National Insurance Capping - MARK SAUNDERS BEng, ATII, ACA explains how the new special National Insurance payments work

IS THERE A 'know-it-all' in your office who winds you up? The type of person who can quote subsection numbers without really trying, who knows what Lord Reid said in each of his judgments, and who always answers the tricky questions by looking at inheritance tax first. If so, the Government has just given you a most fantastic opportunity: section 3, Social Security Contributions (Share Options) Act 2001.

Ask this person to explain section 3 of the Act. Ask him for some worked examples of how the option rollover rules contained in the section work. You could also ask him if there are any planning opportunities.

While he is looking at section 3, I will set out a few comments on the remainder of the Act.

Background

National Insurance contributions are due on the exercise of most unapproved share options granted on or after 6 April 1999. As the employer's National Insurance liability is uncapped, employers can face huge National Insurance exposures on unapproved options. The Government has introduced new legislation that allows employers to cap what would otherwise be an unlimited liability.

Companies have until 10 August 2001 to take advantage of these new rules, and to do this, they must:

• make a capping election; and
• pay any 'special' National Insurance contributions due as a result of making the capping election.

The amount of the special National Insurance payment is calculated as if the options covered by the election had been fully exercised on 7 November 2000.

If a capping election is made in respect of an option, it will mean that no National Insurance liability (either employee's or employer's) will arise on its eventual exercise. However, there will be no refund of any special National Insurance paid if the option is never exercised or if the liability that would otherwise have arisen on the actual exercise was lower.

What options can be capped?

An option can only be capped if:

• the employee to whom it was granted was subject to tax under Schedule E, Case I at grant;
• it was granted between 6 April 1999 and 19 May 2000 (inclusive); and
• it had not been exercised by 7 November 2000.

There are also special rules that may allow options that have been 'rolled over' after 19 May 2000 to be capped.

The Inland Revenue has confirmed that it is not possible to cap part of an option, even if the option is capable of being exercised in parts under its terms.

How is the election made?

The Revenue's website, www.inlandrevenue.gov.uk/nic/forms.htm, contains an illustrative capping election and gives details of how to make the special National Insurance payment.

The capping elections must be made on an option-by-option basis rather than a global basis. Information that needs to be provided includes the name and National Insurance number of each option-holder as well as full details of the options to be capped.

If the National Insurance liability on the exercise of the option has already been transferred to the option-holder, the procedure is slightly different in that the employee needs to be involved in the process.

The amount of the payment

The special National Insurance payment is calculated as 12.2 per cent of the amount of the gain that would have been subject to income tax under section 135, Taxes Act 1988 on the exercise of the option. If an exemption from National Insurance would normally have been available because the employee was not within its scope or because the shares were not readily convertible assets, the amount of the special payment will be nil.

The amount of the notional gain is not simply the capital gains tax definition of market value less the exercise price. It is the amount that a person 'might reasonably expect to obtain from a sale [of the shares] in the open market' less the exercise price and the amount paid on grant (assuming that it was not a discounted long option). This means that the bid price of the shares should be used where shares are priced on a market that uses a bid-offer basis. In addition, a deduction can be claimed for notional selling costs (although this is not shown on the capping election form supplied by the Revenue).

There is a reference on the Revenue's website to using the capital gains tax definition of market value (Question 19). I do not believe that this is correct and can see no legislative basis for using it.

For unquoted companies, it will be necessary to agree the value of the shares with the Revenue's Shares Valuation Division. There is a box on the Revenue's capping election form to tick to confirm that the value of the shares has been agreed with Shares Valuation Division, and I recommend that the valuation process be started with the Shares Valuation Division as soon as possible.

The Revenue's website also states that companies listed on a stock exchange other than the London or New York stock exchanges should also agree the value of their shares with Shares Valuation Division. This should normally be a formality for such companies.

