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NICK YASSUKOVICH of Andersen examines the High Court's decision in Mansworth v Jelley.
RECENT HIGH Court decision has overruled the Revenue's longstanding position on how to determine the capital gains tax base cost of shares acquired under certain types of employer granted share options. In Mansworth v Jelley [2002] EWHC 442, the High Court ruled that section 29A, Capital Gains Tax Act 1979 (now section 17, Taxation of Chargeable Gains Act 1992) determines the base cost as an amount equal to the fair market value of the shares at exercise (rather than the amount actually paid for the shares under the terms of the option which would apply under core capital gains tax principles). This was on the grounds that if the share option was acquired by reason of the taxpayer's employment or otherwise than by a bargain at arm's length, it followed that this status also attached to the acquisition of the shares themselves.
All references in this article are to Taxation of Chargeable Gains Act 1992, unless otherwise stated.
Background
The taxpayer worked for a large United States bank and, while not resident and not ordinarily resident in the United Kingdom, had been granted options to purchase shares in the bank at their then market price. The right to exercise the options was dependent on his continued employment for at least one year following grant. At a time when he was resident in the United Kingdom, he exercised the options and disposed of the shares. The Revenue assessed him to capital gains tax and, in calculating the chargeable gain, allowed a deduction only for the actual price paid for the shares and the market value of the options at date of grant, which in this instance was agreed to be nil.
The taxpayer appealed, claiming that he should be allowed a base cost equal to the market value of the shares at the date acquired.
The Special Commissioners found for the taxpayer, so the Revenue appealed to the High Court.
Analysis
There was no liability to income tax on the exercise. In the first instance section 135, Taxes Act 1988 did not apply to him as he was not resident in the United Kingdom at the time of grant, and so outside the scope of Schedule E, Case I (see section 140(1)(a), Taxes Act 1988). Furthermore, it is generally accepted that a tax charge under section 162, Taxes Act 1988 should not be imposed in place of section 135, if the option was granted during a period of non residency and not in expectation of an employment in the United Kingdom to which Chapter II of Part V of Taxes Act 1988 could apply.
As there was no charge to income tax on the exercise of the option, there was no ability to increase the base cost of the shares acquired for capital gains tax purposes by reference to section 120.
However, the taxpayer argued that under the terms of what is now section 144(3), section 17 did apply and the base cost of the shares should be their fair market value at acquisition. Section 144(3) (then 137(3), Capital Gains Tax Act 1979) states that the acquisition of an option and the transaction entered into by its exercise 'shall be treated as a single transaction'. Since it was found by the Commissioners that, as a statement of fact, the option was acquired otherwise than by way of bargain at arm's length and also by reason of his employment, so it follows that the shares were acquired in a like manner thus putting the acquisition within the realms of section 17.
The Revenue introduced in court an argument also found in the Capital Gains Tax Manual at paragraphs 56379 to 56386. It argued that the status of the transaction when the shares were acquired was all that mattered. When acquiring the shares, the taxpayer was acting in his capacity as option holder and not in his capacity as employee. Therefore section 17(1)(b) did not apply in determining the cost of the shares. Furthermore he was removed from section 17(1)(a) because the acquisition of the shares was in pursuance of the rights under an option rather than by reason of his employment and the exercise of the option constituted a bargain at arm's length.
Judgment in the High Court
The case was heard by Mr Justice Lightman. In his decision he set out a two-step analysis from which he reached a conclusion in the taxpayer's favour. In the first instance he flatly rejected arguments that the term 'bargain at arm's length' requires no qualities other than those of a simple transaction between two parties. The second step was to decide that section 144(3) did link the acquisition of shares to the grant of the options in such a way that the quality of the latter acquisition flowed to the former for the purposes of section 17. If the option was granted by reason of the employment, then so were the shares subsequently acquired upon exercise. Likewise, if the option was granted by way of bargain at arm's length, then so were the shares acquired upon exercise.
