Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Introduction

Introduction

22A.1Schedule 2 of the Finance Act 2011 added a new Pt 7A to ITEPA 2003 (ss.554A-554Z21), entitled“Employment income provided through third parties”, and made consequential amendments, togetherrunning to some 70 pages of anti-avoidance legislation.

Part 7A adds a layer of complexity to the tax treatment of employees’ share schemes, particularlythose using existing shares held, or to be acquired, by an employees’ trust and, unless care is takenin structuring such schemes, can result in unexpected and penal charges to income tax and NICsarising. The legislation is in broad terms, deliberately casting a wide net, but includes prescriptiveexclusions from the scope of the charges imposed. It is therefore important to ensure, when designingan employees’ share scheme, that the effect of Pt 7A, and of HMRC’s interpretation and application ofit, are well understood. The legislation is entitled “Employment income provided through third parties”.However, this is misleading since, as mentioned below (see, for example, 22A.53), it can give rise tocharges to income tax and NICs in circumstances in which no employment income (or benefit-in-kind)is actually received.

Some practical consequences of the enactment of Pt 7A are set out at 22A.36.

What follows is a description of the provisions of Pt 7A, as it applies to employee share schemes. Thelegislation is, as will be seen, wider than this in its scope and application and, in particular, applies tomany forms of non-registered pension scheme, including arrangements to secure obligations of anemployer company to make future pension provision, deferred bonus schemes and other payments,loans, and transfers or the making available of an asset or property by a “relevant third person”.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Background to Part 7A

Background to Part 7A

22A.2Part 7A addresses two perceived mischiefs: first, the widespread use of employee trusts to defer andavoid income tax and NICs on bonuses, and, secondly, the fact that, since 2006, the tax treatment ofunapproved pension schemes has meant that in many respects it was possible to structure such ascheme in a manner which, taken overall, was taxed more favourably than a “registered pensionscheme”.

As regards the first, companies had, instead of paying a bonus subject to income tax and NICs,chosen to make a contribution to an employees’ trust which was then “allocated” to, or appointedupon a sub-trust for the benefit of a particular employee (or their family). Such contributions did notgive rise to an immediate liability to income tax and NICs under PAYE (arguments to the contrarywere rejected by the Special Commissioners in both the Dextra and Sempra Metals cases (referred toat 21.22) at the Special Commissioners’ hearings and, in relation to NICs, Forde v McHugh [2011]UKUT 78 (TCC)). The whole (or more typically a proportion) of the allocated funds were then lent tothe employee concerned on terms which would, in practice, allow the employee to enjoy the cash orother asset with only (relatively) minimal charges to tax on the benefit of an employment-relatedbeneficial loan. In particular, in many cases the loan would be allowed to remain outstanding untilafter the employment ended and the individual had died, when the loan could be released or writtenoff free of income tax (see ITEPA 2003 subs.190(2)). It might also be argued that the value of theoutstanding loan reduced the value of the deceased’s estate for inheritance tax purposes and that, ifpaid out to the deceased’s family by way of benefits-in-kind after the end of the tax year in which theemployee died, no charges to income tax arose (see ITEPA subs.201(4)). An alternative schemeinvolved the establishment of an offshore employees’ trust in the form of an “employer-financedretirements benefit scheme”, or “efurbs”, (as defined in ITEPA 2003 s.393A (since amended)), towhich employer contributions were made. Arguably such contributions did (at least according tosome, but by no means all commentators—and not the authors) qualify for immediate relief fromcorporation tax. Given the scope for tax-free accumulations of capital gains in such a trust (in thisrespect putting them on a par with registered pension schemes), the overall effect was to put sucharrangements in a more tax-favoured, and flexible, position than a conventional registered pensionscheme subject to the annual and lifetime limits on contributions. There were very many variations onsuch tax-planning ideas being marketed and implemented and it was reported to the House of Lords(Economic Affairs Committee, 4th Report, Finance Bill 2011) that the estimated loss to the Exchequerfrom known schemes in 2008/09 was in the region of £1.1bn and, in the absence of action beingtaken, would rise to an estimated £1.54bn in 2011/12.

The same report criticised HMRC for not having brought forward draft legislation to curb such taxavoidance earlier than it did, but also stated that,

"[the new Part 7A] is extremely complex and beyond the scope of most business peopleto decide whether or not it applies to them. One witness called it ‘the worst legislation hehad ever seen’. There was clearly a very wide and deep unhappiness with this draftlegislation."

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Nevertheless, at Committee Stage of the Bill, David Gauke MP, Exchequer Secretary to the Treasury,spelt out how seriously the Government regarded the threat posed by tax avoidance using EBTs:

"We do not want to dance around the issue any more. For every step, the avoidanceindustry makes a counter-step, but we have marked its card and taken a big step forward… Schedule 2 is needed to maintain a fair tax system."

HMRC challenge and settlement offer

Notwithstanding the introduction of Pt 7A, HMRC also embarked upon a campaign of challengingarrangements involving employee trusts entered into before it had effect and which were regarded byHMRC as involving unacceptable “tax avoidance”. In those cases in which cash or other assetstransferred to an employees’ trust was allocated to, or transferred to a sub-trust or sub-fund for thebenefit of, a named employee and/or his family, HMRC has taken the view that the amount or valueinvolved is properly to be regarded as a payment of “earnings” of the employee subject to income taxand NICs under PAYE. Further, if the company is a “close company” charges to inheritance tax maybe treated as then arising on “participators” in the company (HMRC Spotlight on tax avoidanceno.5—see Vol. 2 at C/323). HMRC also confirmed that a contribution to an efurbs did not rank as a“qualifying benefit” for the purposes of Pt 12 of CTA 2009, and so did not qualify for relief fromcorporation tax on the part of the employer company making the contribution.

Further, and to facilitate or encourage companies to reach agreement with HMRC in settlement ofliabilities which (in the view of HMRC) arose in consequence of an “earmarking” (see below) of assetsin favour of an employee before April 6, 2011, para.59 of Sch.2 to FA 2011 makes provision forHMRC to settle with an employer on the basis that income tax and NICs are paid on any contributionmade to an employees’ trust before April 6, 2011 (with a corresponding corporation tax deduction ifpermitted). If this is done, the employee will be entitled to a corresponding credit against the value ofa “relevant step” taken later giving rise to a charge under the Pt 7A provisions and, if a benefit-in-kindcharge has arisen in relation to a loan by the trust, the settlement will give credit for this provided thatthe income tax and NICs have been accounted for. If a relevant step is taken before the settlement isreached then, if the step relates to a contribution made to the trust before April 6, 2011, HMRC willgive credit on a similar basis save that no credit will be given for any benefit-in-kind charge arising(e.g. on a loan made by the trust). Further details of the terms of the settlement offer were given in acircular reproduced in Volume 2 at Pt C, p.310/a.

HMRC has, on September 4, 2012, issued detailed FAQs relating to the settlement opportunity andrelated issues arising. These are reproduced at C/366 in Vol.2.

Structure of the charge under Part 7A

Rather than, as expected, (a) imposing a requirement on the part of a company making a payment toan employees’ trust (or similar third party) to deposit a sum equal to, say, 50 per cent of that amountwith HMRC (for which credit would be given against any future obligation to account for income taxunder PAYE when taxable payments are made or benefits provided out of the trust), and (b)tightening the rules imposing charges on the benefit of employment-related beneficial loans leftoutstanding for more than (or rolled-over or replaced after), say, one year, HMRC determined tostructure the new legislation in a far more complex manner which imposes charges to income tax(with corresponding liabilities to NICs) on the employee (with a primary obligation on the employer toaccount for the tax under PAYE), notwithstanding that neither the employee concerned, nor anyrelative or associate necessarily receives any immediate benefit—or even knows of thecircumstances giving rise to the charges. It was suggested that this avoided the perception ofimposing yet another “tax burden on business”.

The language of Part 7A

The language used in Pt 7A signals a fresh approach to statutory drafting. Rather than seeking toensure clarity, precision and thereby afford taxpayers certainty as to whether or not tax is charged in

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any given factual situation, the draftsman has deliberately set out to make clear the circumstances inwhich the charge will apply, but leave a great deal of uncertainty as to whether or not, in any givensituation, a charge under Pt 7A will not apply. This is evidenced by the use of terms such as“earmarking”,“… in essence …”, “recognition [provided in connection with employment]”, “award [ofremuneration or shares]”, and “… so far as it covers [an employee]…” and by the use (believed to befor the first time in a taxing statute) of “… for example …” (rather than “including, without limitation,…”). Again, the reference in s.554Z1(2) to treating “a man and woman living together as if they werespouses of each other” goes beyond the long-established definition of “connected persons” (in ITA2007 s.993) and implies the need for a subjective judgement on the part of HMRC officers as to thedomestic activities of individual employees and those with whom they might share accommodation!

A consequence of such drafting is that tax payers will be heavily reliant upon HMRC practice, ratherthan the application of established rules of statutory interpretation, in seeking to determine if particularcircumstances will give rise to a charge under Pt 7A and, if so, on what amount—see further thecommentary at 22A.15. There is no statutory clearance procedure (see 22A.58).

The provisions of Pt 7A are referred to below as “the DR rules”.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Background to Part 7A

The dates from which the DR rules have effect

The dates from which the DR rules have effect

22A.3The DR rules in general have effect in relation to “relevant steps” (see below) taken on or after April 6,2011. Related regulations amending the NIC regulations so as to introduce corresponding charges toNICs have effect from December 6, 2011 and, save as mentioned at 22A.41, have effect so as toimpose charges to NICs on amounts counting as employment income under Pt 7A on and after thatdate (see further, 22A.41).

To thwart attempts to forestall the new, and penal, charges on payments and loans made by arelevant third person on or after December 9, 2010, charges under the DR rules arise in relation toany such payment, loan or transfer made on or after that date if or insofar as the amount concerned isnot repaid before April 6, 2012. In that case, the charge will be treated as arising on April 6, 2012 as ifthe step had in fact been taken on April 6, 2012.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Background to Part 7A

HMRC guidance

HMRC guidance

22A.3AHRMC has published, as part of its Employment Income Manual, guidance on the application of therules in Pt 7A of ITEPA 2003—see http://www.hmrc.gov.uk/manuals/eimanual/eim 45000.htm.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Part 7A In Outline

Part 7A In Outline

22A.4For a charge to arise under Pt 7A there must be:

•an existing, prospective or former office or employment of a person (A) with an employer (B)(“the employment”); and

•a “relevant step” taken by a “relevant third person”.

Further, there must be an arrangement (“the relevant arrangement”) to which A is a party or whichotherwise relates to A and it must be reasonable to suppose both that:

(a)“in essence” the relevant arrangement is (wholly or partly) a means of providing, or is otherwiseconcerned with, the provision of:

(i)rewards;

(ii)recognition; or

(iii)loans;

in connection with the employment; and

(b)“in essence” the relevant step is taken wholly or partly in pursuance of the relevant arrangementor there is some other connection between them (s.554A(1)).

This is referred to by HMRC as the “section 554A gateway”.

The charge to income tax

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In such circumstances, a charge to income tax will arise on the basis that the value of the “relevantstep” (see 22A.35), if it is not an “excluded” relevant step, counts as employment income of theemployee, subject to the application of various reductions and reliefs as mentioned below.

The essence of the matter

It is unclear what is added to s.554A by the use of the term “in essence”. All relevant circumstancesare to be taken into account “in order to get to the essence of the matter” [sic] (s.554A(12))—perhapsan attempt to codify the “sniff test”! (See 22A.9.)

Meaning of “arrangement”

This is expressly defined, in s.554Z(3), as including “any agreement, scheme, settlement, transaction,trust or understanding (whether or not it is legally enforceable)”.

In relation to (a) above, it does not matter if the relevant arrangement does not include details of thesteps which might be taken in connection with the provision of rewards, recognition or loans (forexample: details of sums or assets involved or of how or when or by whom or in whose favour anystep might be taken (s.554A(6)).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

The Six Steps

22A.5It is perhaps easiest to consider the application of Pt 7A in terms of there being six steps to be takenin applying the DR rules

Step 1: is there an arrangement (“the relevant arrangement”) to which a former, existing orprospective employee (or director) is a party or which otherwise covers or relates to that individualwhich, in essence, it is reasonable to suppose is an arrangement for the provision of either (i) rewardsor (ii) recognition, or (iii) loans, in connection with an employment (s.554A(1)(b) and (c))? (see 22A.6);

Step 2: is there a “relevant step” (see 22A.7 and 22A.15 et seq.) taken by a “relevant third person”(ss.554A(1)(e)(7)-(10) and s.554B-554D)? (see 22A.7);

Step 3: is it reasonable to suppose that the relevant step is, in essence, taken in pursuance of therelevant arrangement or is there some other connection between the relevant step and that relevantarrangement (s.554A(1)(e)) (see 22A.9);

Step 4: is the “relevant step” excluded from the scope of the charge (ss.554E-554N)? (see 22A.10);

Step 5: what is the taxable value of the relevant step (see 22A.11); and

Step 6: is the taxable amount reduced by any of the reliefs afforded by Chapter 2 of Pt 7A (s.554Z(4)-(8) or by reason of other reliefs in ss.554Z9-554Z15)?; (see 22A.12 and 22A.43 et seq.).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

Step 1: Relevant arrangement

Step 1: Relevant arrangement

22A.6It is a pre-requisite of Pt 7A that a charge under the DR rules will only arise if:

(a)a person (“A”) is an employee (or director), or a former or prospective employee (or director), ofanother person (“B”);

(b)there is an arrangement to which A (or a person linked with A) is a party or which otherwise(wholly or partly) covers or relates to A (or a linked person); and

(c)it is reasonable to suppose that, in essence, that arrangement, so far as it covers or relates to A(or a linked person) is (wholly or partly) a means of providing, or is otherwise concerned (whollyor partly) with the provision of, rewards or recognition or loans in connection with suchemployment (or office) of A with B.

The relevant arrangement must relate to the office or employment concerned. If, for example, there issuch an “arrangement”, but it genuinely relates, not to a prospective or former employment, butinstead to another employment, or a period of self-employment, or employment with someone otherthan B—such as an employment with another member of the same group—then the first requirementfor the rules to apply is not met in relation to the employment with B (although, if, on the facts, thearrangement in question relates to such other employment, then the DR rules may still apply).

The use of the present tense (“a person is…a former employee”) suggests that a charge cannot arisein relation to a relevant step taken in favour of an employee who has died, but s.554A(4) expresslyprovides that a charge does not arise by reason of a relevant step which is an “earmarking” (seebelow) taken after the employee’s death (which implies it would otherwise). See 22A.49.

Meaning of “person linked with A”

A person linked with A is:

(a)a person who is or has been connected with A;

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(b)a close company in which A or any other person within (a), (c) or (d) is or has been a participator(see 16.28);

(c)a company in which A or any other person within (a), (b) or (d) who is or has been a participatorand which would be a close company if it were UK resident; or

(d)a 51 per cent subsidiary of a company within (b) or (c) above.

(s.554Z1(1))

For the meaning of “connected person”, see 7.19A but, for these purposes, a man and woman livingtogether as if they were spouses are to be treated as if they were spouses of each other and,likewise, two people of the same sex living together as if they were civil partners are to be treated asif they were civil partners of each other.

Note that once a person has become a person linked with an employee(, etc.), he, she or it willremain a linked person after the death of that employee. An individual born after the death of Acannot be linked with A as they were never connected with A.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

Step 2: Is there a “relevant step” taken by a “relevant third person”

“Relevant steps”

“Relevant steps”

22A.7There are three types of “relevant step”:

•The “earmarking” of money or of an asset by the person holding that asset (being a “relevantthird person”), or a relevant third person beginning to hold an asset (or money or an assetbeginning to be held on behalf of a relevant third person), in either case, specifically with a view,so far as the relevant third person is concerned, to a later relevant step being taken by anyperson in relation to that asset or money or an asset deriving from it (s.554B).

•any of the following steps taken by a relevant third person to, or for, the employee or a personchosen by the employee or, if the step is taken by the relevant third person at the employee’sdirection or request, any other person:

•the making of a loan;

•the payment of a sum of money;

•the transfer of an asset;

•making available (however informally) a sum or asset as security for a loan or for meeting aliability;

•procuring that the person in question acquires “securities” (as broadly defined in s.420, forthe purposes of ITEPA Pt 7—see 17.14), an interest in securities or a securities option, thetime of acquisition being the time given in s.421B(2)(a)—see 7.17 (s.554C).

•The relevant third person, without transferring an asset, making it available, however informally,

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for the person in question to benefit from in a way which is substantially similar to how theywould have benefited had the asset been transferred at that time or, an asset having been madeso available for the person in question to benefit from, it continues to be made available at theend of the period of two years from cessation of the employment (s.554D).

