Response to HMRC consultation on marketable securities published on 17 th July 2014

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1 Response to HMRC consultation on marketable securities published on 17 th July 2014 Pett, Franklin & Co. LLP is a multi-disciplinary practice, regulated as a law firm, specialising in advising on tax, remuneration and employee share schemes. Its client base comprises a broad range of multinational listed, AIM-listed, unquoted public and private companies, including owner-managed businesses and employee-owned companies. Based in Birmingham, its clients are typically based in London or Scotland. David Pett is author of Employee Share Schemes, the 2-volume looseleaf textbook on the subject (pub. Sweet & Maxwell) which is updated every 6 months. The comments in the paragraphs below are in response to the to the numbered questions in the Consultation Document. 1. The proposal, to change the tax point of employee share acquisitions was put forward to the OTS on the basis that it would remove the unfair anomaly which exists between the tax treatment of employment-related securities and other forms of non-money remuneration which, as a general rule, are charged to income tax as earnings if, and when, they are capable of being turned to pecuniary account. Unlike, say, a car or other readily-marketable form of non-money earnings, shares in an unquoted company cannot normally be turned to pecuniary account unless and until some other person stands ready and willing and able to buy them (at whatever price). The shares may, at any given time, have a market value determinable in accordance with the rules in Part 8, TCGA 1992, but it does not follow that, in the hands of the employee who has acquired them, that value is capable of being realised, either immediately, or at all. As a rule of thumb, a share in an unquoted company is of no value to man or beast unless and until someone is willing to purchase it. Under current (general) tax rules, an employee who is gifted such a piece of paper, insofar as he does not immediately pay for such a share, charged to income tax on its market value, regardless of whether he or she is capable of realising that value. This can result in a dry tax charge. Whilst some employees undoubtedly benefit (in both commercial and tax terms) from acquiring, paying tax on the initial market value of, and then holding shares until such time as they can be sold, many who acquire, and suffer tax on, such shares never do so. This might be because, for example, the value of the share falls or there is never an occasion when they have an opportunity to sell at any price. It is accepted that, if the shares are subject to a shortterm risk of forfeiture, there will be no tax on acquisition, but it is not always the case that shares acquired by employees are intended to be at risk of being forfeited (i.e. at risk of being obliged to be disposed of for less than their market value ). That said, it might be strongly argued that the OTS proposal is, to a large extent, already reflected in the current law. A profit or incidental benefit from an employment received in the form of shares in a private company for which there is no market and no ability to sell them for valuable consideration, does not represent money s worth (per s 62(3), ITEPA 2003) and is not therefore taxable as earnings, if the shares are of no direct monetary value to the employee and are not capable of being converted into money or something of direct monetary value to the employee. That said, HMRC has taken the view (and the courts and tribunals have confirmed) that shares acquired by reason of employment are earnings and, in practice, the amount to be charged to tax has been determined by reference to the market value of such shares determined in accordance with the rules in Part 8, TCGA However, ITEPA does not expressly provide for how the amount of earnings (i.e. the value of non-monetary earnings) is to be determined other than in the case of employee shareholder shares (determined by reference to market value as defined in Part 8, TCGA 1992 s226a(3)) and residual benefits-in-kind (determined by reference to the cost of the benefit s203).