He concluded that 'no-one could fairly or sensibly regard the taxpayer's acquisition of shares (looked at as a whole) as an acquisition by way of bargain at arm's length'. In addition, the acquisition of shares was 'at least in part by reason of the taxpayer's employment'. The base cost of the shares for capital gains tax purposes was their market value at the date the option was exercised.
As an aside he also considered the situation on the basis that the Revenue was correct and the exercise of the options should be looked at without regard to the grant. In such circumstances, he did not believe that the exercise of an option was a bargain at arm's length being merely a unilateral action by the holder which rendered unconditional a previously struck contract.
The Revenue's appeal was dismissed.
Decision for the taxpayer
Commentary
The case seems to apply to all types of employer granted share options other than those:
- granted under a Revenue approved share option scheme where no income tax is payable at exercise (section 185(3), Taxes Act 1988 separately ensures that section 17 does not apply when calculating the cost of shares acquired under such options);
- where exercised options are satisfied by the issue of new shares direct to the employee by the company (section 17(2)(a) requires that there is a corresponding disposal which will not be the case if the company issues new shares).
It will be a particularly useful case for those who are granted share options when not resident in the United Kingdom while on an international assignment with their employer, and who subsequently dispose of the shares when they are back in the United Kingdom capital gains tax régime.
Also affected are foreign nationals granted share options when living abroad, but who are then assigned to the United Kingdom where they exercise options and dispose of shares when United Kingdom resident (if the shares are non-United Kingdom situs assets then the case will only apply to foreign domiciliaries if they remit the proceeds of disposal to the United Kingdom). Effectively these taxpayers can expect to avoid not only an income tax liability as before but, if they dispose of the shares shortly after exercising the option, also a capital gains tax liability.
There is some doubt as to whether the judgment affects cases where the options were granted after 27 November 1995. From this date, section 149A ensures that section 17 is disapplied in calculating the consideration on grant of an option by reason of employment. The facts of this case took place prior to this date, so the judgment does not consider the impact of section 149A. However, in my opinion the wording of the section is clear enough: it is in point only when someone acquires an option by reason of employment and it disapplies section 17 on grant. But when a post 27 November 1995 option is exercised, the grant of the option ceases to be an identifiable event due to section 144(3) and we are now concerned with a single transaction which is effectively the acquisition of shares. Accordingly, while section 149A disapplies section 17 when the option is granted, section 144(3) disapplies section 149A when the option is exercised, and hence the taxpayer is, as a result of Mansworth, able to obtain the benefits of section 17.
Those exercising enterprise management incentive options may also be able to uplift the base cost for capital gains tax purposes to the market value at the date the shares are acquired. There is no equivalent of section 185(3) for such options, and this will lead to many realising a considerable tax saving. Those designing schemes based around such options may wish to consider carefully the means by which shares are made available in satisfaction of exercised options to ensure that employees do not fall foul of the corresponding disposal rule in section 17(2)(a).
The circumstances of the option grantors must also be considered. The Mansworth ruling may alter their tax position on their disposal of the shares in satisfaction of the option exercise because section 17 and section 144(3) also govern the consideration received by the option grantor. The case is likely to have increased their capital gain on the disposal of shares to the option holder. To minimise this increased gain, grantors, who are individuals resident in the United Kingdom, or trustees may consider an election under section 165, although this might boost the eventual gain realised by the grantee. This latter point will not affect those liable to income tax at exercise as section 120 effectively allows an uplift in base cost to the market value of the shares on exercise. In other cases it would be helpful if the share option scheme was administered by an offshore trust which was not liable to capital gains tax when disposing of shares in satisfaction of option exercises.
Finally, it is necessary to consider any requirement to amend previously filed tax returns to claim a reduced chargeable gain or indeed a capital loss (or for the grantor: increased gains and reduced losses). Where a gain is being adjusted, given that this case is a clear reversal of the Revenue's view, it will be difficult to persuade the Revenue to allow an amendment outside the self assessment time limits under the error or mistake clause (section 33, Taxes Management Act 1970). Subsection (2A)(a) prevents such a claim if the original return was prepared in accordance with generally prevailing practice.
