Victory Is Sweet

THE INLAND REVENUE suffered what it no doubt believed to be a tactical defeat in the long running battle it had waged with taxpayers over section 29A, Capital Gains Tax Act 1979 (now section 17, Taxation of Chargeable Gains Act 1992) in March 2002. This defeat took the form of the High Court decision in Mansworth v Jelley [2002] STC 1013.

In this battle, the Revenue's primary objective had been to deny employees exercising share options a claim to take the fair market value of the underlying shares (on the date acquired) as their base cost for capital gains tax purposes. Section 17 allowed such a claim in respect of any asset acquired by reason of employment or otherwise than by bargain at arm's length. This battle had been waged extensively in Revenue publications and individual taxpayer cases.

In December 2002, the Revenue suffered yet another tactical defeat, this time in the Court of Appeal. This was a defeat which seems to have been so heavy, that it is in wide scale retreat on all fronts, having even given up ground that most opponents would have assumed could be safely held for the duration. At the time of writing, the Revenue is regrouping behind the Hadrian's Wall known as the self-assessment régime, and is no doubt busily sharpening its most effective current weapon, namely the 2003 Finance Bill. However, I understand that it is being extensively lobbied by business organisations, which are demanding that some of the stones in this wall be temporarily removed to allow taxpayers some extra foraging behind enemy lines.

For an analysis of the case, I refer you to my review of the High Court decision 'Revenue Confounded' in Taxation, 30 May 2002 at pages 246 to 247. I understand that tax counsel may comment on the appeal in a future issue of the magazine, and therefore the purpose of this article is not to repeat the detailed arguments and technical background to the decision. Rather, I aim to explain some of the implications of this case for those who have disposed of shares acquired through the exercise of an employer granted share option. This is not a comprehensive analysis of all technical issues. Instead, I seek to focus on the broad impact and the resulting issues concerning amending returns within the context of the current self-assessment régime.

All references in this article are to the new sections in Taxation of Chargeable Gains Act 1992 unless otherwise stated.

The Revenue has always argued that, for people in such circumstances, section 17 did not allow them to take the fair market value of the shares at exercise as their base cost. In its view, where, for instance, a taxpayer exercised an option and disposed of the shares straightaway, he realised a nil income tax charge but a capital gains tax charge on the profit realised from the exercise.

However, Mansworth v Jelley allows them to claim the fair market value of the shares at acquisition as their base cost. This reduces their capital gains tax to nil and typically, but not always, their only tax exposure on the profit realised is with the tax régime where they were resident at or from grant/vest. Figure 1 includes a 'before and after' calculation to show the impact of Mansworth on an example fact pattern.

Unfortunately, a review of the legislation does not fully support the whole of this statement. Certainly the case does in a technical sense apply to these people. It confirms that shares acquired by the exercise of an employer granted share option are not acquired by way of a bargain at arm's length. But it in no way confirms that, where fair market value replaces actual acquisition cost for the purposes of computing the chargeable gain or allowable loss, the taxpayer can add on to this any uplift for amounts charged to income tax by reference to section 120. As Michael Sherry pointed out in Taxation, 23 January 2003 at page 363, section 120 works in tandem with section 38(1): but section 17, which this case now makes applicable, effectively replaces section 38(1). This matters not for those who acquired the shares through enterprise management incentive scheme options, as they have no income tax charge. Nevertheless, for those exercising unapproved share options, it would seem that the Revenue's position on this matter is more beneficial than the case indicates.

Fortunately, taxpayers may presumably rely on the judicial review case R v Commissioners of Inland Revenue ex parte MFK Underwriters Agencies Ltd and others [1989] STC 873 as justification for taking the Revenue's position on their tax return rather than the position supported by the law. In this case, Lord Justice Bingham is most concise: 'No doubt a statement formally published by the Revenue to the world might safely be regarded as binding, subject to its terms, in any case falling clearly within them'.

Figure 2 illustrates the position of someone who follows the Revenue position in respect of a disposal of shares acquired under an unapproved share option.

However, the note failed to mention how these rules might differ for someone seeking only to claim a capital loss. Section 43, Taxes Management Act 1970 suggests this is five years and ten months from the end of the tax year of the claim. While many believe that section 42(2), Taxes Management Act 1970 technically overrides this section, it would appear from the Revenue's Capital Gains Tax Manual at paragraph CG15813 and the Revenue notes to the capital gains pages (See CGN11), that for losses realised in years covered by the self-assessment régime, the extended period of five years after the normal filing deadline is in point. Thus for shares disposed of in 1996-97 where, pre Mansworth v Jelley, the capital gains tax computation showed a nil gain and nil loss, a claim could be made prior to 31 January 2003 to claim the loss which Mansworth now allows. For disposals in years prior to the introduction of self assessment, there is no time limit for claiming a loss.

As a result of this technical note, tax professionals working in personal and expatriate tax departments have had a busier January than ever before. The need to identify clients affected by the decision and make claims or file amended returns for some of them prior to 31 January, has put intense pressure on existing resources.

I understand that certain business organisations did lobby the Revenue to be flexible with the 31 January deadline in respect of these claims. At the time of writing I do not know if they were successful but, given the tight deadline, a relaxation of the deadline would surely have led (or will surely lead) to significant loss of revenue.

The Revenue has also relaxed the rules in circumstances where there has been a corresponding disposal of the shares acquired by exercise of the option (typically by an employee benefit trust). For tax returns filed before 12 December 2002 only, it will not seek to collect the increased tax due by the disposer as a result of the increase in disposal proceeds deemed to take place by the operation of section 17(1). Given the quantum of the retrospective tax loss as a result of this case, the decision not to collect additional tax on the other side of the transaction is to be welcomed, albeit with some surprise.

The final difficulty concerns the exact value of losses which may now be claimed outside the normal self-assessment repair régime. Some taxpayers can claim allowable losses for years in which they are unable to repair a self-assessment return. How those losses interact with gains which have been declared on tax returns that may no longer be repaired is not something which is explicitly set out in the legislation. It has also been the area of greatest dispute among the interested parties (professional advisers, their clients and the Revenue) since the technical note. Three options have been suggested by various parties but with varying technical explanations:

There are a number of technical arguments to support this position. One innovative idea I have heard is that the error being rectified is not the claiming of a loss the taxpayer did not know he had, but the offsetting of the loss against a gain. In other words, claim your loss under the terms of section 43, Taxes Management Act 1970 and then claim to offset the loss against any gains on returns outside the normal self-assessment repair deadlines of ibid., section 9ZA by recourse to ibid., section 33.

Nicholas Yassukovich is a senior tax manager in the global employment solutions practice in Ernst & Young's London office. The views expressed are not necessarily those of his firm. He can be contacted by e-mail: nyassukovic@uk.ey.com and tel: 020 7951 8210. He is indebted to Steve Wade and Rosemary Martin for assistance with this article.