The first two of these “relevant steps” are considered in more detail at 22A.15 below. In practice, thethird step above is unlikely to be relevant in relation to employee share schemes.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

Meaning of “relevant third person”

Meaning of “relevant third person”

22A.8A “relevant third person” is:

•any person other than A (the employee) or B (the employer); or

•either A or B, if they are acting as a trustee (it is considered that this means a trustee in thesense of someone holding assets on trust for himself (or another) as distinct from holding suchassets as nominee or bare trustee) (s.554A(7)).

It should be noted that a relevant step taken by someone other than a relevant third person (such asthe employer, provided it is not acting as a trustee, or any other member of the same 51 per centgroup of companies) will not give rise to a charge under the DR rules. It follows that, for example, thegrant, by the employer company, of an option to subscribe for new shares in that company and thesubsequent issue of new shares or a transfer of treasury shares when it is exercised, will be outsidethe scope of the DR rules.

Groups of companies

If the employer (B) is a company and a member of a “group of companies” at the time the relevantstep is taken, then—unless there is a connection between the relevant step and a “tax avoidancearrangement” (see 22A.14)—references to B are to be read as including references to any othercompany which is a member of that group at that time.

So, a “relevant step” taken by another member of the same 51 per cent group of companies (notacting as trustee) in relation to an employee of a member of that group will not be a step taken by a“relevant third person”. It follows that, for example, if the holding company of a 51 per cent group ofcompanies issues, or grants options to subscribe for, shares in that company to employees of anothermember of that group, such steps will be outside the scope of the DR rules. Likewise, a loan made byanother member of such group to an employee of another member of that same group will not giverise to a charge under the DR rules.

If, however, a member of the group has established an employees’ trust of which the trustee is awholly-owned subsidiary of the group holding company, then, for example, the transfer, or grant ofoptions over shares in any member of the group, or the making of a loan, by the trustee, will be a steptaken by a “relevant third person”, notwithstanding that the trustee is a member of the same 51 percent group and may therefore give rise to charges under the DR rules.

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Except as mentioned at 22A.38, loans to employees or directors (etc.), should be made only by theemployer company (or another member of the same 51 per cent group of companies), and not by theEBT trustee. A loan by a bank may be excluded, but only if it satisfies the restrictive requirements ofs.554F (commercial transactions).

Meaning of “group of companies”

For these purposes, "group of companies" has the meaning given in TCGA 1992 ss.170(2)–(11), butread as if references in those provisions to “75 per cent” were substituted by references to “51 percent”. Under this definition, a company (“the principal company”) and all its 51 per cent subsidiaries(and any 51 per cent subsidiary of such a subsidiary—and so on) form a group. The company cannotbe the principal company of a group if it is itself a 51 per cent subsidiary of another company. Acompany cannot be a member of more than one group, but if it would otherwise be a member of twoor more groups, it is a member only of that group (if any) of which it would be a member applying thetests set out in s.170(6) in order. See TCGA 1992 s.170(5) and (7)–(11).

Joint ventures

If the employer (B) is a company whose issued ordinary share capital is owned as to 50 per cent byeach of two shareholders (so that it is not a 51 per cent subsidiary of either), one of which takes a“relevant step”, that step will be taken by a “relevant third person” as it is not a member of the samegroup for these purposes.

Limited liability partnerships (LLPs)

An LLP is not a “company” for the purposes of s.170 (see s.170(9)). However, if the employer (B) isan LLP (as opposed to a Limited Partnership or a conventional trading partnership), then—unlessthere is a connection between the relevant step and a tax avoidance arrangement (see 22A.14)—references to B are also to be taken as including references to any wholly-owned subsidiary (perCA 2006 s.1159(2), i.e. directly wholly-owned subsidiary) of B at the time the relevant step is taken.

Given that the more usual scenario is that the individual in question is an employee of a subsidiary ofthe LLP, this provision should perhaps have been crafted on the basis that, if A is an employee of awholly-owned subsidiary of an LLP, then references to B should be taken as including the LLP andany other company which is a wholly-owned subsidiary of the LLP … but it was not!

Shareholders

A shareholder in a company, other than a corporate shareholder which is the parent or a member of a51 per cent group of companies, will be a "relevant third person" in relation to an employee ordirector of that company. It follows that the grant, by such a shareholder to such an employee ordirector, of a share option may well be a “relevant step” (see 22A.16) taken by a “relevant thirdperson”. In such a situation, it might be possible to structure the option grant or award of shares so asto fall within one of the exclusions in any of ss.554H–554M (see 22A.24 et seq. below).

In the case of a corporate shareholder which is not a parent or member of the same 51 per centgroup of companies as the employer company, reliance cannot be placed upon the exclusions froman “earmarking” charge (in relation to shares in the corporate shareholder) in ss.554J–554M as suchshares will not be “relevant shares”—see 22A.26.

Pre-acquisition inducements

The earmarking or awarding of shares or other benefits by a company (“Company X”) for directors oremployees of a target company in advance of the target becoming a member of the same 51 per centgroup of companies as that of which Company X is a member, will be a “relevant step” taken by a“relevant third person”.

Demergers

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Care must be taken to ensure that any “relevant step” taken by a member of a 51 per cent group ofcompanies in relation to directors or employees of another member of that group in connection with ademerger of that other member, is taken at a time when the two companies remain members of thesame 51 per cent group of companies. A “relevant step” taken after such a demerger will be taken bya “relevant third person”.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

Step 3: Connection between “relevant step” and “relevant arrangement”

Step 3: Connection between “relevant step” and “relevant arrangement”

22A.9It must also be reasonable to suppose that “in essence” the relevant step is taken (wholly or partly) inpursuance of the relevant arrangement or that there is some connection (direct or indirect) betweenthem.

This cuts both ways: if, for example, the relevant step is taken in the normal course of the domestic,family or personal relationships of the person concerned, then in “essence” it might be the case thatthe step is not taken in pursuance of an arrangement for the provision of rewards or recognition inconnection with an employment of that person (cf. s.421B in ITEPA 2003 Pt 7).

Suppose, for example, that a daughter is employed in a family-owned company and her fatherpromises that if, after, say, five years, she remains actively engaged in the business of the company,he will then transfer (say) 33 per cent of his shares to her, then, whilst the making of this promise is arelevant step by a relevant third person, it is submitted that it is not reasonable to suppose that, “inessence”, it is anything other than a family arrangement (and not concerned with the provision ofrewards or recognition in connection with the daughter’s employment with the company).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

Step 4: Is the “relevant step” excluded?

Step 4: Is the “relevant step” excluded?

22A.10A charge to income tax under the DR rules does not arise if the “relevant step” is excluded under anyone of the prescriptive exclusions in ss.554E–554X. Those most relevant to employee share schemesare:

•section 554E—HMRC approved SIPs, SAYE schemes, CSOPs and EMIs (see 22A.18 and 19below);

•section 554H—“earmarking” of deferred remuneration (see 22A.25 below);

•section 554J—conditional share awards (see 22A.26 below);

•section 554K—“exit only” share awards (see 22A.27 below);

•section 554L—conditional share options (see 22A.28 below);

•section 554M—“exit only” share options (see 22A.29 below); and

•section 554N—certain steps by virtue of which charges arise under specific charging provisionsin Pt 7 relating to employment-related securities (see 22A.22 below).

Note that, except in the case of s.554E and s.554N, the exclusions listed above only provideexclusions from an “earmarking” charge and not from a charge arising by reason of any other“relevant step”.

HMRC power to exclude other “relevant steps”

HMRC has the power to make regulations excluding from a Pt 7A charge any relevant step of aspecified description. Such regulations may have retrospective effect. This is a very broad powerenabling HMRC to afford retrospective relief in bona fide situations not involving tax avoidance, which

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might otherwise fall foul of Pt 7A in circumstances in which there was no intention to imposeadditional or penal tax charges. At the time of writing, one such set of regulations, relating toparticular types of pension, has been published in draft for consultation.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

Step 5: How is the charge calculated?

Step 5: How is the charge calculated?

22A.11Section 554Z2 provides that, if Chapter 2 of Pt 7A applies by reason of a “relevant step”, the value ofthe “relevant step” counts as employment income of the employee for the tax year in which the“relevant step” is taken (or, if the step is taken before the employment begins, for the tax year inwhich it begins). The value of the “relevant step” is determined in accordance with s.554Z3. Insummary, if the “relevant step” involves a sum of money, its value is the amount of the sum but inother cases the value will normally be the market value when the step is taken of the asset which isthe subject of the step. See further 22A.35.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

Step 6: Is the amount on which tax is charged to be reduced?

Step 6: Is the amount on which tax is charged to be reduced?

22A.12The amount which counts as employment income may be reduced by reason of each of the followingprovisions which, so far as applicable, are to be applied in the following order:

•section 554Z4—residence issues (see 22A.43 below);

•section 554Z5—overlap with an earlier “relevant step” (see 22A.44 below);

•section 554Z6—overlap with a general earnings charge (and certain other types of earnings)(see 22A.45 below);

•section 554Z7—exercise price of share options (see 22A.46 below); and

•section 554Z8—cases in which consideration is given by the employee for a transfer of an asset(see 22A.47 below).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Six Steps

Other reliefs from a charge under Chapter 2, Part 7A

Other reliefs from a charge under Chapter 2, Part 7A

22A.13Special provision is made for employees (,etc.) to whom the remittance basis applies (see 22.48below) and if the “relevant step” is taken after the death of the employee (see 22A.49 below).

Further, relief (from a later charge to income tax) is available on a “just and reasonable” basis if, aftera “relevant step” is taken, a later event occurs which would give rise to a liability to income taxotherwise than under the DR rules or the employment-related securities provisions in Chapters 2–5 ofITEPA 2003 Pt 7 (see 22A.50 below).

Relief from an “earmarking” charge under the DR rules may also be sought by application to HMRC if,following an “earmarking” charge, there occurs an event which is not a “relevant step” by reason ofwhich no further “relevant step” is or will be taken in relation to the sum or asset which was thesubject of the “earmarking charge” (or which has arisen or derived from it) and there is no connectionbetween the later event and a tax avoidance arrangement (see 22A.51 below).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Meaning of “Tax Avoidance Arrangement”

Meaning of “Tax Avoidance Arrangement”

22A.14Many of the exceptions and exclusions from the various provisions of Pt 7A depend upon there beingno connection with a “tax avoidance arrangement”. This is defined in ss.554Z13–554Z16. It is firstdefined as an “arrangement which has a tax avoidance purpose”. This is then further defined asmeaning that, in relation to a person who is a party to the arrangement, that person has as a mainpurpose, or one of the main purposes, in entering into the arrangement the avoidance of tax (incometax or corporation tax) or national insurance contributions (NICs). Further, in determining if any step isconnected with a tax avoidance arrangement, the step is so connected if (for example) it is taken(wholly or partly) in pursuance of either (1) the arrangement or (2) an arrangement at one end of aseries of arrangements with the tax avoidance arrangement being at the other end. It does not matterif the person taking the step is unaware of the tax avoidance arrangement, but presumably someoneinvolved must have a tax avoidance purpose.

This, of course, begs the question: what exactly is a tax avoidance purpose? On this thorny questionthe legislation is silent, leaving it to the tribunal and the courts to determine in the light of case lawauthorities. See, for example, a decision of the Special Commissioners in Burns v Revenue andCustoms Commissioners [2009] STC (SCD) 165—but note that this relates to the question of whethersteps were taken with a tax avoidance purpose, whereas in the context of the DR rules the question isnot whether there is a tax avoidance purpose, but whether, if so, that is a “main” purpose.

An employee share incentive may be structured in a manner which optimises the tax treatment, butalmost invariably the “main purpose” is to provide an incentive for enhanced performance or rewardfor, or recognition of, services to the company or group.

If a step is taken, or arrangement entered into, to achieve a legitimate commercial aim, such asallowing an employee to benefit from future growth in value of shares in a company, and the incentiveis structured in one particular manner rather than another simply because to do so will optimise thetax and NICs treatment of either the employee or the employer (or both), then it might be stronglyargued (as against HMRC) that whilst a saving of tax or NICs is indeed a purpose of the arrangement,it is not to be taken as a “main” purpose. So, for example, it is understood that HMRC will not seek tochallenge an arrangement intended to enable an employee to benefit from future growth in value ofshares by reason only of the fact that it has been structured as, for example, joint share ownership(see 22A.57), rather than as an unapproved share option, notwithstanding the difference in taxtreatment of such types of award. Indeed, whilst, in the case of joint share ownership, any growth invalue accruing to the employee should normally fall to be taxed as capital gain, the overall tax cost interms of consideration given and/or income tax and NICs paid on acquisition of the employee’sinterest as joint owner may mean that, in the absence of substantial growth, and taking account of theabsence of relief from corporation tax on any such growth accruing to the employee, there could belittle or no overall saving of tax.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Relevant Steps

Types of “relevant step”: an “earmarking” of assets—section 554B

What is an “earmarking” (etc.)?

What is an “earmarking” (etc.)?

22A.15Although any step within s.554B is widely referred to (even by HMRC) as an “earmarking”, s.554Bdescribes two distinct types of step, and only the first uses the term “earmark”. The second limb hasbeen referred to as a “quasi-earmarking”, but would appear to be wider in scope than the first anddoes not require any positive act on the part of any person, merely the formation, or change, of anintent. Section 554B provides that:

"(1)A person (‘P’) [necessarily being a ‘relevant third person’] takes a [relevant] step …if:

(a)a sum of money or asset held by or on behalf of P is earmarked (howeverinformally) by P with a view to a later relevant step being taken by P or anyother person (on or following the meeting of any condition or otherwise) inrelation to:

(i)that sum of money or asset, or

(ii)any sum of money or asset which may arise or derive (directly orindirectly) from it, or

(b)a sum of money or asset otherwise starts being held by or on behalf of P,specifically with a view, so far as P is concerned, to a later relevant step beingtaken by P or any other person (on or following the meeting of any condition orotherwise) in relation to:

(i)that sum of money or asset, or

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(ii)any sum of money or asset which may arise or derive (directly orindirectly) from it

[and ,for these purposes,] it does not matter whether or not the sum of money orasset in question has previously been held by or on behalf of P on a differentbasis.]"

Further, subs.554B(2) provides that it does not matter: (a) if details of the later relevant step have notbeen worked out; (b) that any condition which would have to be met before the later relevant step istaken might never be met; or (c) if A, or any person linked with A, has no legal right to have a relevantstep taken in relation to any sum of money or asset mentioned above. That said, in relation to A, thearrangement in pursuance of which the relevant step is taken has to be in connection with theemployment of A, not that of a person linked with A (although a charge may of course arise on thepart of the linked person if the arrangement is in connection with his or her employment).

Commentary

Clearly, the intention of the draftsman was to cast the net wide and bring into charge under Pt 7Athose situations in which sums or assets are retained by a trustee (or other third party) on terms suchthat, whilst the employee knows that it is “in the bag”, no “earnings” have been received such aswould, under general rules, trigger an immediate charge to income tax under either s.6 (charge to taxon general earnings and specific employment income) or any other charging provisions. However, theuse of the term “earmarking” is regrettable, since it is used in a sense that is at odds with its normal,everyday, sense of marking or appropriating something to denote personal ownership or possession.In the context of Pt 7A, the term is used in its figurative sense of denoting that something is assignedto a definite purpose (per Concise OED).

An “earmarking” of property within subs.554B(1)(a) has to be “with a view to a later relevant stepbeing taken” and this necessarily requires a subjective judgement to be made of whether the relevantthird person “earmarking” the property is doing so with another “relevant step” in mind. Although it isnot necessary for the relevant third person to have worked out the details, there does have to be aprospective payment or transfer of an asset (including the making of a loan, grant of a securitiesoption or making an asset available (per s.554D)) in contemplation, albeit only in outline, as withoutthis the “earmarking” cannot be made “with a view to” a later step being taken. In particular, there hasto be an identifiable individual or individuals in respect of whom the property is so “earmarked” (seeEIM 45100).

It is also necessary that the property “earmarked” is at that time held “by or on behalf of” the personwho is “earmarking” it. A relevant step within s.554B cannot then be taken in relation to any sharesbefore the point in time at which the trustee (or other third party) holds the property, or such propertyis then in existence and held by a person on behalf of the relevant third person. So, for example, thefact that a trustee of an employees’ benefit trust (“EBT”), which does not yet hold cash or shares, hasagreed with the sponsoring company to satisfy a conditional award of shares, or the exercise of ashare option granted, to a named employee if called upon to do so and if or to the extent that it thenhas funds available to acquire the shares, does not mean that it has taken a “relevant step”. Untilsuch time as the trustee is put in funds, or has funds it can call upon, sufficient to enable it to acquiresuch shares (by way of subscription or purchase) it will not hold assets which can be the subject of an“earmarking”.

Section 554B(1)(b) is tantamount to a restatement of s.554B(1)(a) omitting the use of the term“earmarking”. The language used implies a passive state on the part of the relevant third person sothat, for example, if a trustee of an EBT merely accepts a recommendation from the employer that agiven number of shares within a pool of shares already held should be allocated towards thesatisfaction of an award made to a particular named employee, a relevant step will then be taken inrespect of those shares. Once again, the property in question must actually be held by (or on behalfof) the relevant third person.