Automatic capping elections

One of the main differences between the Act and the original bill is that there are provisions for a capping election to be made automatically if the amount of the special National Insurance payment due for a particular option would be nil. This will cover:

• options that are underwater on 7 November 2000;
• options over shares in an unlisted companies whose shares were not readily convertible assets on 7 November 2000;
• approved options (which is handy if these are, for example, cash cancelled at a later date); and
• employees who were taxed under Schedule E, Case I but who were, on 7 November 2000, outside the National Insurance régime, e.g., certain expatriates.

Automatic capping elections are very useful. However, some companies may want to notify the Revenue that they are assuming that an automatic capping election applies. This could be helpful evidence to support a 'reasonable excuse' claim if the Revenue were subsequently to decide that a real capping election and special National Insurance payment should have been made. Alternatively, a contemporaneous file note setting out why an automatic election was thought to have been made could be helpful.

A practical difficulty with automatic capping elections is that companies which know nothing about them will continue to pay National Insurance on exercise even though they do not have to do so.

Readily convertible assets

The normal rules for establishing whether or not a share is a readily convertible asset on 7 November 2000 apply for these purposes section 203F, Taxes Act 1988 and Statutory Instrument 1994/1212). Shares in a listed company will be readily convertible assets, as will shares in companies where 'trading arrangements' exist for their shares, for instance where an employee has a put option. Shares will also be readily convertible assets where it is 'likely' that 'trading arrangements' will come into existence in accordance with an 'understanding' or agreement existing on 7 November 2000.

For most companies, it will be easy to determine whether or not the shares are readily convertible assets. However, for companies that were in the process of floating or were in the process of being sold, the issue is more complicated. In the Standing Committee debate on the definition of readily convertible assets, the Financial Secretary said that shares would be readily convertible assets if the company 'plans to float and has taken meaningful steps towards flotation. For example, it may have instructed brokers, merchants [sic] and others about its intentions. When a company has done less than that, a desire to float will not be enough...'.

Further information about the Revenue's view as to whether or not a share is a readily convertible asset can be found in the September 1998 edition of Tax Bulletin.

Should an election be made?

For options exercised between 8 November 2000 and 10 August 2001, hindsight can be used to decide whether or not to make a capping election. This means that if less National Insurance would be due with a capping election compared with the normal rules, a capping election should be made.

In situations where an automatic capping has not been made, it can be hard to decide whether to make an election. In these circumstances, companies will normally want to calculate the net present value of making a capping election compared with not making one. This can be quite difficult as volatility, share price growth rates, lapse rates and the time value of money will all need to be considered.

Option rollovers

The office know-it-all has now reappeared with a copy of the Act (see www.hmso.gov.uk/acts/acts2001.htm) and a yellow highlighter pen. While he is busy highlighting away, you may be interested to know that Lord McIntosh said in Parliament of section 3:

'the provision is both a masterpiece of drafting and a tribute to the cunning and complexity of the minds of the legal profession.'

In the House of Commons, an explanation of the option rollover rules was called 'racy' and 'intoxicating'.

In my previous article I said, 'special rules apply to options that have been rolled over since 19 May 2000'. I did not set out full details because I was embarrassed about the fact that I did not understand them properly. I am less embarrassed now because I have worked out that nobody else I know understands them properly (read the first bit of section 3(6) and the last bit of section 3(7), if you want to be convinced that you do not understand them either).

By the time that you have reached the end of this article, the know-it-all will have quietened down a good deal. The yellow pen will probably be in the bin, the Act in the other corner of the room. 'No idea,' he will say, 'roll on tax simplification'.

You will be able to explain that where there has been a parity option rollover, i.e. the exercise price and the value of the shares under option are the same, the new option will stand in the shoes of the old options and so can continue to be capped. This is known because the Government said so in Parliament. In a few weeks or months time, the Revenue will have produced a guide as to what it believes the option rollover rules say and everything will be hunky-dory. Legislation by Tax Bulletin will strike again.

Mark Saunders is a senior manager in Andersen's human capital practice, specialising in share plans. He can be contacted on 0118 952 3323 or via e-mail: mark.saunders@uk.andersen.com.

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