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A Legislation-Based Remedy?
KIRSTY PAYNE suggests that the acquisition of founder shares in new companies may not need to be reported.
A Legislation-Based Remedy?
KIRSTY PAYNE suggests that the acquisition of founder shares in new companies may not need to be reported.
I HAVE READ Martin Riley's article (see ' Another Revenue-Induced Headache', Taxation , 8 July 2004 at page 375) and would like to suggest an alternative argument for founder shares acquired by directors of newly-incorporated companies not having to be reported on form 42. The reporting obligation is contained in section 421J, Income Tax (Earnings and Pensions) Act 2003 (and all other references are to that Act unless stated otherwise), which requires certain people to report 'reportable events'. Reportable events are described in section 421K, and the relevant one for our purposes is at 421K(3) (a) :
'an acquisition … of securities … pursuant to a right or opportunity available by reason of the employment of the person who acquires the securities …'.
What this subsection does not say is 'an acquisition of employment-related securities'.
'Employment-related securities'
The rather curious definition of 'employment-related securities' in section 421B(8) says that:
'"employment-related securities" means securities or an interest in securities to which Chapters 2 to 4 [of Part 7, Income Tax (Earnings and Pensions) Act 2003] apply (ignoring any provision of any of those Chapters which limits the application of the Chapter to a particular description or descriptions of employment-related securities).'
If one ignores the provisions of Chapters 2 to 4 that describe which securities those chapters refer to, the only remaining relevant provisions are those in Chapter 1, specifically in section 421B.
Section 421B(1) says that Chapters 2 to 4 apply to 'securities ... acquired by a person where the right or opportunity to acquire the securities ... is available by reason of an employment of that person ...'. Section 421B(2) provides an extended meaning of 'employment' so that 'for the purposes of subsection (1) ... "employment" includes a former or prospective employment'. Section 421B(3) contains a so-called 'deeming provision' which states that generally 'a right or opportunity to acquire securities ... made available by a person's employer ... is to be regarded for the purposes of subsection (1) as available by reason of an employment of that person …'.
Section 421B(1) states what Chapters 2 to 4 apply to, and sections 421B(2) and 421B(3) apply only for the purposes of section 421B(1). Therefore, these provisions do not have any bearing on the reporting obligations in sections 421J and 421K (which are in Chapter 1). The wording in section 421K requiring the reporting of an acquisition of shares pursuant to a right or opportunity made available by reason of employment therefore has to be interpreted in the absence of the extensions in sections 421B(2) and (3).
Revenue guidance?
As Martin Riley mentions, the Revenue guidance on what constitutes shares acquired by reason of employment has not been updated to take account of the Income Tax (Earnings and Pensions) Act 2003 or the Finance Act 2003. That guidance (in paragraph 4.4 of the Share Schemes Manual ) continues to set out a number of situations (including two relating to shares issued to directors on formation of a company) where the Revenue accepts that shares acquired by employees are not acquired 'by reason of employment' for the purposes of the old provisions in the Taxes Act 1988 and the Finance Act 1988. Is this guidance still applicable? The Revenue declined to answer that question in a meeting with the Share Schemes Lawyers Group in November 2003.
Why not 'employment-related securities'?
One cannot help wondering why Parliament decided to draft section 421K in the way it did, which seems to have been a deliberate move away from requiring the reporting of an acquisition of 'employment-related securities'. Perhaps it was to avoid the Revenue being deluged with reports of acquisitions of securities in circumstances where no income tax charge will ever arise.
Alternatively, it is tempting to think that it is part of a well thought-out scheme which requires notification of events which may give rise to a tax charge, but not those which will not. Of course, section 421K does require the reporting of an acquisition of securities at market value, where there will usually be no tax charge, but one can understand the Revenue wanting to know about such acquisitions so that it can take its own view on whether 'market value' has been paid. The argument that the reporting obligation is tied to the possibility of a tax charge is supported by the fact that an acquisition of free or cheap securities by an employee which is not taxed under Chapters 2 to 5 may be taxed by reason of the general charging principles set out at the beginning of Income Tax (Earnings and Pensions) Act 2003, in particular sections 9, 15 and 62. Those provisions impose a tax charge on a profit or incidental benefit that is money or money's worth (which the acquisition of cheap shares will be) and is obtained by an employee from an employment . There is no deeming provision to extend the meaning of the italicised words beyond their natural meaning. Accordingly, the reporting obligation more or less fits the potential tax charge.
But what about an acquisition of securities with an artificially depressed market value? Section 446B imposes a tax charge on acquisition by a person in circumstances that fall within the extended meaning of employment, but the only reporting obligation that could apply to this acquisition (section 421K(3) (a) ) only applies if the shares are acquired by reason of employment (with no extended meaning). And what about an acquisition of securities on exercise of a securities option? Again, section 476 imposes a tax charge on acquisition by a person in circumstances that fall within the extended meaning of employment (by virtue of section 471), but the only reporting obligation that could apply to this acquisition is again section 421K(3) (a) . (Section 421K(3) (h) relates only to assignment of release of securities options.) Consequently, an acquisition of securities with an artificially depressed market value, or of securities on exercise of an option, in circumstances which fall within Chapters 3A and 5 respectively only because of the relevant deeming provision, would not fall to be reported.
Alternative argument
If the analysis contained in this article is wrong, and the deeming provision in section 421B(3) does somehow apply for the purposes of section 421K, then there is still an argument for the acquisition of founder shares not being reportable in certain cases. Consider the case where a company is incorporated by the founders subscribing their names to the memorandum of association and thereby each taking the number of shares in the company stated in the memorandum against his name. Aside from the issue of whether the employment exists yet (which Martin Riley points out may be an issue), in this case the company itself does not come into existence until the shares are acquired. How then can the company be said to make available the right or opportunity to acquire the shares, as required by section 421B(3)?
Closing comment
The general impression one gets from the Revenue is that all acquisitions of securities by employees, in any circumstances whatsoever, should be reported, so whether or not it would subscribe to the analysis set out above or the alternative argument relating to founder shares must, for the moment, remain open to doubt.
Kirsty Payne is an assistant solicitor in the Employee Share Incentives Group at Mayer, Brown, Rowe & Maw LLP.
