Lucky for Some?

KEITH M GORDON MA, ACA, CTA identifies another possibility of double tax relief for holders of employee share options.

AS CONTROVERSY REIGNS over the correct capital gains tax treatment of unapproved share options following the Court of Appeal decision in Mansworth v Jelley , this is an ideal opportunity to consider the impact of a recent change to the income tax treatment on the exercise of unapproved share options, and an intriguing possibility of unexpected additional income tax relief for some optionholders.

At the time of writing, the Income Taxes (Earnings and Pensions) Bill is before the House of Lords and (subject to the constitutional niceties) is expected to take effect from 6 April 2003. However, statutory references here are to the Taxes Act 1988 unless otherwise stated; references to clauses will be to clauses of the Bill as brought to the House of Lords from the Commons.

Tax payable on the grant of an option

As far as income tax is concerned, share options can be taxed on up to two occasions. The first is when the option is granted, the second when the option is exercised (or assigned or released).

In most cases, no income tax is payable in respect of the grant of a share option. This is because section 135(2) (rewritten in the Bill at clause 474) excludes from tax the grant of a share option that cannot be exercised more than ten years after grant. For options granted before 6 April 1998, the options could not be exercisable after seven years.

Further, the ten-year rule need not be met in respect of options granted under the enterprise management incentives legislation ( paragraph 43 of Schedule 14 to the Finance Act 2000). However, it should be noted that the option under that legislation must at least be capable of exercise within ten years of grant ( paragraph 39 of Schedule 14 to the Finance Act 2000).

However, when tax is payable on the grant, tax is payable under normal principles, i.e. the employee is taxed on the value of the option received - broadly the discount (if any) of the exercise price compared with the market value of the shares that may be acquired under the terms of the option.

In order to reduce the incidence of double taxation, section 135(5)(a) (rewritten as clause 478(2)) gives relief in respect of the tax charge on the grant of the option when the option is subsequently exercised, assigned or released. It is the method of calculating this relief that changed with effect from 6 April 2002.

The position before 6 April 2002

Until the introduction of the changes made by Finance Act 2002, this relief was simply calculated in terms of the tax payable on the grant. So if £100 tax was paid when the option was granted to the employee, any tax charge on the subsequent exercise, etc. would be reduced by £100.

In many ways, this form of relief was quite sensible. However, it was out of line with other sets of rules, for example those dealing with tax charges that might arise on the exercise of options under a company share option plan. These other rules provide that the gain arising on the exercise of an option be reduced by the amount treated as income on the grant (see section 185(8)(a) or clauses 479(2)(d) and 480(2)(c)).

Another problem with the line taken in respect of unapproved share options is the difficulty to ascertain precisely how much tax is charged on a particular event - especially now that we no longer have schedular assessments for different income sources. As a result, the two types of relief were brought together in Finance Act 2002.

The position from 6 April 2002

Section 37(1) of, and paragraph 1 of Schedule 6 to the Finance Act 2002 provide that any amount treated as income on the grant of an unapproved option shall now be deducted from the gain arising when the option is exercised, etc. Of course, this form of relief means that an employee who pays little tax on the grant of an option (because of a low marginal rate of tax) will now get the same relief as someone who pays 40 per cent tax on the grant. Conversely, an employee whose marginal rate has fallen since the option was granted will be worse off under the new rules.

Which options are affected?

It was suggested from some quarters that the new rules were introduced with retrospective effect. In other words, any exercise, etc. of a share option after 5 April 2002 would be calculated on the new basis irrespective of the date on which the option was originally granted. However, it is submitted that this is not necessarily the case. Under an alternative interpretation, options granted before 6 April 2002 still carry a credit for the tax paid on grant, rather than require an adjustment for the income charged to arise on the grant.

To reach the alternative interpretation, it is first necessary to consider the commencement provision that applied to the new rule. This is in section 37(2), Finance Act 2002 which states that the amendments made by Schedule 6 'have effect for the year 2002-03 and subsequent years of assessment'.

Secondly, one should consider the context of the rule in section 135(5)(a). It does not provide a simple calculation of the income to be charged upon the exercise, etc. of the option. Instead, it builds upon the basis stated in section 135(1) that the option was 'obtained by [a] person as a director or employee of [a] body corporate'. It then proceeds on the assumption that the grant was chargeable to tax. If the grant meets these conditions, then the legislation provides for an adjustment when the option is subsequently exercised, etc. As a result, in my view options obtained before 6 April 2002 are not affected by the new rules.

The position from 6 April 2003

No doubt, any controversy regarding the correct interpretation will be litigated at some future date. However, the Bill currently before Parliament adds a further layer of intrigue. Subject to any stated changes in the law, it is intended that the new Bill makes no changes in the law. In particular, the law as it exists on 5 April 2002 should not be affected by the introduction of the Bill on the following day (paragraphs 1 and 2 of Schedule 7 to the Bill). In order to effect this, the rest of Schedule 7 contains some transitional provisions.

In particular, paragraph 64(2) provides that for any share option obtained before 6 April 2003 'any amount charged to tax under Schedule E in respect of the receipt of the share option is a deductible amount'. If the Finance Act 2002 changes were to have retrospective effect, then this produces the correct result. However, it would be strange if one could interpret 2002 legislation with the benefit of looking at what Parliament did in 2003. So if the 2002 changes did not have retrospective effect, one might now have a case of double relief being available. This is illustrated in the Example on this page. I am sure that this point will make future litigation even more likely.

Example

Keith Gordon is a director of ukTAXhelp Ltd, a company specialising in providing tax advice to other professional businesses. He can be contacted on keith.gordon@ukTAXhelp.co.uk.

Keith's recent book A Guide to Employee Share Schemes - The tax rules for employers and employees is available. Details can be obtained via www.ukTAXhelp.co.uk/books.htm.

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