2 It is only a matter of practice that has, over the years, led to the taxable value of shares being determined by HMRC SAV in accordance with the rules in Part 8, TCGA notwithstanding that those rules are not expressed to apply for the purpose of determining the taxable amount of general earnings, as opposed to amounts treated as earnings under the specific charging provisions of Parts 7 and 7A, ITEPA (which all refer to market value as defined in Part 8, TCGA). In the case of unquoted shares, s273 TCGA refers to the assumption of a notional sale, the market value being the price which the shares might reasonably be expected to fetch on such a sale in the open market (per s272(1)). Where, in reality, there is no immediate prospect of the employee being able to convert the shares into something of direct monetary value such a determination of market value ignores, or at least sidesteps, the fact that the shares have, at that time, no monetary value which can be realised by the employee. The OTS proposal would not be necessary if HMRC were to adopt a practice of accepting that, in the case of shares which cannot immediately be sold for cash or other valuable consideration, their taxable value is close to zero. However, this would obviously open up the prospect of widespread tax avoidance as shares acquired with little or no taxable value later acquired substantial value which is capable of being realised at a later time. We agree with the OTS that the existing unfairness first referred to above should be seen as a problem of the timing of the incidence of a charge to income tax on earnings, rather than a problem of how the taxable value of shares is to be determined at a given time. In the case of unquoted shares, the tax point (i.e. the time when the value of shares acquired as general earnings is to be charged to income tax and NICs) should be not the time of acquisition, but, if later, the time when they first become marketable i.e. are first capable of being converted into money or something of direct monetary value to the employee (per s 62(3)). In effect, this would normally be the time when they can first be sold by the employee for a consideration of an amount not substantially less than their market value (per Part 8, TCGA). If, in the event, the shares never do become marketable, (eg because the company goes bust ), the employee would avoid suffering a charge to income tax on a notional value which he never receives or enjoys. Shares for which there is a market, because they are listed or AIM-listed shares or because there exist other arrangements whereby some person is ready and willing to buy the shares should the employee wish to sell, would, for these purposes, always be marketable. By contrast, shares in a private company in relation to which nobody has either the means or the wish to buy shares from an employee-shareholder would be non-marketable. Existing tax rules distinguish between shares which are readily-convertible assets ( RCAs ) and those which are not, but those rules do not reflect this dichotomy between shares which are in fact marketable and those which are not. Indeed, shares which are not corporation tax-deductible will always be RCAs. Likewise, shares in respect of which arrangements are being made to facilitate a future sale or market are RCAs, notwithstanding that when if, for example, such arrangements fail to be given effect, the value of the shares cannot then be realised. In any event, these rules apply to determine how the tax is collected, and if charges to NICs also arise, not when a charge to income tax arises. In relation to the proposal generally, a consequence of the change would be that it allows employees to acquire ordinary unrestricted shares in a private company on the basis that the tax point occurs only at the time when, so far as the employee is concerned, they have an immediate and recognisable value, as opposed to simply a hope value. This would be a major simplification in the sense that it would avoid the existing need to explain to companies and employees why it is that the acquisition of a seemingly worthless piece of paper will

3 nevertheless, under current tax rules, give rise to an immediate charge to income tax on what might in reality be a purely notional value. It would also reduce costs to employer companies as they would then be more easily able to afford opportunities to allow employees to acquire shares which have little or no actual value (apart from their hope value ) without significant administrative cost (and no NICs), knowing that tax will be due, and accounted for under PAYE, only when the shares are capable of being turned to pecuniary account, whereupon any decision of the employee to keep or sell the shares becomes a purely investment, rather than a tax-driven, decision. 2. See 1 above. 3. See 1 above. 4. The prospect of a dry tax charge is of particular concern to the smallest, start-up, and highrisk private companies of the type which we would expect the government to be promoting. It is amongst such companies that the greatest risks associated with such dry tax charges are most likely to be found. We have seen a number of companies, particularly in the bio-tech sector, which have failed (as a result, typically, of the failure of the particular drug or technology being developed) resulting in those employees who have acquired, and paid tax on, shares being left with an actual loss for which no form of relief from income is necessarily available. 5. The idea as originally put forward to the OTS was that the employee and employer should be able to elect at any time that all shares in a given company would be deemed to be marketable securities, and therefore immediately chargeable to income tax and NICs, at a time on or before, but not greater than, 30 days before such election is made. Such an election would be deemed to include a s431 election. [It should be noted that it is presently open to an employer and employee, by making an amendment to restrictions attaching to shares and then making an election under s430, to accelerate the tax point in relation to restricted securities at any time.] Our instinct is that, on balance, HM Treasury would benefit (in terms of increased tax receipts) from accelerated payment of tax on the market value of unrestricted shares as, apart from those companies in relation to which there is genuine uncertainty as to their prospects for future growth in value, many would (as is the case with so many privateequity backed companies) be willing to gamble on the prospects of future growth and the future saving of income tax by making such an election sooner, rather than later. Accordingly, we would expect the number of such elections to be at least as great as the number of s431(1) elections presently made. 6. We do not understand why this should be perceived as a risk, given that it is likely to result in accelerated payment of tax into the Treasury, whilst at the same time protecting those more vulnerable companies from unfair dry charges if, as would be likely in the case of such companies, they choose not to make such an election until their prospects of success become more apparent. 7. We agree that an election under the new proposals should encompass, and also take effect as, a s430 or 431(1) election. That shares are to be deemed marketable should also imply that they are RCAs. For the reasons given above, using the present definition of RCA to determine when shares are marketable would be unsatisfactory as it takes no account of whether in fact the value of the shares is capable of being realised. We would also propose that an election should be capable of being made at any time (not only within a limited period after acquisition) by the employee, the issuing company and, if different, the employer ( a bilateral election ), and should take effect in relation to all shares of whatever class held by that employee (whenever acquired). There should also, however, be a facility to enable the company itself (and, if different, the employer company) to make such an election which would apply in respect of all shares in

