INCOME TAX – employment income – sale of whole of share capital of holding company of Appellant – whether sale of employment related shares in holding company by managing director of Appellant was for more than market value thereby occasioning charge to income tax by virtue of chapter 3D, part 7 ITEPA 2003 — held sale for more than market value — appeal dismissed
SPECIAL COMMISSIONERS OF INCOME TAX
- and -
THE COMMISSIONERS FOR HER
MAJESTY’S REVENUE AND CUSTOMSRespondents
Special Commissioner: David Demack
Sitting in public in Edinburgh on 29 November 2006
Michael Sherry of counsel instructed by Messrs Anderson, Anderson and Brown, chartered accountants of Aberdeen, for the Appellant
Jane Paterson of counsel instructed by HM Revenue and Customs for the Respondents
© CROWN COPYRIGHT 2007
- In this appeal by “Company A”, a wholly owned subsidiary of “Company B”, the issue for determination is whether certain ordinary shares in Company B held by Mr G, the managing director of Company A, as employment-related securities, and sold as part of the sale of the whole of the share capital of Company B were sold for more than their market value. Her Majesty’s Commissioners for Revenue and Customs (“HMRC”) contend that the shares were so sold, and consequently the sale occasions a charge to income tax determined under Part 2 of the Income Tax (Employment and Pensions) Act 2003 (“the ITEPA”) by virtue of Chapter 3D of Part 7 of that Act. (The determination under appeal was initially made under Chapter 4 of Part 7 of the ITEPA in the sum of £423,894 but HMRC have since abandoned reliance on that Chapter to maintain it. They now rely on chapter 3D for the purpose so that if I dismiss the appeal, the amount determined must be adjusted). In contrast, Company A maintains that the shares were sold for their market value so that the whole of the consideration received by Mr G falls to be brought into computation of his capital gain on the disposal under the Taxation of Chargeable Gains Act 1992 (“the TCGA”).
- If the disposal in question does occasion a charge under the ITEPA, the amount of the income charged by virtue of section 446Y of the ITEPA is to be treated as though it had been a payment of income to Mr G by Company A. Company A is then required to account for tax in respect of that notional payment under the PAYE provisions as though it were an actual payment. That is why the appellant taxpayer is Company A, Mr G’s employer, and not Mr G himself.
- The real dispute between the parties is the market value of the shares in Company B held by Mr G for the purpose of Chapter 3D of Part 7 of the ITEPA, and how that value is to be determined.
- The case for Company A was presented by Mr Michael Sherry of counsel, and that for HMRC by Miss Jane Paterson, also of counsel. They produced an agreed statement of facts and a bundle of copy documents. From that statement, as supplemented by the contents of the relevant documents, I find the following facts to have been established.
- On 20 October 1999 Mr G entered into a service agreement with Company A whereby with effect on 22 November 1999 he was appointed managing director of Company A for an indefinite period terminable by either party on not less than six calendar months’ prior notice. The agreement also provided for its automatic termination in certain circumstances, e.g. on Mr G attaining the age of 65, and for his immediate dismissal, e.g. for any act of gross misconduct. In the event, Mr G took up his employment with Company A on 8 November 1999.
- As part of the arrangements under which Mr G took up his employment, he was to be allotted shares in Company B, Company A’ holding company. To deal with that allotment and certain other matters, on 9 December 1999 Company B held an extraordinary general meeting at which four resolutions – two special resolutions and two ordinary resolutions – were passed on a show of hands. Only the two special resolutions are relevant to the present dispute. They took the following form:
“1.That the entering into by the company of the subscription and shareholders’ agreement among the Company, Mr G and certain shareholders of the Company in the form annexed hereto for identification purposes be and is hereby approved.
2.That the regulations contained in the document headed ‘new Articles of Association’ annexed hereto be and they are hereby adopted in the Articles of Association of the Company to the exclusion of all existing Articles hereof.”
