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Replies to Queries -- 3 - Valid tax deduction?

25 April 2001
Issue: 3804 / Categories:

We act for a large United States multinational. The ultimate parent company is a Delaware incorporated company and is quoted on the New York Stock Exchange. The headquarters for its European activities is the United Kingdom, which employs several thousand employees.

We act for a large United States multinational. The ultimate parent company is a Delaware incorporated company and is quoted on the New York Stock Exchange. The headquarters for its European activities is the United Kingdom, which employs several thousand employees.

Each year, the United Kingdom employees are awarded stock options (i.e. shares in the United States company) as part of their remuneration package. When the United Kingdom employees exercise their options, shares in the United States company are awarded to them. At present, there is no charge from the United States parent to the United Kingdom company.

If the United States parent was to start recharging the United Kingdom company (for the difference between the option grant price and the exercise price or market value), would the United Kingdom company be entitled to a tax deduction? What is the statutory authority?

(Query T15,794) – Dragon.


For any expense to be deductible for the purposes of Schedule D, Case I, it must be wholly and exclusively laid out for the purposes of the trade, profession or vocation.

One must then consider if such a question has been placed before the courts and, if so, what was the result of their determinations. A similar case has come before the courts – Lowry v Consolidated African Selection Trust Limited 23 TC 259. The facts of the case were that shares of a quoted company, which were being traded at a premium, were issued to named employees at par. The company claimed a deduction for the difference between the market price and par. The case was eventually decided in the House of Lords in the Crown's favour. However, this basic fact, which could discourage 'Dragon' from making a claim for a deduction, hides some interesting possibilities which are highlighted by reading the full judgment. As a first point, the decision in favour of the Crown was by a majority of 3 to 2. In addition, at each step of the appeal process the decision of the preceding court was reversed. These facts show that the case was very finely balanced; with such cases, a small change of circumstances which helps the taxpayer's case can ensure a successful outcome.

When deciding this case, the main point on which the company failed was the fact that no actual expenditure was incurred. The deduction was merely the potential for profit which had been foregone by not issuing the shares at a premium through the market.

The fact that the employees had been assessed on the premium by virtue of the decision in Weight v Salmon 19 TC 174 did not affect the merit of the claim for a Schedule D, Case I deduction. In his judgment, Viscount Caldecote stated:

'I find no guidance from the fact that the employees have had to pay income tax on the premium value of their shares. The assessment on the employees was on the ground that, holding an office or employment of profit, they received a profit therefrom: the right to include a deduction of the amount in question in the trading account of the company for the purposes of Schedule D must be justified by a finding that the company incurred a trading expense.'

Readers may discern the potential distinction that 'Dragon' may be able to exploit. In the aforementioned case, the company issuing the shares was the employer. For 'Dragon's' client, the company issuing the shares is the parent company of the employer. In this scenario, the deduction being claimed by the employer is an actual expense and it is not hypothetical.

For this reason, the client of 'Dragon' can, in my opinion, claim a deduction for the recharged expense. – Hodgy.

Presumably the United States company is entitled to a deduction for the option gain and what 'Dragon' seeks is a means of reflecting this treatment in a United Kingdom tax context. Unfortunately 'Dragon' does not give enough factual information to allow a conclusive answer to be given. For example, is the scheme approved or unapproved? Are the shares in the United States company new shares that are issued by the United States company to the United Kingdom employees or are they shares already in issue that are passed to the employees by the United Kingdom company? In general terms, however, the answer is as follows.

There is no statutory provision that allows the deduction of an option gain for the purposes of computing Schedule D, Case I profits. It follows that a deduction will be available if the amount concerned satisfies the usual two criteria, i.e. that the expenditure is revenue rather than capital in nature and that it is not specifically prohibited as a deduction by the legislation as interpreted by the courts. In this case, the legislation in point is section 74(1)(a), Taxes Act 1988.

Presently, there is no accounting standard that allows one to deduct an option gain. Thus it follows that if the United Kingdom company were issuing its own shares, the answer would be straightforward. A deduction would be prohibited by section 74(1)(a) on the basis of the decision in Lowry v Consolidated African Selection Trust Ltd 23 TC 259. It is worth commenting that the argument that succeeded in Consolidated African Selection Trust, which was broadly that the amount claimed had not been disbursed, is inconsistent with the analysis of the word 'expended' in Herbert Smith (a firm) v Honour [1999] STC 173 and – if the current Urgent Issues Task Force discussion paper on share-based payment changes the accounting position in the future – will become inconsistent with section 42, Finance Act 1998; and so the way may well be open for further argument, notwithstanding that it may well have to proceed to the House of Lords for conclusive resolution!

However, if, as here, the United Kingdom company does not issue shares but is invoiced by the parent for the provision of the option shares in an amount equal to the value of the shares that the parent is required to issue over the amount that the employees pay, then the nature of the amount changes and Consolidated African Selection Trust ceases to be relevant. The expenditure could properly be argued to reflect the cost to the subsidiary of providing remuneration for the United Kingdom company's employees, in which case the amount charged would be fully deductible as a payment of a revenue nature incurred wholly and exclusively for the purposes of the trade. It would of course be essential to have the transaction accurately reflected in the business records of both parent and subsidiary so that it was clear that what the subsidiary was paying for was a genuine contractual obligation to provide and pay for a proper employee incentive scheme. This should minimise the risk of the Revenue arguing that the transaction is a sham transaction with no basis in reality. – Andrew Gotch, Professional Tax Practice.

Issue: 3804 / Categories:
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