A Suitable Case for Treatment

RICHARD CURTIS probes the workings of section 105A, Taxation of Chargeable Gains Act 1992.

AROMATHERAPY, HOMEOPATHY, REFLEXOLOGY. Not to be outdone in the new age stakes, the Revenue is now also offering an 'alternative treatment': of course, being British, I have a natural cynicism towards this - not that I could probably find anyone to manipulate my feet anyway. However, we all love, in these times of greater complexity and stress, a 'provision that is designed to be helpful and to simplify the tax position of employees'. Conservative spokesman, Howard Flight, used these words (let's imagine that they were spoken in soothing tones) during the Finance Bill 2002 debates with regard to section 50, Finance Act 2002. This inserted, like an acupuncture needle through skin, new section 105A into the Taxation of Chargeable Gains Act 1992. This section - 'shares acquired on the same day: election for alternative treatment' - is accompanied by supplementary provisions in section 105B.

What is the standard treatment?

So, if section 105A is an 'alternative treatment', what is it the alternative to and what is the standard treatment? The answer, unsurprisingly, is section 105, Taxation of Chargeable Gains Act 1992, which deals with situations where 'securities of the same class are acquired or disposed of by the same person on the same day and in the same capacity'.

As a brief background note, it is not uncommon for holdings of the same shares in the same company to be acquired in different tranches and it is presumably common knowledge that, when disposing of such shares, the taxpayer cannot simply choose which ones he has disposed of for capital gains tax purposes; instead, strict rules apply. Before April 1998 the general rule was that shares were 'pooled' and disposals reduced the pool with the accumulated cost being apportioned to each disposal. Different rules now apply and those not dealing with capital gains tax on a daily basis can be forgiven if their memory on this point is a little hazy as the rules seem to change on a regular basis. A brief summary of the current order of identification for capital gains tax purposes (provided by Tolley's Capital Gains Tax ) may be of help.

• Acquisitions on the same day as the disposal.
• Acquisitions within 30 days after the day of disposal (thus countering 'bed and breakfasting').
• Previous acquisitions after 5 April 1998 on a last in/first out (LIFO) basis.
• Shares acquired after 5 April 1982 and comprised in the pool at 5 April 1998 ( i.e. the 'section 104 holding' - previously known as the 'new holding').
• Shares acquired pre 6 April 1982 (the '1982 holding').
• Shares acquired on or before 6 April 1965 on a last in/first out basis.
• If the shares disposed of are still not exhausted, shares acquired subsequent to the disposal (and beyond the above-mentioned 30-day period).

As mentioned, section 105 deals with the implications of the first priority: acquisitions on the same day as disposal. The basic aim of the 'same day' rule is to frustrate 'bed and breakfast' transactions, where a shareholding is sold to crystallise a gain or loss and then repurchased on the same day (or shortly thereafter) to minimise the effect of any change in price. Having to 'match' such a disposal of shares with acquisitions on the same day (or within 30 days as in the second priority) would normally mean that only minimal gains or losses can be made, but the costs of sale and re-purchase, as well as the risk of price fluctuations, remain.

So why do we need an 'alternative'?

In the same way as 'take one of these each day and come back in two weeks if it's not any better' solves most medical problems, section 105 deals successfully (at least from the Revenue's point of view) with the problems of most 'same day' transactions in shares and securities. However, a new problem started to arise as more taxpayers began to acquire shares in ways other than by normal stock market purchases.

Section 105A potentially comes into play when shares, 'the approved scheme shares', are acquired either:

• by exercising an option under an enterprise management incentive scheme; or
• by way of an approved share option scheme.

The basic principle of these schemes is to 'incentivise' employees by allowing them to acquire shares in their employing company, but without the normal Schedule E income tax charge that would otherwise arise under section 135(1), Taxes Act 1988. The one adverse 'side effect' of this is that the shares are treated as being acquired at cost, and because this is likely to be less (and for the employee, hopefully much less) than market value at that time, they are therefore 'pregnant with gain'. Under the two above schemes, there is no capital gains tax charge on exercise/acquisition, so does this 'pregnancy' matter if the employee does not intend disposing of the shares for some time? Ordinarily, perhaps not, but suppose that other shares of the same class were acquired on the same day and in the same capacity. This is becoming more common. Because there are conditions and limits to the shares that can be acquired under these approved schemes, employees who acquire shares in these ways may also acquire shares via unapproved share schemes and companies often have a specific day when employees can exercise options to acquire shares under their various schemes.

Shares, for example, from an unapproved scheme (unlike those for approved schemes above) will be subject to an income tax charge under section 135(1) when the option to acquire them is exercised (as well as there perhaps being a charge when the option is granted). However, the 'side effect' of the Schedule E charge is that, because it is calculated by reference to market value on exercise, this value is the acquisition cost and there is thus unlikely to be any inherent capital gain at that point in time. To raise funds to settle the Schedule E liability, employees may therefore decide to sell some of these shares, and this is where the problems start.