7.Pursuant to the first of those special resolutions and the allotment of shares to Mr G, (1) Company B, (2) Mr G, and (3) the holders of 83.8 per cent of the issued share capital of Company B entered into a subscription and shareholders agreement (“the Subscription Agreement”). The Subscription Agreement itself was undated, but the last shareholder to execute it did so on 18 December 1999. It was expressed to be subject to the law of Scotland.
8.By clause 2 of the Subscription Agreement, Company B was to take or procure certain steps including the adoption of new articles of association to the exclusion of its existing articles, and the allotment of 14,465 £1 ordinary shares in Company B to Mr G against payment in cash of £50,000; and, if they had not already done so, the parties should enter into, and Company B should procure that Company A entered into, the service agreement, and that Mr G was appointed a director of both Company B and Company A.
9.Clause 3, entitled “Termination of Service Contract”, provided for Company B to “buy back” the shares issued to Mr G in the event of his service contract with Company A being terminated, and included at clause 3.7 a requirement that if any shareholder who had not signed the document took or threatened to take proceedings to prevent the “buy back”, Company B and the signatories to the Subscription Agreement would promptly “take all reasonable steps to resolve the matter”. Clause 4 dealt with “Disposal”. In the event of, inter alia, a change in control of 50 per cent or more of the issued share capital of Company B prior to the second anniversary of completion of the Subscription Agreement, Mr G was to receive £125,000 for “Mr G’s Shares” from Company B or the purchaser. The phrase “Mr G’s Shares” was defined in clause 1 as meaning the “Ordinary Shares to be subscribed by Mr G pursuant to clause 2.1.2 together with any Shares derived from the said shares at any time as a result of a bonus issue or capitalisation of reserves or a consolidation or sub-division of the share capital of the company, and for the avoidance of doubt,
(i) there shall be excluded therefrom any Shares acquired by Mr G as a result of a rights issue or the acquisition of any Shares by Mr G from any other holder of Shares in the capital of the Company; and
(I observe that there was no clause 2.1.2 in the Subscription Agreement. The clause providing for Mr G’s subscription of 14,465 shares in Company B was clause 2.2.2).
10.But in the event of a share disposal taking place on or after the second anniversary of completion, the price to be paid to Mr G for “Mr G’s Shares” was to be determined in the following way:
“4.2.1In the event of a Shares Disposal taking place on or after the second anniversary of the Completion Date, Mr G shall sell and the Shareholders shall procure that the Company or that the purchaser in terms of the Shares Disposal shall purchase Mr. G’s Shares at a price equal to the aggregate of the sums calculated in accordance with (i) and (ii) below.
(i) the lower of £50,000 and the sum equivalent to:
B X C X 0.74whereA equals the number of Mr. G’s Shares,
B equals the total number of Shares, and
C equals the Net Asset Value plus the Notional
all as at the date of the Shares Disposal; and
(ii)the sum equivalent to:
(D – (E + F))whereD equals the Consideration
3E equals the Target Net Asset Value as at the date of the Shares’ Disposal,
F equals the sum calculated in accordance with sub- paragraph (i) above.”
(Broadly speaking, in the event of a disposal to a third party, the formula entitled Mr G to a one-third share in the value by which Company B had increased from the date of his initial share purchase to the date of disposal).
11.By clause 6.1 of the Subscription Agreement those shareholders entering into it expressly acknowledged that Mr G was to be entitled to a payment additional to that to be made to other shareholders on Company B being sold by a disposal of its shares. Clause 7.1 dealt with Mr G’s ability to deal in Company B shares; and Clause 9 stated that his rights under the Subscription Agreement were not assignable. Clause 11.2 dealt with the priority of the articles of association and the Subscription Agreement in the following terms:
“The provisions of this Agreement shall prevail over the [existing] Articles [of Association] (and any other Articles of Association of the Company subsequently amending or replacing the same) such that if there is any conflict between the two the provisions of this Agreement shall prevail and rule to the exclusion of any such conflicting provisions of the Articles or such other Articles of Association”
- The articles of association of Company B adopted on 9 December 1999, and subsequently registered at Companies House, confirmed its authorised ordinary share capital as £323,200. By article 5, all the ordinary shares carried equal rights in terms of the articles; and article 11 provided for the directors in their absolute discretion and without giving any reason to decline to register any transfer of shares, but subject to their registering the transfer of any ordinary shares to inter alias a member of the family of a member of the company or deceased member, a transfer to a trust created by a member, or to the legal personal representative of a deceased member. And article 12 provided for the company to be appointed agent for any member who wished to sell his or her shares “at a price to be mutually agreed between the transferor and the company which the auditors of the company (acting as experts and not as arbiters) shall certify in writing to be in their opinion the fair value thereof on a going concern basis between a willing seller and a willing buyer”.