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An example of a situation in which s.554B(1)(b), but not subs.554(1)(a) will apply is where the trusteeof an EBT appoints a nominal sum of, say, £1 upon the trusts of a revocable sub-trust and all of thefunds of that sub-trust held from time to time are “earmarked” in favour of an employee or his family. Ifthe employer subsequently transfers additional funds directly to the sub-trust by way of contribution,whilst it is arguable that s.554B(1)(a) does not apply, s.554B(1)(b) clearly does.

If, for example, A PLC makes conditional share awards to employees within its 51 per cent group onthe basis that such awards might be satisfied using shares sourced:

•by new issue;

•out of treasury;

•from a pool of shares held by an EBT; or

•from shares purchased in the market by an EBT using funds provided by the company,

and a final decision to use shares held, or to be acquired by, the EBT is not taken by the companyuntil immediately before the award shares, having vested, are to be transferred (without the EBTtrustee beginning to hold shares with a view to satisfying awards to named employees), then no“relevant step” is taken within s.554B (see HMRC guidance at EIM 45105). A “relevant step” (withins.554C) will be taken if and when the shares (or cash equivalent) are transferred to, or to the order of,the employee by the trustee.

If, for example:

(a)an employer company or its holding company (assuming they are members of a 51 per centgroup of companies) has put an EBT in funds to acquire shares, and has in place a “linkingagreement” (see 20.11A) where under the EBT agrees that, if called upon to do so, it will satisfyvested share awards made by the company; and

(b)the employer company (or its holding company)—without informing the EBT trustee—”earmarks”a number of shares in anticipation of the vesting of share awards made (or options granted) to itsemployees by the company (or its holding company),

then, although the EBT trustee (being a “relevant third person”) holds the shares, it has not taken a“relevant step” within s.554B as it has neither “earmarked” any shares nor begun to hold shares witha view to a later relevant step being taken by it or the company. Even if the trustee is said to hold theshares on behalf of the employer company (which is not technically correct as a matter of trust law),the employer company is not a “relevant third person”.

What if, in that example, the company informs the trustee of the fact that the awards have been, orare to be, made? HMRC has accepted, in its guidance, that if the EBT trustee knows only theaggregate number of shares in respect of which awards have been made, and the aggregate numberof employees to whom such awards have been made, but not the number of shares in respect ofawards made to individual named employees, then no “relevant step” within s.554B will have beentaken (see EIM 45100). It follows that, if the “linking agreement” requires, as a condition of the trusteeagreeing to satisfy any awards, that the company must notify the EBT trustee of the making of theawards/grant of options, then it is vital that this requirement for notification be restricted to theaggregate numbers, not the terms of individual awards or the identity of individual awardholders. It is

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likely that many older forms of “linking agreement” will need to be amended to take account of thispoint.

The latter example gives rise to the question of exactly how much (if any) knowledge of individualshare awards can be imputed to an EBT trustee (or other relevant third person) in order for thetrustee to be treated as having taken a relevant step within s.554B? This is of particular concern tothose commercial organisations providing both trustee and share plan administration services. It isnot uncommon for such organisations to provide both the (typically offshore) trusteeship of an EBTand an administration service which includes the maintenance of detailed records of the grant,vesting, and exercise of awards/options and management of portals (, etc.). If such services areprovided by one and the same legal person, or by individual administrators who perform bothfunctions, then it is clear that knowledge of the terms of awards made/options granted to named oridentifiable employees will, if matched by shares actually held by or on behalf of the EBT trustee,amount to the taking of a relevant step within s.554B. If the trusteeship function and theadministration are performed by distinct legal entities, albeit under common ownership, then it is amatter of fact whether the EBT trustee has sufficient knowledge of the making of an award/granting ofan option to a named individual for a relevant step to have been taken under s.554B. The existence ofa “Chinese Wall” established as between individuals engaged in the distinct roles of trustee andadministrator will not be sufficient to avoid a relevant step under s.554B, whether or not suchindividuals are employed by the same or different entities. It will always be a question of fact in eachcase. That said, HMRC have confirmed that the fact that separate legal entities are in the samecorporate group will not be sufficient for HMRC to assume that knowledge of the one entity is sharedby the other entity, although if the separate legal entities have directors in common, then the positionmay be far from clear.

It is understood that HMRC accept that knowledge of individual awards detailed in an RNSannouncement made by a listed or AIM-quoted company cannot, of itself and without more, beimputed to a trustee so as to give rise to an earmarking if the trustee is not otherwise made aware ofsuch details, provided that the announcement does not specifically refer to the award(s) beingsatisfied by shares held by the trust.

Tax charged in consequence of a change of intent?

By reason of s.554B(1)(b), it seems that a charge may now arise by reason only of a change of intenton the part of a person holding assets, regardless of whether the employee concerned therebyacquires any actual or prospective entitlement to benefit, or any assurance that he will in fact receiveany benefit, and even if the employee has no knowledge of such change of intention on the part of the“relevant third person”. Such a basis of charge is thought to be unique in the UK tax system and itsurely raises the possibility that the courts might yet strike down any attempt by HMRC to pursue acharge under Pt 7A in such circumstances on the grounds that the statutory authority for imposing it issimply too vague to be enforceable.

Earmarking may be distinct from the making of an award/grant of an option

The grant of an employment-related securities option is itself a “relevant step” (per s.554C(1)(c)), butis excluded by s.554N(2). Nevertheless, HMRC is understood to be of the view that the grant of anoption by a “relevant third person” to acquire shares held by, or to be acquired out of cash held by oron behalf of, that person involves both (a) the grant of the option and (b) the “earmarking” (per s.554B) of the shares (or cash) by the relevant third person with a view to the transfer of such shares uponthe exercise of such option (the “earmarking” being specifically with a view to such later transfer ofshares upon exercise of the option).

It follows that, if the option is on terms which do not satisfy the exclusion in either ss.554L or 554M(and do not otherwise satisfy the exclusion in s.554H (deferred remuneration)), a charge to incometax may arise at the time of grant on the basis that a relevant step (an earmarking) has then beentaken by a relevant third person. This affords a “trap for the unwary” which may adversely affect (forexample) an employer company and its individual shareholder granting an unconditional option to anemployee to acquire shares held by the individual shareholder. By reason of s.554Z7 (see 22A.46),the value of the relevant step may be reduced by the amount payable upon exercise of the option(and, in the case of a “market value” share option, reduced to nil). Further, the amount counting asemployment income by reason of the earmarking will be a deductible amount in calculating the

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amount charged under Pt 7 on exercise of the option (see 11.27F).

Simultaneous earmarking and transfer

If shares are earmarked by an EBT (or other relevant third party) with a view to such shares beingtransferred by the EBT at the same time, the earmarking will not be considered a separate relevantstep on the basis that it is not a step taken with a view to a later relevant step being taken (see EIM54110).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Relevant Steps

Types of “relevant step”: an “earmarking” of assets—section 554B

Types of “relevant step”: payment of sum, making of a loan, or transfer ofasset—section 554C

Types of “relevant step”: payment of sum, making of a loan, or transfer ofasset—section 554C

22A.16A “relevant step” is taken if a person, being a relevant third person:

(a)pays a sum of money to a relevant person;

(b)makes a loan to a relevant person;

(c)transfers an asset to a relevant person (s.554C(1)(b));

(d)takes a step by virtue of which a relevant person acquires securities, an interest in securities or asecurities option, these terms having the meanings they have for the purposes of theemployment-related securities charging provisions in Chapters 1–5 of ITEPA 2003 Pt 7 (s.554C(1)(c)); or

(e)makes available a sum or asset as security for a loan to a relevant person or as security for anyliability or the performance of any undertaking by a relevant person (s.554C(1)(d)).

It is unclear if, for the purposes of (d) above, the reference to “securities [, etc.] … as defined in s.420for the purposes of Chapters 1–5 of Pt 7” means that, to fall within s.554C(1)(c), the shares(, etc.)concerned must be “employment-related securities” or merely “securities”. If it is only the former, then(given that a transfer of such shares would in any event be caught by s.554C(1)(b)) the grant of anoption to acquire shares which are not employment-related securities would be outside the scope ofs.554C.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Relevant Steps

Types of “relevant step”: an “earmarking” of assets—section 554B

Types of “relevant step”: making an asset available—section 554D

Types of “relevant step”: making an asset available—section 554D

22A.17This relates to making an asset available for a “relevant person” to benefit from, without the assetactually being transferred to that person. This will not normally be relevant in the context of anemployees’ share scheme.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions from a Charge under Part 7A

Exclusion of HMRC-approved SIP, SAYE share option and CSOP schemes

Exclusion of HMRC-approved SIP, SAYE share option and CSOP schemes

22A.18A charge under Pt 7A does not apply by reason of a “relevant step” if it is taken “under” any of:

•an HMRC-approved SIP;

•an HMRC-approved SAYE share option scheme; or

•an HMRC-approved CSOP.

(s.554E(1)).

The use of the term “under” suggests that the relevant step must be taken pursuant to, and inaccordance with, the terms of the approved plan. HMRC has confirmed that the rules of an approvedplan may expressly provide for shares to be “earmarked” for the purpose of satisfying options grantedunder the plan and that such a provision would be accepted by HMRC to be a feature which isreasonably incidental to the purpose of providing benefits in the nature of shares (see 12.3 and 13.1).

This alone would not exclude steps taken by, for example, an EBT in transferring shares, orearmarking shares (in advance of their transfer) with a view to satisfying awards made or optionsgranted or to be granted under any such approved plan. Accordingly, s.554E(3) further provides thatany relevant step (taken by a relevant third person) does not give rise to a Pt 7A charge if it is taken“solely for the purpose of …” acquiring or holding shares to be awarded under a SIP or to be providedpursuant to SAYE or CSOP options or providing shares pursuant to an award of shares under a SIPor an SAYE or CSOP option. This exclusion does not apply if there is a connection between therelevant step and a tax avoidance arrangement or if immediately before or after the step is taken thetotal number of shares (of any type) held for that purpose exceeds the maximum number (of thattype) which might reasonably be expected to be required in relation to the approved scheme for thosepurposes over the period of 10 years from the day on which the relevant step is taken.

So, for example, if an EBT holds, say, 1,000 shares and agrees to make available such number ofthose shares as is expected to be required to satisfy the exercise of (say) options granted under anHMRC-approved SAYE share option scheme, or CSOP, then such “earmarking” will, in the absenceof a tax avoidance main purpose, be excluded, as will the later transfer of such shares upon theexercise of such options. In determining the maximum number of shares reasonably required over a10-year period, it is the shares earmarked for the satisfaction of the approved awards/options that areto be taken into account, not other shares which are held by the EBT for any other (or no defined)

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purpose (per HMRC guidance). In other words, the shares “ring-fenced” to satisfy HMRC approvedawards/options must not exceed the number reasonably required to satisfy such awards over the next10 years.

It is not necessary for shares to be held in separate trusts for the purposes of each type of HMRC-approved scheme, and HMRC have confirmed (in their guidance) that it is possible to use one trustfor both HMRC-approved and non-HMRC approved schemes and still meet the requirements ofs.554E in relation to the HMRC-approved schemes. Likewise, a pool of shares held to satisfy awardsmade or options granted under a number of HMRC-approved and non-HMRC approved plans inwhich an employee is a participant will not fail the test of shares being held “solely for the purpose of…” as mentioned above.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions from a Charge under Part 7A

EMI option shares

EMI option shares

22A.19Section 554E(6) affords a similar exclusion from a charge under Pt 7A if the relevant step is for thesole purpose of granting, acquiring or holding shares to be provided pursuant to, or providing sharespursuant to, EMI options provided:

(a)there is no connection with a tax avoidance arrangement; and

(b)the total number of shares held in relation to the EMI options by the person taking the relevantstep or any other persons for such purposes does not exceed the maximum number which mightreasonably be expected to be required in relation to the EMI options over a 10-year period.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions from a Charge under Part 7A

“Fallback charges”

“Fallback charges”

22A.20If at any time shares (or other property) in respect of which this exclusion applies cease to be heldsolely for the purposes of awards or options under an approved scheme but continue to be“earmarked” with a view to providing benefits(, etc.) to an employee or former employee otherwisethan under an HMRC-approved plan, or for the purpose of satisfying EMI options, then a relevant stepis deemed to be taken at that time (so giving rise to a Pt 7A charge) (s.554E(10) and (11)).

On a strict reading of Pt 7A, it would appear that if an HMRC-approved SAYE share option ceases tobe an approved share option, or a discounted EMI share option ceases to qualify as an EMI shareoption, this may give rise to an immediate “fallback” charge if the shares remain earmarked for theoption holder or a person linked with the option holder.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions from a Charge under Part 7A

Other employment-related securities exclusions

Other employment-related securities exclusions

22A.21There are a range of other exclusions from an “earmarking” charge (only) which each relate to aspecific type of award:

•deferred conditional share awards;

•deferred share awards conditional upon an “exit event”;

•conditional share options; and

•share options exercisable only upon an “exit event”.

As these are exclusions only from an “earmarking” charge, they are each dealt with separately at22A.25–22A.29 below.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions from a Charge under Part 7A

Exclusion of a relevant step which gives rise to certain charges under Part 7(employment-related securities)

Exclusion of a relevant step which gives rise to certain charges under Part 7(employment-related securities)

22A.22Section 554N affords exclusions from a Part 7A charge in relation to a relevant step if it is theoccasion of any of certain (but by no means all of the) charges or taxable events under theemployment-related securities rules in Pt 7 of ITEPA 2003. In particular, there is no exclusion for arelevant step by virtue of which restricted securities are acquired if they are not subject to short-termrisk of forfeiture (although the amount of any Pt 7A charge may be reduced as mentioned at22A.42–22A.48 below). Likewise, there is no exclusion for shares acquired from a “relevant thirdperson” on deferred payment terms (see 22A.47 and 22A.53 below).

Acquisition of employment-related securities subject to a risk of forfeiture

An acquisition of employment-related securities (e.g. by transfer from an EBT) is excluded if they aresubject to short-term risk of forfeiture, so that by virtue of s.425(2) no charge to income tax arises(see 10.13).

Grant of an employment-related securities option

The grant of an employment-related securities option by a relevant third person is excluded from a Pt7A charge by s.554N(2).

However, if a relevant third person (e.g. an EBT or individual shareholder) grants a share option then,in the opinion of HMRC, the grant is distinct from the “earmarking” of shares held to satisfy thatoption. It follows that if, for example, either an EBT or an individual shareholder grants an option toacquire shares held then, unless the terms of the option satisfy the conditions mentioned at 22A.28 or22A.29, an immediate “earmarking charge” could still arise by virtue of s.554B (see 22A.15).

Restricted securities: post-acquisition chargeable event

A Pt 7A charge is excluded if the relevant step is a chargeable event for the purposes of the rulesrelating to “restricted securities”—see 10.14 et seq.—by virtue of which an amount counts asemployment income of the employee.

This exclusion also applies if there would have been such a chargeable event but for any exemptionby reason of death, non-UK residence at the time of acquisition, or the relief afforded by s.429 (see10.16) or apart from an election having been made under s.430.

Suppose, for example, that an EBT transfers to an employee a beneficial interest in shares upon andsubject to the terms of an agreement which imposes restrictions (as that term is specially defined for

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the purposes of Chapter 2 of Pt 7—see 10.8) upon the shares, and unusually, no s.431(1) tax electionis made. The EBT subsequently agrees to lift such restrictions so that the employee thereuponacquires an unrestricted interest in those shares:

(a)the initial acquisition will be a “relevant step” (per s.554C(1)(b) or (c)) which is not excluded, butif it is gifted so that the employee suffers a general earnings charge on the market value of therestricted interest, then the value of the relevant step will be reduced to nil (per s.554Z6);

(b)as no s.431(1) election was made on acquisition, the lifting of restrictions is a “chargeable event”per s.426 by virtue of which an amount counts as employment income of the employee; and

(c)by reason of s.554N(4), such relevant step is excluded.

If restrictions on the shares are imposed by the terms of a contract between the employee and theemployer (or another member of the same 51 per cent group), rather than an agreement between theEBT trustee and the employee, then any lifting of the restrictions by the company would be outsidethe scope of the DR rules (not being a “relevant step” taken by a “relevant third person”), although if as.431 election was not made, a charge might still arise under Chapter 2 of Pt 7.

If a s.431(1) election had been made on acquisition then it is clear from s.554N(6) that no Pt 7Acharge arises upon the subsequent lifting of restrictions, notwithstanding that no charge to tax arisesunder s.426 (in consequence of the tax election having been made).

Convertible securities: chargeable event

A Pt 7A charge is excluded if the relevant step is a chargeable event for the purposes of the rulesrelating to “convertible securities”—see 10.57 et seq.—by virtue of which an amount counts asemployment income of the employee (A). Note that there is no exclusion for a relevant step which isthe acquisition of convertible employment-related securities (although the amount of any Pt 7A chargemay be reduced as mentioned at 22A.43–22A.48 below).