4 that company (of whatever class) acquired, and subsequently acquired, as ERS. Such a unilateral election would be capable of being made: (a) only within 14 days of the first acquisition of ERS; and (b) without the need for the consent of, or any reference, to any employee who has already acquired such shares. Such an election should be of no effect if the shares are in fact sold to an unassociated person within, say, 30 days of the date on which the election is made. This would avoid elections being made shortly before the occurrence of, say, an anticipated sale of the company when shares are sold at a much higher pro rata value as compared with the discounted, albeit unrestricted, market value which would otherwise be charged to income tax in consequence of such an election being made. 8. We suggest that the definition of what is a marketable security be based on the notion of identifying the first point in time at which holders of such securities may, if they so choose to do so, dispose of a beneficial interest in such shares to any person for a consideration which is not substantially less than the (actual) market value (per Pt 8, TCGA) of shares of that class (or of that company), or what would be such market value if all of the issued shares capital was then sold (i.e. taking a pro-rata value without discount for minority interest). Whilst we accept that there is uncertainty in applying such a test, the structure of the taxing regime should be self-policing in that : (a) assuming, for illustrative purposes, that the shares will steadily increase in value over time, the later the occasion of charge so the greater is the amount on which the charge is levied; (b) if the company and its employees anticipate that, going forwards, there is now a real likelihood of growth in value of the shares and this outweighing the risks of a failure of the company employees are more likely to want to make such an election, to suffer an immediate charge to tax and NICs on the unrestricted market value of the shares at that time, thereby accelerating the receipt of funds by the Treasury and ensuring that, for the employee, future growth in value above the UMV at the time of election will normally fall to be charged as capital gain; (c) in the case of those companies whose future growth prospects are uncertain, the decision to defer an election would protect against unfair charges arising on the acquisition of ERS but result in the Treasury receiving a greater amount of tax if shares do in fact become marketable before an election is made. 9. Put another way, the default position should favour the Treasury, as the tendency would be for companies anticipating growth to want to elect (as is the case now with most private-equity backed companies) in order to cap their exposure to employers NICs. In the case of those companies generating profits and wanting to pay dividends on ERS, it would also be appropriate to make an election so as to avoid charges to NICs on such dividend payments made to the holders of non-marketable ERS. Only rarely would a company be seeking to argue that its shares were not marketable if there was any element of doubt or uncertainty on this question. Where doubt existed, the company and its employees would generally be expected to want to elect sooner rather than later. In those other cases in which doubt existed (as to whether the shares are marketable ) it is not obvious why it would be in the interest of the Treasury to argue that they are if this would result in collecting a smaller amount of tax than if a wait and see approach is adopted.

5 10. Only insofar as some employees agree to an election being made and others do not, so that some only of a (for example) dividend payment will fall to be taxed as earnings, will require additional record-keeping. However, this should not be overly-burdensome given modern record-keeping systems. A company with non-marketable ERS wishing to pay dividends (for example) would need to weigh up the pros and cons of suffering NICs on such dividend payments and having employees be taxed on such receipts as earnings, and making an election thereby incurring immediate charges on the UMV of the shares but allowing normal dividend tax treatment going forward. 11. We are unclear as to why a backstop date is considered necessary. In reality the backstop is surely the date of actual disposal of the ERS to an unassociated person when, if no election has then been made, a charge to income tax and NICs will arise on the actual amount of proceeds received. To be clear, we would expect non-marketable shares to be deemed to become marketable shares immediately before they are disposed of to an unassociated person. 12. We think the difficulties mentioned at 3.24 are more apparent than real : the employer could still account for PAYE on the unrestricted market value of the ERS at the date on which the shares become marketable, the employee making a claim on his SA Return to reduce the taxable amount, and the amount which he is obliged to make good under s222, if the actual proceeds of sale are less. If they are greater, the position is, in many respects, no different from that which exists at present if shares subject to a short-term risk of forfeiture are sold and no s 425 or 431 election has been made. The amount on which income tax and NICs is due must, notwithstanding that the shares are sold without reference to the employer, be ascertained by the employer in order that it can account for PAYE tax on the correct amount. If the PAYE has been accounted for before the shares are in fact sold within the 14 day period, an additional amount of tax may need to be accounted for at the next occasion on which PAYE tax is due for payment. 16 th September 2014 Pett, Franklin & Co. LLP