- In consideration of £50,000 paid by Mr G to Company B, 14,465 of its £1 ordinary shares were allotted to him on 9 December 1999. I find that the Subscription Agreement post-dated that allotment.
14.On 16 May 2000 Mr G purchased a further 258 £1 ordinary shares in Company B from a fellow shareholder for £864. He did so as part of an exercise of the rights of pre-emption contained in its articles of association by all the shareholders of Company B to purchase the shares of an existing shareholder.
- On 29 November 2003, the entire issued share capital of Company B consisting of 222,037 £1 ordinary shares, was sold to Company C, an unconnected third party, pursuant to an agreement (“the Sale Agreement”) made between all the shareholders in Company B and Company C. The relevant provisions of the Sale Agreement are set out in the Schedule to my decision.
16.The Sale Agreement provided for the full consideration of £6 million for the ordinary shares in Company B to be reduced by £96,781 in the event of the Inland Revenue not having confirmed that by the time the sale was completed the moneys due to Mr G were not liable to employer’s national insurance contributions. As that confirmation had not been provided by completion, the consideration in fact paid to the ordinary shareholders in Company B was £5,903,219.
17.Applying the formula contained in Clause 4.2.1 of the Subscription Agreement to all his shares in Company B, by agreement among all Company B’s shareholders Mr G was allocated and paid £1,451,172 for his shares.
18.By a disclosure letter, also dated 29 November 2003, the shareholders in Company B made various disclosures and gave warranties to Company C. Amongst the matters disclosed at clause 5.7, was the existence of the Subscription Agreement, to which disclosure was added, “However, this agreement is to be terminated at completion”.
The Legislative Framework
19.The legislation upon which HMRC rely to support the determination under appeal is to be found in part in Part 7 of the ITEPA and in remainder in Part VIII of the TCGA. The relevant parts of Chapters 1 and 3D of Part 7 of the ITEPA provide as follows:
417 Scope of Part 7
(1) This part contains special rules about cases where securities … are acquired in connection with an employment.
(2) The rules are contained in –
Chapter 3D (securities disposed of for more than market value)
Chapter 4 (post-acquisition benefits from securities)
(3) The following make provision for amounts to count as employment income – Chapters 2 to 6 …
420Meaning of ‘securities’ etc
(1) Subject to subsections (5) and (6) for the purposes of … Chapters 2 to 5 the following are ‘securities’ –
(a) shares in any body corporate (wherever incorporated) …
421Meaning of ‘market value’ etc
(1) In this Chapter and Chapters 2 to 5 ‘market value’ has the same meaning as it has for the purposes of TCGA 1992 by virtue of Part 8 of that Act.
421AMeaning of ‘consideration’
(1) This section applies for determining the purposes of Chapters 2 to 5 the amount of the consideration given for anything.
(2) If any consideration is given partly in respect of one thing and partly in respect of another, the amount given in respect of the different things is to be determined on a just and reasonable apportionment.
421BApplication of Chapters 2 to 4
(1) Subject as follows (and to any provision contained in Chapters 2 to 4) those Chapters 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.
(2) For the purposes of subsection (1) –
(a)securities are … acquired at the time when the person acquiring the securities … becomes beneficially entitled to those securities … (and not, if different, the time when the securities are … conveyed or transferred), and
(b) ‘employment’ includes a former or prospective employment.