This exclusion also applies even if there would have been such a chargeable event but for anyexemption by reason of death, non-UK residence at the time of acquisition, or the relief afforded bys.443 (see 10.61).

Exercise of an employment-related securities option

A Pt 7A charge is excluded if the relevant step is a chargeable event in relation to anemployment-related securities option (i.e. is the exercise, release or assignment of such anoption)—see 11.27C—by virtue of which an amount counts as employment income of the employee(A). Such an option would, for example, include an L-TIP award structured as the grant of a “right toacquire shares”. This exclusion also applies even if there would have been such a chargeable eventbut for any exemption by reason of death or non-UK residence at the time of grant. So, a transfer ofshares by an EBT or other relevant third person upon the exercise of an unapprovedemployment-related share option (or the exercise of an option granted under an SAYE option schemeor a CSOP or as an EMI option in circumstances giving rise to a charge to income tax), will not giverise to a Part 7A charge.

However, if at any earlier time shares are earmarked with a view to satisfying such option exercise,care must be taken to ensure that the terms of the option satisfy the requirements for exclusion froman earmarking charge in ss.554L and 554M (see 22A.28 and 22A.29 below).

Shares acquired at an undervalue: discharge of a notional loan

Although it is difficult to envisage circumstances in which it might otherwise arise, a Pt 7A charge is

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excluded if the relevant step is an event which gives rise to the discharge (presumably either anactual or a deemed discharge) of a notional loan for the purposes of s.446U (see 7.27). Given thatany release or writing-off of the liability which gave rise to the notional loan would not appear to be arelevant step within ss.554B, 554C or 554D in the first place, it is difficult to envisage circumstancesin which this exclusion will be in point.

Disposal of employment-related securities for a consideration greater thantheir market value

A Pt 7A charge does not apply “by reason of an event” which is a disposal of employment-relatedsecurities for a consideration which exceeds their market value (so that a charge arises underChapter 3D of Pt 7 of ITEPA 2003 (see 7.36). On one view, if it is the relevant step which must besuch a disposal, then the only circumstance in which this might arise is if an employee acting astrustee sells shares at an overvalue (and it is difficult to envisage such a circumstance arising inpractice). The use of the term “by reason of an event” suggests that this exclusion extends to asituation in which an employee sells shares at an overvalue to, say, an EBT or other “relevant thirdperson”, the relevant step being the payment of consideration by the relevant third person.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions from a Charge under Part 7A

Exclusion of subsequent relevant steps—subsections 554N(7)–(11)

Exclusion of subsequent relevant steps—subsections 554N(7)–(11)

22A.23If an employee(, etc.) acquires shares and either pays (by way of new consideration) at the time ofacquisition, or (insofar as any consideration paid is less than the full market value of the shares)suffers a general earnings charge to income tax on, their market value (whether upon an immediategift or sale or upon the exercise of an option), provided there is no connection with a tax avoidancearrangement, no charge under Pt 7A will arise in relation to any subsequent relevant step taken inrespect of those shares (s.554N(7)–(11)).

So, for example, suppose that an employee is invited to acquire from an EBT the beneficial interest inshares in his employer company on terms that he pays upfront (say) 50 per cent of their market valuebut must agree:

(a)that legal title to the shares remains held by the EBT;

(b)not to sell the shares for five years otherwise than upon a takeover;

(c)to offer his shares for sale upon leaving employment for a consideration which, if he is a “bad”leaver, or it is within three years, is the amount he first paid or, otherwise, their market value; and

(d)to join in making a s.431(1) election in relation to such acquisition (see 10.25).

After five years, the employee is at liberty to sell the shares.

The initial acquisition of the beneficial interest from the EBT is a relevant step (see 22A.16) by arelevant third person so as, prima facie, to give rise to a Pt 7A charge. However, since he receives acredit for the amount he has paid up-front (s.554Z8) as well as for the general earnings charge on theamount of the discount on acquisition, 1 the amount of the initial Pt 7A charge is reduced to nil.

By virtue of s.554N(7)–(11), the employee is protected against any subsequent Pt 7A charge whichmight otherwise arise when, for example, the legal title to the shares is released to the employee.

Notwithstanding the fact that, in this example, the EBT trustee retains the legal title to the shares, it isunderstood that HMRC accepts that (quite apart from s.554N) there is no “earmarking” of the sharesas (a) the employee has acquired, and either paid for, or been charged to income tax on, the fullmarket value of the shares and (b) the legal title is not therefore held “with a view to” a subsequent

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relevant step being taken (in the sense in which that phrase is used in s.554B). In effect, the sharesalready belong to the employee and cannot therefore be “earmarked” with a view to a later relevantstep being taken.

If the shares are first subscribed by the employee on terms that he agrees to pay their full marketvalue, but this is left outstanding unpaid (see 7.36 et seq.), and the employee is required to permit thebare legal title to be held by an EBT, it appears that s.554N(7)–(11) do not apply (see s.554N(8)(b)).However, in this situation, the better view is that neither the acquisition by the EBT as bare trustee,nor the subsequent transfer of legal title by the EBT when the shares are sold, involve a “relevantstep”, and even if it does, the value of such “relevant step” will be de minimis as the value lies in thebeneficial interest which has already been acquired by the employee.

If, by contrast, existing shares are purchased by an employee from an EBT or other “relevant thirdperson” on such terms, then the DR rules will apply because there is a transfer of shares by arelevant third person (see s.554C(1)(6) or (c))—see 22A.16, but the consideration is not given“before, at or about” the time the relevant step is taken (transfer of shares per s.554C(1)(b) or (c))—see 22A.47.

1. Note: If a s.431(1) election is made, the amount of the discount falling to be charged to incometax will be determined by reference to the (generally higher) unrestricted market value of theshares—see 10.19.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusions Only from an “Earmarking” Charge

22A.24The following exclusions are from a charge under Pt 7A which would otherwise in consequence of a“relevant step” which is an “earmarking” per s.554B (only).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusion from “earmarking” charge: deferred remuneration—section 554H

Exclusion from “earmarking” charge: deferred remuneration—section 554H

22A.25If a relevant third person earmarks money or an asset which represents remuneration of anemployee, a charge to income tax under Pt 7A (and NICs) will immediately arise on the value of theremuneration unless the terms of the award satisfy the requirements of s.554H. These are that:

(a)if the award were provided to the employee (A) on the award date, it would be a payment ofPAYE employment income in respect of A’s employment with B;

It should be noted that if the subject of the earmarking, and of the award, is of shares which arenot readily convertible assets (see 7.42), this exclusion will not be available because the gift ofthose shares, if made at the time of the award, would not be a payment of PAYE employmentincome.

(b)it is awarded on terms the main purpose of which is to defer the provision to A of theremuneration to a specified date (“the vesting date”) while providing that it is revoked if specifiedconditions are not met on or before that vesting date.

Whilst s.554H(1) refers to the need for more than one such “specified condition”, it is thought that, ongeneral principles of statutory interpretation, one such condition is sufficient. This is implicit in theguidance given by HMRC at EIM 45360 (see the reference to the only circumstance resulting inspecified conditions failing to be met being departure as a “bad leaver”).

(c)there must be no connection with a tax avoidance arrangement—see 22A.14;

(d)the specified “vesting date” must not be more than five years after the date of award. Thiscontrasts with the 10-year long stop in the case of deferred share awards or conditional shareoptions—see below);

(e)when the award is made, there must be a reasonable chance that it will be revoked because notall the specified conditions will be met on or before that date;

The terms may also provide that the award will be partly revoked if not all of the specified conditions

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are met on or before the vesting date.

(f)the main purpose of the award must not be the provision of “relevant benefits” (i.e. retirement ordeath benefits, including—in this context—pension income);

(g)when earmarked, the earmarked cash or assets (which could be shares in any company, notnecessarily shares in the employer company or another member of the same 51 per cent groupof companies) must represent only the deferred remuneration and nothing else.

It does not matter that the earmarking occurs after the award has been made, but the specifiedvesting date must be within five years of the award, not the earmarking (if later). Note that, by contrastwith the exclusions for share awards or options, there is no provision for exclusion of an earmarkingmade in advance of the award of deferred remuneration.

Need for conditionality

The specified conditions must be genuine and the terms must not amount to a guaranteed provisionof income at a future date. HMRC have indicated in their published guidance that it is sufficient thatthe only circumstance in which the award will not vest is that the employee is a “bad leaver” (asdefined in the terms of the award) provided it is realistic to suppose that the terms of the “bad leaver”provision could be satisfied and it is clear that the employee cannot expect to receive the award inthat event. It is understood that “bad leaver” must, for these purposes, be defined to include morethan simply leaving by reason of gross misconduct (cf. the reference in s.424(1)(b) relating to sharessubject to a short-term risk of forfeiture). It is however acceptable for the terms to reserve to thedirectors or remuneration committee a discretion to allow payment to a bad leaver in exceptionalcircumstances, but any such discretion must be genuine.

The exclusion is not lost if the remuneration is in fact received before the specified vesting dateand/or the specified conditions are met, provided this does not cast doubt on the genuine nature ofthe deferral (so it would not trigger a retrospective earmarking charge), but if the early receipt is notchargeable under PAYE then a “fallback” charge will arise at the end of the specified vesting date.The transfer of cash or assets to the employee by a relevant third person on payment of the deferredremuneration will give rise to a Pt 7A charge, but if it is fully charged to tax under the general earningsprovisions, the amount charged under Pt 7A will be reduced to nil.

Early payment of the deferred remuneration in defined circumstances may be provided for in theterms of the award, but this must not be the main purpose of the award.

Subsequent lifting of conditions

If an award is made on terms that satisfy s.554H(1) and (2) and some time thereafter some of theconditions are lifted so that there is no longer any reasonable chance that the award will be revoked,then this will not necessarily mean that the exclusion is lost. If the conditions to which the award wasfirst subject were genuine, so that the “main purpose” test was satisfied when the award was madeand they were not made and/or subsequently lifted with the purpose of avoiding a charge to tax (e.g.under Pt 7A) then, subject to any fallback charges arising as mentioned below, the exclusion from aPt 7A charge on the original “earmarking” should hold good.

Provision of the deferred remuneration

Payment or provision of the deferred remuneration by an EBT or other relevant third person will primafacie give rise to a Pt 7A charge by reason of s.554C(1) but insofar as this gives rise to earningswhich are subject to a general earnings charge, the Pt 7A charge is reduced (but not below nil) by theamount of such earnings (see 22A.45).

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Fallback charges

If the earmarked cash or assets cease to be held on terms that it represents the deferredremuneration (e.g. because the award is revoked or the award is now to be paid by the employerrather than out of an employees’ trust) but it continues to be earmarked with a view to providing abenefit to the employee, a Pt 7A charge will arise at that time on the value of the earmarked cash orassets and on a just and reasonable proportion of any earmarked income generated by such assets(e.g. dividends on “earmarked” shares if the employee is, or will become, entitled to such dividendson receipt of the shares).

Unless, before the end of the “vesting date”, the deferred remuneration has been paid subject todeduction of PAYE as employment income, or the award has been revoked in accordance with itsterms, a Pt 7A charge will arise in relation to the amount which would have been PAYE income if theearmarked deferred remuneration had been provided to the employee at that time (and a just andreasonable proportion of any earmarked income on the money or asset)—s.554H(7)–(11).

As regards revocation or release, see 22A.56.

Application of section 554H to deferred conditional share awards

If the shares which are to be the subject of a deferred conditional award do not fall within thedefinition of “relevant shares”, it may be appropriate to try to structure the award so as to fall withinthe scope of s.554H, as ss.554J and 554L will not apply.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusion from earmarking charge: grant of deferred share award—section554J

Exclusion from earmarking charge: grant of deferred share award—section554J

22A.26If any person makes a conditional deferred share award (as is common in the case of manyL-TIPs—see Chapter 8) and a relevant third person thereby (or separately) earmarks shares to satisfythat award, a charge to income tax under Pt 7A (and NICs) will immediately arise on the value of theshares so earmarked, unless the terms of the award satisfy the requirements of s.554J.

These requirements are:

(a)the award must be of “relevant shares” (see below);

(b)the main purpose of the award must be to defer the receipt of shares or cash to a specified date(confusingly referred to as “the vesting date”), while providing that the award is revoked (in partor in whole) if specified conditions are not met on or before the vesting date;

(c)the vesting date must be not more than 10 years after the award date;

(d)at the award date, there must be a reasonable chance that the award will be revoked becausenot all the specified conditions will be met on or before the vesting date;

(e)the main purpose of the award must not be the provision of “relevant benefits” (i.e. retirement ordeath benefits, including—in this context—pension income).

An earmarking charge which might otherwise arise under Pt 7A will not arise if:

(f)the subject of the earmarking is relevant shares held solely with a view to satisfying an awardwhich fulfils the criteria described above;

(g)

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the number of “relevant shares” so “earmarked” does not exceed the maximum number whichmight reasonably be expected to be needed for satisfying the award; and

(h)there is no connection between the earmarking and a tax avoidance arrangement.

Meaning of “the vesting date”

The terms of the award must specify a “vesting date” which is not more than 10 years after the awarddate. This specified date is not necessarily—and, indeed, will not normally—be the date on which theaward shares are expected to become “vested” in the sense in which that term is normallyunderstood, this being either:

(a)the time at which the awardholder ceases to be at risk of not becoming entitled to award sharesin consequence of, for example, performance targets being met and/or continuity of employmentfor a given period; or

(b)the time at which the awardholder becomes beneficially entitled, as against the grantor, to theshares (albeit that legal title to the shares is not transferred until a later time).

Rather, “the vesting date” in the context of s.554J refers to the latest date by which shares whichbecome vested must be transferred to the awardholder, or the awardholder must be paid a cash sumin lieu so that the earmarked shares are no longer held in relation to the award (or by which the awardmust be revoked in accordance with its terms). If none of those actions have been taken before “thevesting date”, then a fallback charge will arise at the end of “the vesting date” by reason of s.554J(8).Accordingly, “the vesting date” will normally be specified as a date which is either the 10thanniversary of the award date or an earlier date which is set sufficiently far in the future as will ensurethat in every conceivable circumstance the award will either:

(a)have become vested and the shares or cash paid out to the awardholder in satisfaction of hisentitlement under the terms of the award; or

(b)have been revoked in accordance with its terms (as to which, see 22A.56),

before that date (taking account of, for example, the risk that a transfer of shares may be necessarilydeferred by reason of the company being in a “close period” or a delay in finalising accounts and/orthe extent to which performance targets have been met, causing such a transfer to be unexpectedlydeferred.

It is understood that HMRC will accept that a plan rule which provides for a transfer of shares “assoon as practicable” after the vesting date is sufficient to satisfy this requirement of s.554J.

HMRC have confirmed that “the vesting date” need not be specified in terms of an actual calendardate but may, for example, refer to an as yet unknown date on which profits for a year will bedetermined by the directors (e.g. “30 days after the date of approval by the directors of the accountsfor the second financial year following that in which the award is made”). It is understood that it mayalso be expressed in terms of a date which may be deferred in consequence of any person beingrestricted from transferring shares in consequence of the Model Code or other applicable rules orregulations imposing restrictions on dealings in shares until those restrictions no longer apply.

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The points made above apply also in relation to a share option intended to satisfy the requirements ofs.554L (see 22A.28), except that in relation to such a share option, the vesting date refers to the timeat which the option must normally first become exercisable in consequence of the specified conditionsbeing met, and such fallback charges will normally arise, if at all, at the end of the “final exercisedate”, being the 10th anniversary of the date of grant.

Meaning of “relevant shares”

These are defined (in s.554I) as (i) shares (or other securities) in B or another member of the same51 per cent group of companies or securities which are units in a collective investment schememanaged by B or another member of the same 51 per cent group of companies or (ii) a cashequivalent.

The need for conditionality

The use of the phrase "on or before the vesting date" means that an award may be on terms thatvesting (in its normal sense) is conditional upon the attainment of a performance target over a givenperiod of time, but the shares are not received by the awardholder until some time after the end ofthat period. Allowing a period, between “vesting” (in the sense that the condition(s) has (or have)been met in full or in part) and the specified vesting date, during which the awardholder has adeferred, but unconditional right to receive the shares, appears to be at odds with the spirit, if not thewording, of Pt 7A. However, it is understood that HMRC interprets s.554J (and the like exclusion ins.554L in relation to share options) on this basis.

There must be:

•a specified date (not later than the tenth anniversary of the award date) on or before which, if allconditions are satisfied, the shares will be transferred to the awardholder;

•at least one condition, of which there is, at the time of award, a reasonable chance that it will notbe met, that runs for a period following the award date.

Whilst s.554J(1) refers to the need for more than one such “specified condition”, it is thought that, ongeneral principles of statutory interpretation, one such condition is sufficient.

