment” would seem to have been anomalous, so a limitation to the deeming provision may be appropriate.

However, a point which seems to have been overlooked is that both the original option and the replacement option were granted to Quest Advantage Ltd (Mr Noble's personal service company) rather than to Mr Noble personally. This, of course, would not necessarily prevent s. 471 ITEPA from applying because of the phrase “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”, which makes clear that it doesn't matter...

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