Because shares of the same class acquired on the same day and in the same capacity are treated as a single holding and effectively 'pooled' under section 105, their cost is averaged and as shown by the Example , this can lead to a gain arising when some are sold. So, in seeking to raise funds to pay one liability (income tax under Schedule E), another liability (capital gains tax) has arisen. What can be done?

Quick nurse, the screens!

Unfortunately, screens will not protect the shares from this outbreak of capital gains tax liability, but an election under section 105A may do. With effect from 6 April 2002, this section allows the two holdings, say one acquired under an approved share option scheme and the other under an unapproved scheme (together termed 'the relevant shares') to be treated separately and the holding that produces the smallest gain is treated as the first one sold. There are, of course, detailed conditions to be satisfied before the section can be administered.

The shares

An individual must acquire 'relevant shares' of the same class on the same day and in the same capacity. Some of these shares must then be 'approved scheme shares', i.e. acquired as a result of either:

• an enterprise management incentive scheme under paragraph 1(1) of Schedule 14 to the Finance Act 2000, where paragraph 44, 45 or 46 of that Schedule applies; or
• an approved share option scheme under section 185(1), Taxes Act 1988, where subsection 185(3) (a) or (b) applies.

Paragraphs 44, 45 or 46 of Schedule 14 set out the calculation of any income tax liability under section 135. This will be £nil where the option is to acquire shares at not less than their market value when the option is granted, otherwise (generally) the taxable amount is limited to the difference between market value at grant and the amount paid.

Section 185 provides tax exemptions and reliefs for approved share option schemes, with section 185(3) providing that, on exercise of the option, no income tax liability will arise and nor will a capital gains tax charge arise under section 17, Taxation of Chargeable Gains Act 1992 (disposals and acquisitions treated as made at market value).

Enterprise investment scheme shares

Subsections 105A(7) (a) and (b) provide that if shares were issued under the enterprise investment scheme and then transferred to the individual by the husband or wife, these shares are treated as having been acquired by that individual on the day that they were issued.

The election

Subsection 105A(2) provides that an election can be made when an individual 'first makes a disposal' of any relevant shares ( i.e. shares that include 'approved scheme shares'). The election will mean that the provisions of subsections 105A(3), (4) and (5) will then apply as follows.

• The 'approved scheme shares' will be treated as acquired in a separate transaction from the other relevant ( i.e. 'same day') shares and as being disposed of after the other relevant shares.
• But an election under section 105A will not displace normal enterprise investment scheme relief rules. However, shares that have obtained either income tax and/or capital gains tax deferral relief under the scheme are treated as being disposed of after other 'relevant shares', but before 'approved scheme shares'.
• Similarly, where shares have been 'reorganised' under section 127, Taxation of Chargeable Gains Act 1992, their identity as approved scheme shares (or not) is preserved.

The supplements

No, these are not vitamins, but section 105B, which follows up with 'Provision supplementary to section 105A'. The numbered subsections provide as follows.

(1) The identification rule in section 105A, once brought into play, overrides any other way of identifying shares that have been disposed of.

(2) The time limit for making the election is the first anniversary of the 31 January following the end of the tax year in which the disposal took place. So if the disposal is during the year ending 5 April 2003, the election must be made by 31 January 2005.

(3) If 'clogged shares' ( i.e. shares subject to restrictions, such as the right to dispose of them) were acquired on the same day, these are treated as a different class under section 104(4), Taxation of Chargeable Gains Act 1992. These shares are subject to any previously made section 105A election only with effect from the date of lifting of the restriction.

(4) Deemed part disposals of shares as a result of a capital distribution or a receipt in a reorganisation ( sections 122(1) and 128(3), Taxation of Chargeable Gains Act 1992) are not treated as disposals and are ignored for the purposes of making a section 105A election.

(5) Ordinary shares in a venture capital trust cannot be subject to a section 105A election.

(6) , ( 7) and (8) Definitions and interpretations are provided by these subsections.

The final prognosis

Having analysed section 105A, attention must be drawn to Mansworth v Jelley [2002] STC 1013, covered by Nicholas Yassukovich in his article 'Victory is Sweet', Taxation , 13 February 2003 at page 454.

Without going into the full details of that case, it is now possible for a capital loss to arise on the disposal of shares acquired via unapproved employee share options or Enterprise Management Incentive share options because both the market value at exercise and the amount, if any, charged to income tax are included in the acquisition cost. Nicholas's article gives some examples of the decision in operation. This will mean that if an election is made under section 105A a loss, rather than a nil liability, may arise. Depending upon the taxpayer's other circumstances, this may affect whether an election is required or not. Such considerations may be short-lived if there are changes in this year's Budget.

It should also be noted that section 105A only addresses 'same day' transactions. Practitioners should also be aware of potential problems if, say, an option to purchase unapproved shares is exercised on Monday and the shares are sold on Tuesday. If an option to purchase approved shares is exercised within 30 days of that disposal, this acquisition will be linked to the previous disposal under the '30-day rule'. This could ( Mansworth v Jelley aside) result in a gain, that could not be relieved by a section 105A election.

So, pending the Budget and any further Mansworth v Jelley treatments, a detailed diagnosis of a taxpayer's 'same-day' acquisitions is required to ascertain whether a section 105A election should be administered.

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