So, for example, an award of “relevant shares” could be made conditional upon the attainment of atarget relating to the personal performance of the awardholder over a fixed period of one yearbeginning with the award date, on terms that the vested shares (i.e. shares which become vested inconsequence of the performance target being met) are to be transferred at or before a later date (e.g.after the third anniversary of the award date). At the award date there must be a reasonable chancethat the condition(s) which must be satisfied, in order for the awardholder to receive the vested awardshares on the specified vesting date, might not be met. The terms may also provide for partialrevocation if some, but not all, conditions are met before the vesting date. So, for example, the awardterms could provide that none of the award shares will be transferred if, before the vesting date, theemployee leaves otherwise than for a “good” reason, but that some only of the award shares will betransferred depending on the extent to which performance targets are met.

The specified vesting date (i.e. the fixed date on or before which the shares will be transferred) canbe set as any time after the award date, but care must be taken to ensure that it is sufficiently far inthe future to ensure that, once the performance period has ended, the shares will be transferred tothe employee at a time which, after allowing for drawing up accounts, ascertaining the extent to whichaward shares have become vested in consequence of the performance targets having been met, andfor the likelihood of any close periods restricting the transfer of the shares, is still on or before thespecified vesting date.

So, for example, the terms of the award could provide as follows:

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•the award is of up to, say, 1,000 shares but the actual number which “vest” will depend upon theextent to which targets set in relation to the performance of the company over the period of threefinancial years (beginning with that in which the award is made) are met. Insofar as they are notmet, the award is revoked in whole or in part;

•the “specified vesting date” is the fourth anniversary of the date of award (or, if the company isthen in a close period or otherwise restricted from procuring a transfer of the “vested” awardshares, the thirtieth day after the day on which all such restrictions have been lifted);

•the “vested” award shares will be transferred on the specified vesting date or, if the directors sodetermine, at such earlier time as the directors are satisfied that the performance targets havebeen met in whole or in part.

In practice, if the award vests in consequence of the targets being met in whole or in part, the awardshares might normally be transferred well before the “specified vesting date”.

A danger for the company and the awardholder lies in the possibility that, if the “specified vestingdate” is not set sufficiently far in the future, the award shares which “vest” in consequence of thetargets being met are not actually transferred until after the “specified vesting date”. In this event, a“fall back” charge under Pt 7A will arise at the end of the specified vesting date by reference to thevalue of the earmarked shares (insofar as the award has not been revoked in consequence of targetsnot being met) at that time—see below. To protect against this, the “specified vesting date” should beset sufficiently far in the future to ensure that award shares which vest in consequence of targets orother conditions being met, will actually be transferred on or before that date.

Early transfer of the award shares may be provided for in the terms of the award, but this must not bethe main purpose of the award.

It would appear to be open to a company to set one or more vesting conditions (of which there is areasonable chance that they will not all be met at or before the specified vesting date) which relate toa period expiring in advance of the vesting date so that, if or insofar as the conditions are met, theacquisition of the shares, whilst deferred, is then otherwise unconditional. It is understood that if, inthis example, the period of conditionality is set artificially short, with the intention of seeking to avoidthe application of a Pt 7A charge in respect of what is otherwise a deferred award of shares, thenHMRC will disallow the exclusion under s.554J on the basis that the award is connected with a taxavoidance arrangement (per s.554J(3)(c)). That said, if the commercial purpose is to make an awardof shares on deferred terms, albeit on terms intended to secure exclusion under s.554J, then (unlessthe tribunal decision in the Deutsche Bank case is finally upheld on appeal—see the discussion at10.63), there must be a reasonable chance that a court would accept that the award of the shares onsuch terms does not have as a main purpose the avoidance of tax.

Subsequent lifting of conditions

If an award is made on terms that satisfy s.554J(1) and (2) and some time thereafter some of theconditions are lifted so that there is no longer any reasonable chance that the award will be revoked,then this will not necessarily mean that the exclusion is lost. If the conditions to which the award wasfirst subject were genuine, so that the “main purpose” test was satisfied when the award was madeand they were not made and/or subsequently lifted with the purpose of avoiding a charge to tax (e.g.under Pt 7A) then, subject to any fallback charges arising as mentioned below, the exclusion from aPt 7A charge on the original “earmarking” should hold good.

Transfer of vested award shares

The actual transfer of vested award shares will, prima facie, give rise to a Pt 7A charge although if, asis normally the case, a general earnings charge arises on the market value of the shares transferred,the Pt 7A charge is reduced to nil (see 22A.45).

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Fallback charges

If the earmarking is in relation to an anticipated award, the award is not actually made within threemonths thereafter, and the shares remain earmarked to satisfy an award of shares intended to satisfythe requirements for exclusion in s.554J(1)), a Pt 7A charge arises at the end of that three-monthperiod in relation to the value of the earmarked shares (and any earmarked income on them)—s.554J(4) and (5).

Likewise, if any of the shares in question cease to be held for the purposes of satisfying an excludedaward but continue to be earmarked for the employee (presumably otherwise than for satisfyinganother award intended to meet the requirements of s.554J(1)(b)–(e), a Pt 7A charge will arise at thattime in relation to the value of the earmarked shares (and any income on them)—s.554J(6) and (7).

Unless and to the extent that, before or “as soon as reasonably practicable after” the end of thespecified “vesting date”:

•award shares have actually been transferred to the employee in circumstances which give rise toemployment income chargeable to income tax; or

•the employee receives a cash sum which is chargeable to income tax and which eitherrepresents the proceeds of disposal of award shares or is from another source “and,correspondingly, the shares are no longer held by any person in relation to the award”; or

•the award is revoked in accordance with its terms and “correspondingly, the shares are nolonger held by any person in relation to the award”,

a Pt 7A charge will arise at the end of the vesting date in relation to the value of earmarked shares(and any earmarked income on them)—s.554J(9)–(12).

As regards the revocation or release of an award, see 22A.56.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusion from earmarking charge: “exit-only” deferred shareawards—section 554K

Exclusion from earmarking charge: “exit-only” deferred shareawards—section 554K

22A.27A similar exclusion, from an earmarking charge, is afforded by s.554K in relation to deferred shareawards which are conditional upon the occurrence of an “exit event”. However, in this case, the awardshares must be shares or securities in a trading company or a company which controls a tradingcompany which is the employer company or another member of the same 51 per cent group ofcompanies.

Meaning of “exit event”

For these purposes, an "exit event" is defined (by s.554I(6)) as:

(a)the admission of shares in the relevant company to trading on a stock exchange (note: this is notfurther defined, so would include AIM and is not restricted to a “recognised stockexchange”—see 16.6);

(b)all the shares in the relevant company, or a substantial proportion (undefined) of them, aredisposed of to persons none of whom is connected with any of the persons making any disposal;

(c)if the relevant company is a trading company, the company’s trade, or a substantial proportion ofit, is transferred to a person who is not connected with (per ICTA 2007 s.993) the relevantcompany nor is a shareholder in it, nor is connected with such a shareholder;

(d)the assets of the relevant company, or a substantial proportion of them, are disposed of to suchan unconnected person;

(e)the relevant company begins to be wound up (see CTA 2009 subs.12(7)); or

(f)a controlling shareholder ceases to have control provided that no person connected with thatformer controlling shareholder thereupon acquires control of it (control having the meaning givenby ITA 2007 s.995).

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Terms of award

The award must be on terms the main purpose of which is to ensure that the relevant shares are, or acash sum determined by reference to their market value at the time of payment is, received by theemployee only if a specified exit event occurs and, at the time of award, there is a reasonable chancethat such an exit event will occur. The main purpose of the award must not be the provision ofrelevant benefits (i.e. retirement or death benefits, including—in this context—pension income).

An earmarking charge which might otherwise arise under Pt 7A will not arise if:

(a)the subject of the earmarking is shares or cash held solely with a view to satisfying an awardwhich fulfils the criteria described above; and

(b)the number of shares so earmarked does not exceed the maximum number which mightreasonably expect to be needed for satisfying the award; and

(c)there is no connection between the earmarking and a tax avoidance arrangement.

Transfer of award shares

The actual transfer of the award shares will, prima facie, give rise to a Pt 7A charge although if, as isnormally the case, a general earnings charge arises on the market value of the shares transferred,the Pt 7A charge will be reduced to nil (see 22A.45).

Fallback charges

If the earmarking is in relation to an anticipated award, and the award is not actually made withinthree months thereafter, a Pt 7A charge will then arise in relation to the value of any earmarkedshares which continue to be held by the same relevant third person on the basis mentioned in (a)above (and any earmarked income on them)—s.554K(3) and (4).

Likewise, if any of the shares in question cease to be held for the purposes of satisfying the excludedaward but are earmarked for an employee, a Pt 7A charge will arise at that time in relation to thevalue of the earmarked shares which continue to be held by the same relevant third person on thebasis mentioned in (a) above (and any income on them)—s.554K(5) and (6).

Unless, and to the extent that, before the end of the period of six months starting with the date onwhich an exit event actually occurs:

•award shares have actually been transferred to the employee in circumstances in which thisgives rise to taxable employment income; or

•the employee receives a cash sum which is chargeable to income tax and which eitherrepresents the proceeds of disposal of the shares or is from another source “and,correspondingly, the shares are no longer held by any person in relation to the award”

a Pt 7A charge will arise at the end of such period of six months in relation to the value of theearmarked shares (and any earmarked income on them)—s.554K(7)–(10).

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© 2013 Sweet & Maxwell

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusion from earmarking charge: grant of conditional share option—section554L

Exclusion from earmarking charge: grant of conditional share option—section554L

22A.28If any person grants an option to acquire “relevant shares” and a relevant third person thereby (orseparately) earmarks shares to satisfy that option, a charge to income tax under Pt 7A (and NICs) willimmediately arise on the value of the shares so earmarked, unless the terms of the option satisfy therequirements of s.554L.

These requirements are:

(a)the option must be to acquire either (i) “relevant shares” (i.e. shares or other securities in theemployer company (B) or another member of the same 51 per cent group of companies orsecurities which are units in a collective investment scheme managed by B or another memberof the same 51 per cent group of companies) or (ii) a cash equivalent;

(b)the main purpose of the grant must be to ensure that the option is not exercisable before aspecified date (“the vesting date”), while providing that the option is not to be exercisable at all ifspecified conditions are not met on or before the vesting date;

(c)the vesting date must be not more than 10 years after the grant date;

(e)there must be a reasonable chance that the option will not be exercisable at all because not allthe specified conditions will be met on or before the vesting date; and

(f)the main purpose of the grant must not be the provision of “relevant benefits” (ie retirement ordeath benefits, including—in this context—pension income).

An earmarking charge which might otherwise arise under Pt 7A will not arise if:

(a)the subject of the earmarking is “relevant shares” held solely with a view to satisfying the

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exercise of an option which meets the criteria described above;

(b)the number of “relevant shares” so earmarked does not exceed the maximum number whichmight reasonably be expected to be needed for satisfying the award; and

(c)there is no connection between the earmarking and a tax avoidance arrangement.

Meaning of “the vesting date”

The terms of the award must specify a “vesting date” which is not more than 10 years after the date ofgrant. This specified date is not necessarily—and, indeed, will not normally—be the date on which theoption shares are expected to become “vested” in the sense in which that term is normallyunderstood, this being the time at which the optionholder ceases to be at risk of the option lapsing inrespect of any shares in consequence of, for example, performance targets being met and/orcontinuity of employment for a given period, albeit that the option may not, by its terms, becomeexercisable until a later date (e.g. the third anniversary of the date of grant). Rather, “the vesting date”in the context of s.554L refers to the time at which the option will normally first become exercisable inrespect of any of the option shares in consequence of all of the specified conditions being met inrespect of such option shares.

HMRC have confirmed that “the vesting date” need not be specified in terms of an actual calendardate but may, for example, refer to an as yet unknown date on which profits for a year will bedetermined by the directors. It is understood that it may also be expressed in terms of a date whichmay be deferred in consequence of any person being restricted from transferring shares inconsequence of the Model Code or other applicable rules or regulations imposing restrictions ondealings in shares.

The need for conditionality

The use of the phrase "on or before the vesting date" means that an option may be on terms thatvesting (in its normal sense) is conditional upon the attainment of a performance target over a givenperiod of time, but the option does not become exercisable until some time after the end of thatperiod. Allowing a period, between “vesting” (in the sense that the condition(s) set has (or have) beenmet in full or in part) and the specified vesting date during which the optionholder has a deferred, butotherwise unconditional entitlement to exercise the option, appears to be at odds with the spirit, if notthe wording, of Pt 7A but it is understood that this is how HMRC interprets and applies the exclusionin s.554L.

There must be:

•a specified date (not later than the tenth anniversary of the grant date) when, if all conditions aresatisfied, the option will become exercisable;

•at least one condition which runs for a period following the date of grant and which, if notsatisfied on or before the vesting date, will mean the option will lapse in full;

•at the date of grant, a reasonable chance that such condition will not be met.

Whilst s.554L(1) refers to the need for more than one such “specified condition”, it is thought that, ongeneral principles of statutory interpretation, one such condition is sufficient (see EIM 45360).

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Early exercise in defined circumstances may be provided for in the terms of the option, but this mustnot be the main purpose of the option.

So, for example, a share option may, by its terms, normally become exercisable on the thirdanniversary of the date of grant if, but only if and insofar as, specified conditions have been met on orbefore that date. In this case, the third anniversary will be “the vesting date”. It matters not thatperformance conditions may have been satisfied at an earlier date.

As at the date of grant, there must be a reasonable chance that the option will not becomeexercisable at all because not all the specified conditions will be met on or before the vesting date.The terms may also provide for partial exercise if not all of the specified conditions will be met on orbefore the vesting date. So, for example, the option terms could provide that the option lapses in full ifthe optionholder leaves employment otherwise than for a “good” reason, and will lapse in part if orinsofar as performance targets are not met.

It does not matter that the conditions first set might subsequently be varied or even removedaltogether, provided that the circumstances in which this is done do not call into question the fact thatthe requirements of s.554L were met at the time of grant.

As regards setting an artificially short period over which the specified condition(s) must be met (i.e.period of conditionality), see the discussion about conditionality of deferred share awards at 22A.26above.

As a Pt 7A charge will arise (per s.554L(9)) if the vested option is not in fact exercised before the endof the tenth anniversary of the date of grant (“the final exercise date”), the option may by its terms beunconditionally capable of immediate exercise as from the specified vesting date until any time up to,but not later than, the tenth anniversary of the date of grant. In this respect, the rules relating tooptions differ from those relating to deferred share awards. In the case of the latter, the conditionalitymust relate to a period before the actual date of transfer of the shares, whereas in the case of anoption it need only be in relation to a period before the option first becomes exercisable on the vestingdate. For this reason it is generally the case that awards under an L-TIP (see Chapter 8) might bestbe structured as nil-cost options (Type B) rather than as contingent share awards (Type C).

The number of shares earmarked for these purposes must not exceed the number reasonablyexpected to be needed for satisfying the option—see 22A.30, and there must be no connection with atax avoidance arrangement—see 22A.15.

“Final exercise date”

This is defined, in s.554L(14), as the date which is 10 years after the grant date (i.e. the tenthanniversary of the date of grant). It is relevant because, unless before that time:

(a)the share option has become exercisable before the end of the “vesting date”, it has in fact beenexercised, and the vested option shares have been received and charged to income tax; or

(b)the share option has become exercisable before the end of the “vesting date”, it has in fact beenexercised and the optionholder has in lieu of shares been paid a cash sum which is chargeableto income tax; or

(c)the share option “ceases to be exercisable by [the employee] (in whole or in part)” and this is inaccordance with the terms of the option (see 22A.56) and “correspondingly, the shares are nolonger held by any person in relation to the relevant share option”; or

(d)the share option has become exercisable before the end of the “vesting date” but, havingbecome exercisable, it subsequently lapses (in whole or in part) before the end of the final

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exercise date,

a fallback charge will be deemed to arise at the end of the final exercise date.

Early exercise provisions

Although “the main purpose” is to ensure that the option is not exercisable before the specifiedvesting date, if the terms of the option also provide for the possibility of early exercise before thespecified vesting date in defined circumstances such as cessation of employment or a change ofcontrol and the option is in fact exercised before the specified vesting date a Pt 7A charge will still beavoided provided that the option gain is then chargeable to income tax.

Subsequent lifting of conditions

If an award is made on terms that satisfy s.554L(1) and (2) and some time thereafter some of theconditions are lifted so that there is no longer any reasonable chance that the award will be revoked,then this will not necessarily mean that the exclusion is lost. If the conditions to which the award wasfirst subject were genuine, so that the “main purpose” test was satisfied when the award was madeand they were not made and/or subsequently lifted with the purpose of avoiding a charge to tax (e.g.under Pt 7A) then, subject to any fallback charges arising as mentioned below, the exclusion from aPt 7A charge on the original “earmarking” should hold good.

Transfer of vested option shares on exercise

The actual transfer of shares by a “relevant third person” upon the exercise of such a share optionwould prima facie give rise to a Pt 7A charge by reason of s.554C(1). However, provided tax on thegain on exercise is charged under Chapter 5 of Pt 7—see 11.27B et seq., the Pt 7A charge isexcluded by s.554N(5)—see 22A.22.