(2) A right or opportunity to acquire securities … made available by a person’s employer or by a person connected with a person’s employer, is to be regarded for the purposes of subsection (1) as available by reason of an employment of that person unless –
(a) the person by whom the right or opportunity is made available is an individual, and
(b) the right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person.
(8)In this Chapter and Chapters 2 to 4 –
‘the acquisition’, in relation to employment-related securities, means the acquisition of the employment-related securities pursuant to the right or opportunity available by reason of the employment,
‘the employment’, in relation to employment-related securities, means the employment by reason of which the right or opportunity to acquire the employment-related securities is available (‘the employee’ and ‘the employer’ being construed accordingly unless otherwise indicated), and
‘employment-related securities’ means securities to which Chapters 2 and 4 apply.
(1) For the purposes of this Chapter and Chapters 2 to 4 the following are ‘associated persons’ in relation to employment-related securities –
(a) the person who acquired the employment-related securities on the acquisition
(b) (if different) the employee, and
(c) any relevant linked person.
(2) A person is a relevant linked person if –
(a) that person (on the one hand), and
(b) either the person who acquired the employment-related securities or the acquisition or the employee (on the other),
are connected or, although not connected, are members of the same household.
421DReplacement and additional securities and changes in interest
(1) Subsections (2) and (3) apply when an associated person is entitled to employment related securities (the ‘original securities’) and either –
(a) …; or
(b) by virtue of that person being entitled to the original securities, that person or another associated person acquires other securities … (the ‘additional securities’).
(2) The additional securities are to be regarded for the purposes of section 421B(1) (securities acquired pursuant to a right or opportunity available by reason of an employment) as acquired pursuant to the same right or opportunity as the original securities.
(4) Subsections (2) and (3) apply whether or not the replacement securities, or the additional securities, were acquired for consideration.
CHAPTER 3D – Securities Disposed of for More Than Market Value
446XApplication of this Chapter
This Chapter applies if –
(a) employment-related securities are disposed of by an associated person so that no associated person is any longer beneficially entitled to them, and
(b) the disposal is for a consideration which exceeds the market value of the employment-related securities at the time of the disposal.
446YAmount treated as income
(1) Where this Chapter applies the amount determined under subsection (3) counts as employment income of the employee for the relevant tax year.
(2) The ‘relevant tax year’ is the tax year in which the disposal occurs.
(3) The amount is –
CD – MV – DA
CD is the amount of the consideration given on the disposal,
MV is the market value of the employment-related securities at the time of the disposal, and
DA is the amount of any expenses incurred in connection with the disposal.
(1) In this Chapter ‘market value’ has the meaning indicated in section 421(1)
(2) For the purposes of this Chapter sections 421(2) and 421A apply for determining the amount of the consideration given for anything.
(3) In this Chapter –
‘the employee’, and
‘the employment-related securities’,
have the meaning indicated in section 421B(8)
(4)In this Chapter ‘associated person’ has the meaning indicated in section 421C.”
19. The relevant sections of the TCGA, to be found in Part 8 thereof, are the following:
272 Valuation: general
(1) In this Act ‘market value’ in relation to any assets means the price which those assets might reasonably be expected to fetch on a sale in the open market.
(2) In estimating the market value of any assets no reduction shall be made in the estimate on account of the estimate being made on the assumption that the whole of the assets is to be placed on the market at one and the same time.
(1)The provisions of subsection (3) below shall have effect in any case where, in relation to an asset to which this section applies, there falls to be determined by virtue of section 272(1) the price which the asset might reasonably be expected to fetch on a sale in the open market.
(2)The assets to which this section applies are shares and securities which are not quoted on a recognised stock exchange at the time as at which their market value for the purposes of tax on chargeable gains falls to be determined.
(3) For the purposes of a determination falling within subsection (1) above, it shall be assumed that, if the open market which is postulated for the purposes of that determination, there is available to any prospective purchaser of the asset in question all the information which a prudent prospective purchaser of the asset might reasonably require if he were proposing to purchase it from a willing vendor by private treaty and at arms length.”