Fallback charges

If the earmarking is in relation to an anticipated option grant, and the option is not actually grantedwithin three months thereafter, and any of the shares remain earmarked to satisfy an option granted,or to be granted, to the employee (being an award intended to satisfy the requirements ofs.554L(3)(a)), then a Pt 7A charge arises in relation to the value of the earmarked shares (and anyearmarked income on them)—s.554L(4) and (5).

Likewise, if at any time any of the shares in question cease to be held for the purposes of satisfyingthe excluded award but continue to be earmarked for a specified employee, a Pt 7A charge will ariseat that time in relation to the value of the earmarked shares (and any income on them)—s.554L(6)and (7).

Unless, before the end of the “final exercise date”, the option has become exercisable on the vestingdate, the option has been exercised and either:

(a)the employee has received the shares in circumstances which give rise to employment incomechargeable to income tax; or

(b)the employee has received a cash sum which is chargeable to income tax and which eitherrepresents the proceeds of disposal of the shares or is from another source “and,correspondingly, the shares are no longer held by any person in relation to the relevant shareoption”; or

(c)

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the option has ceased to be exercisable (see 22A.56) in whole or in part and “correspondingly,the shares are no longer held by any person in relation to the relevant share option”,

a Pt 7A charge will arise at the end of the final exercise date in relation to the value of the earmarkedshares (and any earmarked income on them)—s.554L(8)–(13).

This has the positive effect that if, for example, a fallback charge arises at the end of the final exercisedate because the option has not been exercised, there is no relief from the charge to income tax thatwill arise, under Chapter 5 of Pt 7, when the option is later exercised. In particular, none of ss.554Z5,13 or 14 will then apply.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusion from earmarking charge: “exit-only” share options—section 554M

Exclusion from earmarking charge: “exit-only” share options—section 554M

22A.29A similar exclusion, from an earmarking charge, is afforded by s.554M in relation to share optionswhich are conditional upon the occurrence of an “exit event”. However, in this case, the option sharesmust be shares or securities in a trading company or a company which controls a trading companywhich is the employer company or another member of the same 51 per cent group of companies. Fors.554M purposes, an “exit event” has the meaning given at 22A.27.

The grant must be on terms the main purpose of which is to ensure that the option is exercisable bythe employee only if a specified exit event, or an exit event within a specified description, occurs and,at the time of award, there is a reasonable chance that such an exit event will occur.

The main purpose of the grant must not be the provision of “relevant benefits” (i.e. retirement or deathbenefits, including—in this context—pension income).

The exclusion under s.554M is an exclusion from an earmarking charge only. The actual transfer ofthe option shares upon exercise of the option will, if it gives rise to a charge to income tax under s.476(as will normally be the case), be excluded from a Pt 7A charge per s.554N(5)(a).

The number of shares earmarked for these purposes must not exceed the number reasonablyexpected to be needed for meeting the award, and there must be no connection with a tax avoidancearrangement.

Fallback charges

If the earmarking is in relation to an anticipated “exit only” option grant, and the option is not actuallygranted within three months thereafter, and the shares remain earmarked to satisfy an option granted,or to be granted, to a specified employee (being an option intended to satisfy the requirements forexclusion in s.554M(1)(b)–(e)), a Pt 7A charge arises in relation to the value of the earmarked shares(and any earmarked income on them)—s.554M(3) and (4).

Likewise, if at any time any of the shares in question cease to be held for the purposes of satisfyingthe excluded option but remain earmarked as mentioned in s.554B(1)(a) or (b), a Pt 7A charge willarise at that time in relation to the value of the earmarked shares (and any income on them)—s.554M(5) and (6).

Unless, before the end of the period of six months starting with the date on which an exit event occursor, if it ends earlier, the period within which the option may, by its terms, then be exercised:

•the option has been exercised and the receipt of the shares gives rise to employment income

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chargeable to income tax;

•the employee has received a cash sum which is chargeable to income tax and which eitherrepresents the proceeds of disposal of the shares or is from another source “and,correspondingly, the shares are no longer held by any person in relation to the award”; or

•having first become exercisable, the option has lapsed and “correspondingly, the shares are nolonger held by any person in relation to the award”

a Pt 7A charge will arise at the end of such period in relation to the value of the earmarked shares(and any earmarked income on them)—s.554M(7)–(11).

As regards the lapse, revocation or release of an exit-only share option, see 22A.56.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

The requirement that shares earmarked must not exceed the number required

The requirement that shares earmarked must not exceed the number required

22A.30Section 554E (approved schemes), and each of ss.554J–554M, and s.554Z7 (exercise price of shareoptions) each include a requirement that the number of relevant shares earmarked must not exceedthe maximum number which might reasonably be expected to be needed for providing shares for therelevant purpose. In the case of s.554E (HMRC-approved and EMI schemes only), this test relates tothe maximum number of shares that might reasonably be expected to be required for the purposes ofsatisfying HMRC-approved scheme awards or options over a period of 10 years from the day onwhich the relevant step is taken. However, the test in s.554E (unlike those in ss.554J–554M ands.554Z7) is to be applied “immediately before or after the step is taken”. HMRC has stated (see EIM45470) that “the maximum number which one might reasonably expect” will depend on the facts but,apart from exceptional cases, anything up to 100 per cent is likely to be reasonable. It is understoodthat, in relation to s.554E companies will not be required to put in place procedures for monitoring theapplication of this test on a continuing basis. In the case of awards and options to whichss.554J–554M apply, such ongoing monitoring will be necessary. In practice, this means that eachtime an option is granted, up to 100 per cent of the option shares may be earmarked. Presumably, ifsome of those options

Tabular explanation of the available share award/share option exclusions froman earmarking charge under Part 7A

22A.31A charge under Pt 7A does not arise upon an earmarking of shares or cash solely with a view toproviding such shares or cash pursuant to any of the following types of employee share award/optionmade/granted (or to be made/granted within three months after such earmarking) provided that:

(a)the number of shares so earmarked does not exceed the maximum number of shares whichmight reasonably be expected to be needed for such purposes; and

(b)there is no connection with a tax avoidance arrangement.

Care must be taken when structuring such an award or option as, notwithstanding that theaward/option satisfies the terms of an exclusion, a “fallback” charge could still arise under Pt 7A asdescribed above.

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Deferred Share Awards(s.554J)

Exit-Only ShareAwards (s.554K)

Conditional ShareOptions (s.554L)

Exit-Only ShareOptions (s.554M)

This refers to adeferred andconditional award of“relevant shares” (see22A.26) which may besatisfied using sharesto be “earmarked” byan employees’ trust (orother “relevant thirdperson”) and which issubject to thesatisfaction ofconditions (such as, forexample, theattainment of specifiedperformance-relatedtargets set in relation toa period ending afterthe date of award).Notwithstanding thataward shares maybecome “vested” (in thesense that the awardwill no longer berevoked by reason onlythat the conditions havenot been met), as suchawards are normallystructured the awardshares will not usuallybe transferred to theawardholder until alater date (such as, forexample, the thirdanniversary of the dateof award or, if later,after such time as thecompany hascalculated and securedthat the employees’trust has acquired asufficient number ofshares to satisfy theaward).

This refers to adeferred award ofrelevant shares (see22A.26) which may besatisfied using sharesto be “earmarked” byan employees’ trust (orother “relevant thirdperson”) and which issubject to theoccurrence of an “exitevent” (see 22A.27)

This refers to the grantof a conditional right toacquire “relevantshares” (see 22A.27)which may be satisfiedusing shares to be“earmarked” by anemployees’ trust (orother “relevant thirdperson”) and which issubject to thesatisfaction ofconditions (such as, forexample, theattainment of specifiedperformance-relatedtargets set in relation toa period ending afterthe date of award).Notwithstanding thatoption shares maybecome “vested” (in thesense that the optionwill no longer lapse byreason only that theconditions have notbeen met), the optionwill not normallybecome exercisableuntil a specified vestingdate.

This refers to the grantof a right to acquirerelevant shares (see22A.26) which may besatisfied using sharesto be “earmarked” byan employees’ trust (orother “relevant thirdperson”) and which isexercisable only if an“exit event” (see22A.27) occurs.

The main purpose mustbe to defer the receiptof the shares until alater specified fixeddate. The terms of theaward must alsoprovide as follows:

The main purpose mustbe to ensure that theshares (or a cashequivalent sum) arereceived only if such an“exit event” occurs.

The main purpose mustbe to ensure that theoption is not normallyexercisable before thespecified date and isnot to be exercisable atall if specifiedconditions are not meton or before that date.

The main purpose mustbe to ensure that theoption is exercisableonly if such an “exitevent” occurs.

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Deferred Share Awards(s.554J)

Exit-Only ShareAwards (s.554K)

Conditional ShareOptions (s.554L)

Exit-Only ShareOptions (s.554M)

The terms of the optionmust also provide asfollows:

The award shares mustbe in a tradingcompany or a companycontrolling a tradingcompany

The option shares mustbe in a tradingcompany or a companycontrolling a tradingcompany.

A transfer of awardshares may be subjectto the satisfaction ofother conditions, suchas the attainment ofperformance-relatedtargets or continuedemployment.

Exercise of the optionupon an “exit event”may be subject to thesatisfaction of otherconditions, such as theattainment ofperformance-relatedtargets or continuedemployment.

A leaver may, if theterms permit, retain theaward in whole or inpart, but it should not inany event beexercisable in advanceof an “exit event”.

A leaver may, if theterms permit, retain theoption in whole or inpart, but it should not inany event beexercisable in advanceof an “exit event”.

To avoid a fallbackcharge, the shares (orcash) should bereceived within theperiod of six monthsbeginning with the dateof the “exit event”.

To avoid a fallbackcharge, the shares (orcash) should bereceived within theperiod of six monthsbeginning with the dateof the “exit event” or, ifearlier, the latest datefor exercise of theoption as provided inthe option terms.

• the fixed date is notlater than the 10thanniversary of theaward date;

• the specified vestingdate must be not laterthan the tenthanniversary of the grantdate (but, to avoid afallback charge, theoption should not beexercisable later thanthe 10th anniversary ofthe date of grant);

• if specified conditionsare not met on orbefore that date, theaward will be revoked;

• conditions arespecified which, if not

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Deferred Share Awards(s.554J)

Exit-Only ShareAwards (s.554K)

Conditional ShareOptions (s.554L)

Exit-Only ShareOptions (s.554M)

met on or before thatdate, will mean that theoption is not to beexercisable at all;

It does not matter thatshares which havebecome vested inconsequence of theconditions being metare in fact transferredbefore the “specifieddate” but, to avoid afallback charge, theymust be transferred, ifat all, not later than the“specified date”.

There must be areasonable chance atthe award date that theaward will be revokedbecause not all theconditions (being orincluding that whichruns until the specifieddate or, if earlier, theactual date of transfer)will be met on or beforethe specified date.

There must be areasonable chance atthe date of award thatthe “exit event” willoccur.

There must be areasonable chance atthe date of grant thatthe option will cease tobe exercisable becausenot all the specifiedconditions will be meton or before thespecified vesting date.

There must be areasonable chance atthe date of grant thatthe “exit event” willoccur.

The terms may providefor earlier transfer indefined circumstancesif, for example, theemployee is a “goodleaver” or there occursa “change of control”,provided that theacquisition of shares inthese circumstances isnot a main purpose ofthe award.

The option may, by itsterms, becomeexercisable early indefined circumstancesif, for example, theemployee is a “goodleaver” or there occursa change of controlprovided that earlyexercise in suchcircumstances is notthe main purpose of thegrant.

The terms may alsoprovide that, even if theawardholder is a badleaver, all or someaward shares may betransferred on or beforethe specified date if thedirectors (or the

The option may providethat, even if theoptionholder is a “badleaver”, the option maybe exercised in respectof all or some of theoption shares if thedirectors (or the

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Deferred Share Awards(s.554J)

Exit-Only ShareAwards (s.554K)

Conditional ShareOptions (s.554L)

Exit-Only ShareOptions (s.554M)

remunerationcommittee), in theexercise of theirdiscretion, so permit.

remunerationcommittee) in theexercise of theirdiscretion so permit.

The terms may allowfor the award to besettled by payment ofcash determined byreference to the marketvalue of the vestedaward shares.

The terms may allowfor the award to besettled by payment ofcash determined byreference to the marketvalue of the vestedaward shares.

The terms may allowfor the award to besettled by payment ofcash determined byreference to the marketvalue of the vestedoption shares.

The terms may allowfor the award to besettled by payment ofcash determined byreference to the marketvalue of the optionshares.

lapse, then the next occasion on which an option is granted by the same relevant third person, themaximum number of shares which may then be earmarked is 100 per cent of the shares over whichthe new option is granted less the number of shares covered by the option lapses.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusions from an earmarking charge: dividends on earmarkedshares—section 554Q

Exclusions from an earmarking charge: dividends on earmarkedshares—section 554Q

22A.32If dividend income arises on shares which have been earmarked by the trustee of an employees’trust, and the amount of dividends is itself to be earmarked (as might be common in the case of anL-TIP award—see Chapter 8), then if:

(a)a charge to income tax under Pt 7A arose in respect of the earlier earmarking of such shares orwould have done, but for the fact that such “earmarking” was excluded by reason of any ofss.554H–554M; and

(b)immediately before the income arises, the shares remain earmarked; and

(c)it is reasonable to suppose that the income does not exceed an arm’s length return,

then no charge arises under Pt 7A in respect of the earmarking of such dividend income.

Payment of dividends by a “relevant third person”

If employees have acquired from an employees’ trust the beneficial interest in shares (so that suchshares are no longer earmarked by the trustee), but legal title to such shares remains held by thetrustee, dividends paid over to the employee by the trustee, although prima facie being payment of asum of money by a “relevant third person” (per s.554C(1)(a)—see 22A.16), should not give rise to aPt 7A charge because either:

(a)it is not reasonable to suppose that, in essence, the payment is in pursuance of an arrangementfor the provision of rewards or recognition in connection with the employee’s employment (pers.554A); or, possibly

(b)if, unusually, the dividends were paid under an arrangement for the provision of rewards ofemployment in the form of dividends, then s.554N(7)–(11) might apply, if an employee has

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already either paid for, or suffered a general earnings tax charge upon, the market value of theshares at the time of acquisition, so as to exclude such payment from a charge under Pt 7A(although it is understood that HMRC might well assert that these provisions do not applybecause there is a connection between the “relevant step”—payment of the dividend—and a taxavoidance arrangement, per s.554N(11)(b)).

That said, (b) above relies on the presumption that “the subject of the relevant step [i.e. the paymentof the dividend] is [the shares acquired from the trust]” (see s.554N(11)). If the dividend is properly tobe treated as an asset distinct from the shares in respect of which it is paid, this exclusion would notapply.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusions from an earmarking charge: reinvestment of earmarkedassets—section 554R

Exclusions from an earmarking charge: reinvestment of earmarkedassets—section 554R

22A.33If shares which have been earmarked for an employee are held by an employees’ trust and, forexample, in consequence of a takeover or reconstruction of the company concerned, the trusteeacquires shares in the acquiring company and such other shares are themselves then immediatelyearmarked, a Pt 7A charge will not arise in respect of such earmarking unless it is reasonable tosuppose that, in essence:

(a)at the time of acquisition of the new shares, their value is greater or less than the value of the oldshares; and

(b)the difference (or any part of it) in such values might not have been expected if it had been anarm’s length transaction.

Section 554R protects against unexpected charges under Pt 7A arising when “earmarked” assets aredisposed of and the proceeds reinvested in other assets which remain so “earmarked”.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Exclusions Only from an “Earmarking” Charge

Exclusions v reductions

Exclusions v reductions

22A.34It is important to distinguish between:

(a)a relevant step which is excluded from a Pt 7A charge (as mentioned at 22A.18–22A.23above)—these avoid altogether a charge under Pt 7A (with no risk of “fallback” charges);

(b)a relevant step which is an earmarking but may be excluded from a Pt 7A charge (as mentionedat 22A.24–22A.29 above)—these initially avoid a charge under Pt 7A, but with the ongoing riskof a fallback charge arising; and

(c)a relevant step which gives rise to a Pt 7A charge, as it is not excluded, but the amount of whichmay be reduced, possibly to nil (see 22A.42–22A.48 below).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

The Charge under Part 7A

The Charge under Part 7A

22A.35Unless the relevant step is excluded, the value of the relevant step counts as employment income ofthe employee (A) in respect of A’s employment with the employer (B) for the tax year in which therelevant step is taken or, if it is taken before the employment begins, for the tax year in which theemployment commences (s.554Z2). A charge under Pt 7A takes precedence over a charge under thebenefits-in-kind provisions or the rules charging tax on dividends (ITTOIA 2005 ss.382–401B). Arelevant step which is the making of an employment-related loan which does not qualify for exclusionis therefore charged under Pt 7A and not as a taxable cheap loan under ITEPA 2003 ss.173–191.

Value of the relevant step

If the relevant step involves a sum of money, its value is that amount. Otherwise, the value of therelevant step is either (a) the market value (per TCGA 1992 s.272 et seq.) of the asset which is thesubject of the relevant step or, if higher, (b) the expense incurred in connection with the relevant stepby the person or persons at whose cost it is taken. That said, (b) does not apply in relation to arelevant step whereby a relevant person acquires shares (or other securities), an interest in shares ora share option (per s.554C(1)(c)) and (as will normally be the case) any of the employment-relatedsecurities provisions in Chapters 2–4A of Pt 7 of ITEPA apply by virtue of the acquisition (i.e. theshares in question are employment-related securities) (per s.554Z3(4)). Furthermore, (b) above isalso to be ignored in relation to an earmarking charge if the earmarking is with a view to satisfying anemployee share option with an exercise price payable—see s.554Z3(5) and s.554Z7.

It is understood (from statements made at a meeting between the Share Plan Lawyers Group andHMRC) that HMRC will likewise accept that if, upon a transfer of shares to an employee, a generalearnings charge arises (e.g. upon the satisfaction of a vested L-TIP award in the form of a contingentshare award) s.554Z3(4) will apply so that the value of the relevant step is the market value of theshares transferred and not, if higher, the expense incurred in providing the shares. So, if (forexample) the shares were acquired by the employees’ trust at a cost of £10 per share, but had sincefallen to £6 per share at the time of transfer to the employee/awardholder, the value of the relevantstep (the transfer of shares) is £6 per share, not £10 per share. That said, it is unclear whether HMRCwould accept this analysis if (using a similar example) the shares are transferred upon the exercise ofa nil-cost share option (see s.554Z3(5) and s.554Z7) since the requirement in s.554Z7(1)(d)—that anexercise price is payable—would not be met.

Apportioning the amount of a charge between employees

The legislation does not address the question of how to apportion an amount which, in consequenceof a non-excluded relevant step being taken by a relevant third person, counts—or might count—asemployment income of a number of employees. For example, suppose that a “pool” of 100,000shares is earmarked by an EBT trustee to satisfy (non-excluded) deferred share awards, each ofwhich is subject to a different performance target, the arrangement operating on the basis that shareswill be transferred only to those who achieve the targets but so that, at the time of earmarking, sharesin the pool could in due course be transferred to any (or all) of a group of named employees. On a

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strict application of the DR rules, each such employee would suffer an earmarking charge byreference to the value of the entire pool of shares. It is understood that HMRC do not intend to applythe DR rules in a manner which would give rise to such duplicate charges. HMRC guidance (at EIM45130) indicates that if part of the relevant step is taken in relation to each of a number of individualsthe value of the relevant step will need to be apportioned among them on a “just and reasonablebasis”.

Restricted securities—effect of a section 431 election

An election made pursuant to s.431(1) or (2) in relation to restricted securities has the effect ofsubstituting unrestricted market value for actual market value of such shares (or other securities) forthe purpose of determining the amount of any charge under Pt 7A (s.431(3)(e)).

Reporting requirements

Curiously, there are no specific reporting requirements relating to Pt 7A. In practice it is likely that, inthe absence of self-assessment, HMRC will raise assessments in consequence of findings ordisclosures made in the course of an HMRC enquiry.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Practical Consequences of Part 7A

Practical Consequences of Part 7A

22A.36Very broadly, the following practical consequences arise from the need to avoid charges to incometax and NICs arising under the DR rules:

No deferred payment for share acquisitions from an EBT.

Shares should not be offered for sale to employees by an EBT on deferred paymentterms—see 22A.53.

Awards to be made/options granted by member of employercompany 51 per cent group.

If share options granted, and conditional share awards made, to employees anddirectors (etc.) are to be satisfied using shares held, or to be acquired, by an EBT,such options/awards should be granted/made by the employer company or its holdingcompany (assuming that the employer and the grantor company are members of thesame 51 per cent group of companies (see 22A.9)), and not by the EBT trustee.

Avoid earmarking by EBT

However, if an option/award granted/made by a member of the employer company’s 51 per centgroup is intended to be satisfied using shares held, or to be acquired by an EBT (whether bypurchase in the market, subscription or acquisition out of treasury), although, for trust law reasons(see 20.11A), the company must first secure agreement with the EBT trustee that the EBT will, ifasked to do so, use shares held to satisfy such options/awards, the EBT trustee should not beprovided with information identifying the individuals to whom options/awards are to be, or have been,granted/made. The EBT trustee should be informed only of the aggregate number of shares likely tobe required to satisfy the options/awards granted/made on each occasion (see 22A.15).

Ensure awards/options on terms qualifying for exclusion

Share options/awards to be satisfied using shares held or to be acquired by an EBT (or other“relevant third person”, which will include, for example, an individual shareholder)—whether or not

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granted by the company or the EBT trustee or such other “relevant third person”—should (to secureexclusion from any charge to income tax and NICs on any actual—including a possiblyunintended—earmarking of cash or shares) be on terms which satisfy the prescriptive requirements ofs.554H (if a deferred bonus award); s.554J (if a conditional share award); s.554K (if an “exit only”conditional share or cash award); s.554L (if a conditional share option); or s.554M (if an “exit only”conditional share or cash option)—see 22A.24–22A.29 above. Very broadly, in the case of aconditional share award or share option (other than an “exit only” award or option):

(a)the award/option shares which vest must normally be capable of being acquired by theawardholder, or the option must normally become exercisable by the optionholder, only on orbefore a specified date which is not later than 10 years from the date of grant; and

(b)there must, at the time of award, be a reasonable chance that such conditions may not be met(see 22A.26–22A.29).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Practical Consequences of Part 7A

Punitive treatment of third party loans

Punitive treatment of third party loans

22A.37A loan to an employee(, etc.) made by a “relevant third person” (except as mentioned at 22A.38) willnow give rise to an immediate charge to income tax under Pt 7A (and NICs) on the full amount of theloan.

No relief or credit is available for the fact that such loan may subsequently be repaid in full, eitherwithin the term of the loan or at any other time.

No credit against amounts charged under the general rules (in ITEPA 2003 ss.173–191) taxingemployment-related loans is given for charges arising under Pt 7A and there is no £5,000 threshold(as under the general rules).

It follows that any loan to an employee to enable him or her to acquire shares (or indeed for any otherpurpose) should always be made only by the employer company or another member of the same 51per cent group of companies and not by, for example, an employees’ trust or other third party.

Sections 554F (commercial loan transactions) and 554G (“all-employee” benefit packages) affordlimited and restrictive exclusions for certain types of employee loans by a relevant third person.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Practical Consequences of Part 7A

Loans to fund payment of the price payable upon exercise of anemployment-related securities option

Loans to fund payment of the price payable upon exercise of anemployment-related securities option

22A.38There is one other exception to this punitive treatment on third party loans: s.554N(13)–(16) providesthat a Pt 7A charge does not arise by reason of the making of a loan by a “relevant third person” if:

(a)it is made and used solely to enable an employee(, etc.) to fund the price payable for theacquisition of shares upon the exercise of an employment-related securities option (but not anyincome tax payable upon exercise or any other amount);

(b)the option is exercised by the employee and this gives rise to employment income of thatemployee chargeable to income tax or exempt income (which covers SAYE, CSOP and EMI);and

(c)there is no connection between the making of the loan and a tax avoidance arrangement.

If such a loan is not repaid within 40 days after the loan is made, a Pt 7A charge will then arise on thefull amount outstanding at that time.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

PAYE

Accounting for Part 7A income tax under PAYE

Accounting for Part 7A income tax under PAYE

22A.39An amount on which income tax is charged under Pt 7A is “specific employment income” (see ITEPAs.7(4)) and “taxable specific income” (see ITEPA s.10). If the relevant step is the payment of a sum ofmoney, the employer (B) is to be treated as making a payment of PAYE income of that amount on theday when the relevant step is taken or, if later, the day on which A’s employment with B begins orAugust 18, 2011 (s.687A). If it is not the payment of a sum of money, the tax is to be accounted for bythe employer (B) under PAYE on the basis of the best estimate which can reasonably be made of theamount of such employment income (s.695A). For this purpose, the PAYE income is treated as paidon the day on which the relevant step is taken or, if later, the day on which A’s employment with Bbegins. In relation to relevant steps taken before July 19, 2011, the payment is treated as made onAugust 18, 2011.

If the anti-forestalling provisions apply (see 22A.3), a payment is treated as made for PAYE purposes(if at all) on April 6, 2012. PAYE does not apply in relation to such employment income which is taxedon a remittance basis.

The employer (B) has no obligation to account for income tax under PAYE if the person who takes therelevant step (whether or not a person to whom the PAYE Regulations apply) accounts for the incometax in accordance with the PAYE Regulations.

The requirement to account for income tax under Pt 7A under PAYE applies notwithstanding that theshares which are the subject of the relevant step are not “readily convertible assets” (see 7.42).

It would seem that, if the employer company has ceased to exist, HMRC could collect the income taxdirectly from the individuals concerned only insofar as is permitted by reg.81—see 7.51A.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

PAYE

Additional liability under section 222

Additional liability under section 222

22A.40Care must be taken to ensure that any amount due under PAYE is “made good” to the employer bythe employee within 90 days if a (further) penal charge to income tax is not then to arise under ITEPAs.222 (see 7.51).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

National Insurance Contributions

National Insurance Contributions

22A.41Subject to what follows, NICs are due in respect of amounts counting as employment income chargedunder Pt 7A on or after December 6, 2011 (see Social Security Contributions Regulations 2001reg.22B).

The following points should be noted:

•if a charge to NICs arises because an amount treated as employment income is treated asearnings under Pt 7A, a payment of a subsequent amount which (i) is earnings for NIC purposeson ordinary principles; and (ii) represents or arises or derives from the amount so treated asearnings under reg.22B, is to be disregarded to the extent that it does not exceed such amount.For this purpose, all previous payments which have represented or arisen or derived from suchearlier amount are to be taken into account. This ensures that NICs are not charged twice on thesame amount;

•amounts deriving from duties of an employment performed overseas or with an overseasemployer and chargeable only on the remittance basis per ss.554Z9 or 554Z10 (see 22A.48) areliable to Class 1 NICs on the full value of the relevant step (see 22A.35) when it is taken;

Given that PAYE does not apply to such employment income taxed on a remittance basis, this seemsodd, to say the least!

•amounts chargeable under Pt 7A which later attract income tax relief under s.554Z14 (see22A.51) (relief if earmarking not followed by a later relevant step) will not attract correspondingrelief from NICs.

This last point has attracted particular criticism, as it may result in unfair charges where thearrangements were not motivated by tax avoidance. For example, a potential acquirer of a companymight approach its senior managers and “earmark” cash, shares or other assets to be awarded tothem if the acquisition is completed. If such an earmarking satisfies the requirements of the s.554Agateway (see 22A.4), it would trigger charges to income tax and NICs which must be accounted forand, in the case of employer’s secondary Class 1 NICs, borne by, the employer company,notwithstanding that the acquisition does not proceed to completion. The cost of such NIC chargescould be substantial and, it is submitted, would, in such circumstances, be unfair. If the shares aretransferred following a successful completion of the acquisition, relief from a general earnings chargewould be available on a “just and reasonable” basis under s.554Z13.

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•NICs are not charged on amounts counting as employment income on April 6, 2012 by reason ofthe anti-forestalling provisions (as mentioned at 22A.3).

•If HMRC exercises its power under s.554Y to exclude, by regulations, any particular relevantstep from charges under the DR rules, and do so with retrospective effect (per s.554Y(4)), thereis no corresponding power to afford retrospective relief from liability to NICs in respect of anysuch relevant step.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Reductions in the Amount Charged under Part 7A

Reductions in the Amount Charged under Part 7A

22A.42The value of a relevant step is to be reduced in accordance with each of the provisions ofss.554Z4–554Z8, as mentioned below, insofar as they may be applicable. Such reductions are to beapplied in the order of those sections.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Reductions in the Amount Charged under Part 7A

Non-UK residence—section 554Z(4)

Non-UK residence—section 554Z(4)

22A.43If the value of the relevant step, or part of it, is for a tax year in which the employee (A) is non-UKresident, the value, or the part of it, is to be reduced, so far as it is not in respect of duties performedin the United Kingdom. The question of the extent to which the value is not in respect of dutiesperformed in the United Kingdom is to be determined on a just and reasonable basis.

It is therefore necessary first to determine which tax year the value of the relevant step is to be takenas being “for”. For this purpose, ITEPA s.16 (meaning of earnings “for” a tax year) applies as if thevalue of the relevant step were general earnings. The rule is that if it is “earned in, or otherwise inrespect of, a particular period”, it is to be regarded as being for that period. If that period falls withinmore than one tax year, it is apportioned between such tax years on a “just and reasonable” basis.(As regards a situation in which it is not possible to ascribe the earnings to any particular period, seeBray v Best [1989] 1 W.L.R. 167 HL.)

If the tax year in question is before that in which the employment begins, the value of the relevantstep is for the first tax year in which the employment is held. Likewise, if it is for a tax year after theemployment has ended, the value of the relevant step is for the last tax year in which the employmentwas held (see s.17).

So, for example, if in a tax year after that in which the employment ended, shares or other assets are“earmarked” for an ex-employee at a time when he has ceased to be resident in the United Kingdom,such earmarking being in recognition of the performance of his duties in the employment, s.554Z4 willnot apply to reduce the value of the relevant step.

If, however, throughout the last tax year in which the employment was held, the employee (havingpreviously been UK resident), was non-UK resident and all of the duties of the employment wereperformed outside of the United Kingdom, it will be necessary to determine if (on a “just andreasonable” basis) any part of the value of the relevant step is “in respect of” that last tax year inwhich the employee was non-UK resident and performed his duties outside the United Kingdom.

Whatever the percentage which is determined, the value of the relevant step is reduced accordingly.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Reductions in the Amount Charged under Part 7A

Successive relevant steps relating to the same asset—section 554Z(5)

Successive relevant steps relating to the same asset—section 554Z(5)

22A.44If there is an overlap between the asset (or money) which is the subject of a relevant step and theasset (or money) which was the subject of an earlier relevant step which gave rise to a charge underPt 7A, the value of the later relevant step is reduced by the value of the earlier relevant step or if theoverlap covers only part of the asset or sum concerned, by such part of the value of the earlierrelevant step as is just and reasonable. For these purposes, there is an overlap if the asset or cashare the same, or if the asset or cash which is the subject of the later step replaces that which is thesubject of the earlier step.

Note that the relief is given by way of reduction in the value of the subsequent “relevant step”. It doesnot have effect so as to afford relief against the charge first arising under Pt 7A in respect of theearlier “relevant step”. If the value of the shares or other assets which are the subject of suchsuccessive steps has increased, a Pt 7A charge upon the later “relevant step” will only be reduced bythe amount of the lower market value of such shares or other assets at the time of the earlier“relevant step”.

If there occurs a succession of “relevant steps” in relation to the same assets,

"…if any reductions were made under [s.554Z5] to the value of the earlier relevant step,sum or asset P [being the sum or asset which is the subject of the latest relevant step] istreated as overlapping with any other sum of money or asset so far as the other sum ofmoney or asset was treated as overlapping with sum or asset Q [being the sum or assetwhich was the subject of the earlier relevant step]…(!)."

Suppose, for example, that £10,000 cash is earmarked (giving rise to a Pt 7A charge) in favour of anemployee. The cash is invested and grows in value to, say, £11,000. That amount is subsequentlyloaned to a member of that employee’s family (a linked person). In this case, the value of the laterrelevant step—the making of the loan—will be reduced, by the value of the earlier relevant step, to£1,000.

However, suppose that the trustee of an employees’ trust earmarks shares in favour of an employeeon terms which do not qualify for exclusion under any of ss.554J–554M so that a charge to incometax and NICs arises under Pt 7A on the market value of the shares which are the subject of the step(per s.554Z3(2)(a)), say, £10,000. Some time later, those shares are in fact transferred by the trusteeto the employee at a time when their market value has increased to, say, £15,000. That transfer willitself be a “relevant step” (per s.554C(1)(b) or (c)), albeit that if (as would normally be the case) theemployee is subject to a general earnings charge to income tax on the market value of the sharesreceived, the amount on which tax is charged under Pt 7A will be reduced to nil (per s.554Z6). In thisexample, there will be no credit, against the amount on which a general earnings charge arises, forthe amount on which tax has already been charged at the time of the earlier earmarking. Overlap

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relief under s.554Z5 operates only to reduce the value of the subsequent “relevant step” (andtherefore the amount of the subsequent Pt 7A charge) and does not reduce or cancel the initial Pt 7Acharge upon the earlier earmarking. Note that any reduction under s.554Z5 is to be made beforemaking any reduction by way of relief under s.5546 (see below).

On the facts of this last example, relief would only be available on a “just and reasonable” basis,against the liability to income tax on the amount which gives rise to a general earnings charge, unders.554Z13 (see 22A.50).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Reductions in the Amount Charged under Part 7A

Overlap with a general earnings charge—section 554Z(6)

Overlap with a general earnings charge—section 554Z(6)

22A.45If the relevant step gives rise to earnings within s.62 ITEPA 2003 (i.e. subject to a general earningscharge) for a tax year in which A is UK resident or in which, if A is non-UK resident, the relevantearnings are in respect of duties performed in the United Kingdom, the value of the relevant step isreduced (or further reduced) by the amount of the relevant earnings.

So, for example, if an employee is gifted shares from an EBT so that, under the general chargingrules (see 7.2), the actual market value (AMV) of those shares falls to be charged to income tax, theamount charged under Part 7A is reduced to nil. If, however, the shares are sold by the EBT to anemployee for a consideration which is less than their AMV, so that a general earnings charge ariseson the amount of the discount, then the amount on which a Part 7A charge arises will be reduced bythat amount but, whether or not it is reduced to nil will depend upon whether the consideration givensatisfies the requirements of s.554Z8(5) (see 22A.47 below) and, in particular, if it is paid “before, orat or about, the time the relevant step is taken”. Deferred payment terms will not satisfy thoserequirements so that a Pt 7A charge could still arise, notwithstanding the existence of a liability on thepart of A to pay such consideration and with no relief if and when it is paid over.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Reductions in the Amount Charged under Part 7A

Earmarking charge in relation to a share option: reduction to take account ofobligation to pay exercise price—section 554Z(7)

Earmarking charge in relation to a share option: reduction to take account ofobligation to pay exercise price—section 554Z(7)

22A.46If the relevant step is an “earmarking” in relation to an employee share option (whether or not it mightbe satisfied by a cash payment) over “relevant shares”—see 22A.26 —with an exercise price,provided the number of earmarked shares does not exceed the maximum number which mightreasonably be expected to be needed to satisfy the option (see 22A.30) and there is no connectionwith a tax avoidance arrangement (see 22A.14), the value of the relevant step is reduced by theamount of the exercise price payable (or, if there is a reduction for non-residence, by a correspondingpercentage).

It follows that if shares are earmarked by the trustee of an employees’ trust to satisfy the exercise of ashare option and the price payable upon exercise of the option is not less than the market value of theshares at the time they are earmarked, the amount on which tax is charged under Pt 7A is reduced tonil. If, however, the market value of the shares at the time of earmarking exceeds the amount payableupon exercise of the option, a Pt 7A charge will still arise by reference to the amount of the difference.

Note that the reduction afforded by s.554Z7 does not apply in relation to any relevant step deemed tobe taken by virtue of the fallback charges arising after an excluded relevant step in the form of thegrant of a conditional share option, as provided in ss.554L(5), (7) or (9) or 554M(4) (6) or (8) (see22A.28 and 22A.28 and 22A.29 above) has been taken. In other words, if, in relation to sharesearmarked to satisfy an option which satisfies the requirements of s.554L (“the excluded option”),either the option is not granted within three months or, the excluded option having been granted, theshares cease to be earmarked to satisfy the excluded option but remain earmarked for the employee,the reduction does not apply. Such a reduction does however apply in relation to a charge which isdeemed to arise because an excluded share option (as mentioned at 22A.28 and 22A.29 above) hasneither been exercised nor lapsed before the end of the tenth anniversary of the date of grant. If,however, any of the “earmarked” shares cease to be held for the purposes of satisfying the shareoption in question or an excluded share option is not in fact granted within three months after the“earmarking” of shares intended to satisfy that option, but the shares remain “earmarked” for thesame or another employee, then a charge under Pt 7A will again arise on the full value of the“earmarked” shares.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Reductions in the Amount Charged under Part 7A

Cases in which consideration is given by the employee—section 554Z(8)

Cases in which consideration is given by the employee—section 554Z(8)

22A.47In relation to the payment of a sum (including the making of a loan) or transfer of an asset (includingan acquisition by an employee (A) of shares, an interest in shares or a share option), the value of therelevant step is also reduced by the value of any fresh consideration given by A in the form of thetransfer of an asset by the employee to the person taking the relevant step (or, if there is a reductionfor non-residence, by a corresponding proportion) provided that:

(a)the transfer of the asset is made “before, or at or about, the time the relevant step is taken” andis not by way of loan; and

(b)there is no connection between the transfer of the asset by A and a tax avoidance arrangement.

For this purpose, it is to be assumed that the transfer by the employee (A) of the asset is connectedwith a tax avoidance arrangement if:

(a)it was previously loaned to A; or

(b)it is, or carries, any rights or interests under the relevant employment-related arrangement or anyconnected arrangement.

This being an assumption, it can presumably be rebutted by reference to the actual facts orcircumstances.

Likewise, in relation to the transfer of an asset (including an acquisition by an employee of shares, aninterest in shares or a share option), or the making available of an asset under s.554D not alsoinvolving a sum of money, the value of the relevant step is also reduced by the value of any freshconsideration given by A in the form of the payment of a sum of money by the employee to the persontaking the relevant step (or, if there is a reduction for non residence, by a corresponding proportion) ifthe transfer of the asset is made “before, or at or about” the time the relevant step is taken.

References to the employee (A) include references to any person linked with A (see 22A.6).

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Meaning of “made before, or at or about,” the time the relevant step is taken

HMRC have indicated (in their FAQs and in their published guidance) that, in their view, “at or about”normally means a few days either side of the date of the relevant step, although the leeway allowedcould be up to a week and, depending on the particular circumstances, could be longer.

Sales of shares by an EBT on deferred payment terms

There is no protection from an immediate Pt 7A charge upon a sale and transfer of shares by an EBTinsofar as the terms provide for payment of the consideration to be deferred until some time after theshares (or beneficial interest in the shares) are transferred by the EBT or other relevant third person.That said, the amount counting as employment income under Pt 7A will reduce the amount of the“notional loan” deemed to be outstanding for the purposes of charges arising under Chapter 3C of Pt7 of ITEPA (see 7.26 et seq.). No relief is given (against the Pt 7A charge) if the amount outstandingis later paid up (see 22A.53).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Reductions in the Amount Charged under Part 7A

Reduction in the value of the relevant step if the remittance basisapplies—sections 554Z(9)–554Z(11)

Reduction in the value of the relevant step if the remittance basisapplies—sections 554Z(9)–554Z(11)

22A.48If the value of a relevant step is for a tax year in which (a) the remittance basis applies to theemployee, (b) the employee is ordinarily UK resident but (c) the employee in that tax year isemployed by a foreign employer and the duties are performed wholly outside the UK, employmentincome charged under Pt 7A is “taxable specific income” in a tax year in which it is remitted to theUnited Kingdom. If remitted before the employment begins, it is treated as remitted in the tax year inwhich the employment begins. If the employee has multiple associated employments and the dutiesare not wholly performed outside the United Kingdom, a just and reasonable apportionment of theemployment income chargeable under Pt 7A is to be made.

Likewise, if the value of the relevant step is for a given tax year and is not in respect of dutiesperformed in the United Kingdom in that tax year, the remittance basis applies and the employee isnot ordinarily resident in the United Kingdom, employment income charged under Pt 7A is “taxablespecific income” in a tax year in which it is remitted to the United Kingdom. The extent to which thevalue of the relevant step is not in respect of duties performed in the United Kingdom is to bedetermined on a just and reasonable basis.

If the remittance basis applies to part only of the value of a relevant step, the reductions to be madeby way of overlap relief, overlap with a general earnings charge, reduction to take account of anoption exercise price, and to take account of consideration given for a relevant step, are to be giveneffect only to that part (see s.554Z11). For an illustration of how such reductions are to be calculated,see HMRC guidance at EIM 45815.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Consequences of Death

Relevant step taken after the death of the employee—section 554Z(12)

Relevant step taken after the death of the employee—section 554Z(12)

22A.49No Pt 7A charge arises in relation to earmarking after the death of the employee—s.554A(4).

In the case of a transfer of assets, making of a loan(, etc.) per s.554C or making an asset availableper s.554D, if the relevant step is taken after A’s death in relation to a “relevant person” (see below):

•if the relevant person is the employee (A), A’s personal representatives are liable for the Pt 7Atax (i.e. the amount which counts as employment income of A or which is remitted);

•if the relevant person is another individual, the amount chargeable under Pt 7A is treated asemployment income of that other individual;

•if the relevant person is not an individual, the person liable is:

•the person who took the relevant step, if UK resident;

•the employer, if the employer still exists; or

•otherwise, the non-UK resident person who took the relevant step (e.g. offshore trustees).

“Relevant person” is the “relevant person” for the purposes of ss.554C and 554D and thereforeincludes a “linked person”. A transfer of assets by an EBT to a sub-trust made after the death of A fora child born thereafter will give rise to a charge under Pt 7A but it would seem that, on the basis ofs.554Z12, no person is liable for the tax under Pt 7A (although other charging provisions might apply).

If there is more than one such person, the amount on which the tax is charged is to be apportioned ona just and reasonable basis. None of these provisions applies if A’s employment with B never startedbefore A’s death.

Subject to these provisions of s.554Z12, the general rule is stated in s.13(4B) to be that, in relation tospecific employment income under Pt 7A, if the relevant step is taken, or (if relevant) the income is

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remitted to the United Kingdom, after A’s death A’s personal representatives are liable for the Pt 7Atax and the tax is accordingly to be assessed on the personal representatives and is a debt due fromand payable out of the estate.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Other Reliefs from a Part 7A Charge

Just and reasonable reduction to a subsequent liability to income tax—section554Z(13)

Just and reasonable reduction to a subsequent liability to income tax—section554Z(13)

22A.50If, after the occurrence of a relevant step giving rise to a charge under Pt 7A:

(a)a later event occurs which gives rise to a liability for income tax on the part of the employee (A)or any other person under a general earnings charge, or otherwise than under Pt 7A or theemployment-related securities charging provisions in Chapters 2–5 of Pt 7 or Pt 9 (PensionIncome); and

(b)it is just and reasonable to avoid a double charge to income tax in respect of the money or assetwhich was the subject of the initial relevant step,

then, to that extent, there is to be no such liability to income tax (under any charging provision, notonly under Pt 7A) in relation to the subsequent event.

Such relief is available as of right rather than having to be specifically applied for (as is the case withrelief under s.554Z14). It is not available if the later relevant step gives rise to a charge under theprovisions of Pt 7 relating to the taxation of employment-related securities.

Avoiding a double charge to income tax

The fact that shares are “earmarked” in advance of a transfer to employees might appear to result indouble taxation if such “earmarking” is not itself excluded as mentioned in 22A.25–22A.29 above. Onthe facts of the example in 22A.46 above, if the earmarked shares were to be acquired by theemployee upon the exercise of a share option giving rise to a charge to income tax under Chapter 5of Pt 7—see 11.27B), whilst there is no provision for repayment of the Pt 7A tax charged upon theearlier earmarking—see s.554N(1), relief is effectively given by virtue of the fact that the amount onwhich a Pt 7A charge has arisen is a deductible amount in calculating the charge under Chapter 5 ofPt 7 on exercise of the option—see 11.27F.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Other Reliefs from a Part 7A Charge

Relief if an earmarking not followed by a further relevant step—section554Z(14)

Relief if an earmarking not followed by a further relevant step—section554Z(14)

22A.51Application may be made to HMRC by the employee (A) or, if he has died, his personalrepresentatives, for relief on a “just and reasonable basis” from income tax paid under an earmarkingcharge if:

(a)such an earmarking charge has arisen; and

(b)an event which is not a “relevant step” subsequently occurs by reason of which no furtherrelevant step is or will be taken in relation to the earmarked sum or asset (or a sum or assetderived from it); and

(c)there is no connection with a tax avoidance arrangement.

The application for relief must be made within four years after the subsequent event occurs. Therelief, which is to be given by repayment “or otherwise as appropriate” is to be given (if at all) againstnot just the tax paid under the “earmarking” charge but also any penal tax charged under s.222arising in relation to a failure to make good to the employer within 90 days the PAYE tax accountedfor (see 7.51). In determining what is a “just and reasonable” amount of relief, HMRC must haveregard to the reduction in the tax liability “and reduce the amount of relief which would otherwise havebeen given accordingly”.

Examples of situations in which a chargeable earmarking is followed by such an event might be (a) ifearmarked shares were to be sold in the market by the relevant third person who earmarked them,that person no longer holding the shares or their proceeds specifically with a view to a later relevantstep being taken in relation to them; or (b) if the company concerned becomes insolvent and theearmarked shares become worthless. Another example might be if an earmarking was made inrespect of a non-excluded share award and the person making the award subsequently revokes thataward (or the award is released by the awardholder) so that the shares concerned are no longerearmarked for that employee. However, if the shares could, and might, be earmarked or otherwisemade the subject of a fresh award in favour of the same employee, then strictly it would appear thatthe requirement in (b) above will not be met.

That said, if shares held by an employees’ trust have ceased to be earmarked for the satisfaction of aparticular award made or option granted to an employee in consequence of that award or option

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being revoked, released, or because the shares fail to become vested in consequence of anyperformance conditions failing to be met, and those shares do not remain earmarked for thatemployee as mentioned in s.554B(1)(a) or (b) (see 22A.15), the fact that such shares could, if thetrustee in its discretion so determined, be the subject of a fresh award, should not of itself mean thatthe requirement in s.554B(1)(b) is not met.

In any event, it would appear that an earmarking of shares in favour of an employee without theemployee ever actually receiving or benefiting from such earmarking in any way, would not, in theabsence of any subsequent event (which implies a positive act on the part of some person and notmerely an omission to act), qualify for relief under s.554Z14. In such a situation, tax will have beencharged in the absence of any actual receipt of emoluments or benefit-in-kind by any person. The riskof such penal charges arising in what is a wholly commercial arrangement, not involving any taxavoidance, points up the potential injustice of the DR rules.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Points Arising in Relation to Dealings by Employees’ Trusts

Earmarking in advance of a sale or transfer of shares by an EBT

Earmarking in advance of a sale or transfer of shares by an EBT

22A.52In practice, if a company recommends to the trustee of an employees’ trust that the trustee transfershares, or an interest in shares, to an employee by way of a bonus or otherwise in connection withthe employee’s employment, there will, almost inevitably, be a period of time between (a) the trusteeresolving to accept such recommendation and give effect to such a transfer of shares and (b) takingthe actions necessary to effect the transfer. The question arises as to whether, in suchcircumstances, HMRC will claim that there has been a separate earmarking in advance of the transferso as to give rise to a charge under Pt 7A, notwithstanding that the value of the “relevant step” whichis the transfer of shares may, if (for example) the employee either pays or suffers a general earningscharge on the market value of the shares transferred, be reduced to nil (see 22A.45 and 22A.47above). It is understood that HMRC will accept that, simply because trustees decide to do somethingbefore actually doing it, this will not necessarily mean that there will have been an earmarking. So, iftrustees acquire shares and then immediately apply such shares in satisfaction of share awards,HMRC will not argue that there is a separate “earmarking” charge arising prior to the actual transfer(see EIM 45110).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Points Arising in Relation to Dealings by Employees’ Trusts

Offers of shares by an EBT following an earmarking

Offers of shares by an EBT following an earmarking

22A.53If an invitation is to be made to employees to acquire shares from an EBT or other relevant thirdperson, then, again, care is needed if the arrangement will involve a prior “earmarking” by the EBT(whether or not the shares are to be offered at a discount to their market value). Section 554N(1) willnot exclude the earmarking of the shares, even if by virtue of that step the shares are to be acquiredby a person, whether or not they are subject to a short-term risk of forfeiture (see 10.13). Thesubsequent acquisition of the shares by an employee from the EBT will be a relevant step taken bythe EBT (per s.554C(1)(c) and (4)(a) or (b)), but the amount on which tax is charged under Pt 7A willnormally be reduced:

(a)by the amount on which a general earnings charge arises (s.554Z6); and

(b)if, but only if, any consideration paid for the shares is given before, or at or about, the time whenthe shares are transferred (see 22A.23), by the amount of that consideration.

More particularly, s.554N does not protect against the earlier Pt 7A charge on an “earmarking” by theEBT trustee. In relation to such earmarking, the exclusions in ss.554J and 554L will not normally beapplicable as these require the award or option in respect of which the earmarking is made, to be onterms the main purpose of which is to ensure that the shares are received only on, or the option isexercisable only after, a specified vesting date, and that such awards or options are at risk ofrevocation if specified conditions are not met (, etc.). Further, no overlap relief would be availableunder s.554Z5 (see 22A.44) as this only has effect so as to reduce the amount of any subsequentcharge, not the value of the earlier relevant step (here, the earmarking). Likewise, the exclusionafforded by s.554N(7)-(11) (see 22A.23) is of no assistance as this relates only to relevant stepstaken after the acquisition of the shares.

If earmarked shares are later transferred to the employee for whom they were earmarked, and thetransfer is by way of gift, the employee may expect to suffer a general earnings charge on the valueof the shares so acquired (either AMV or, if a s.431 election is made, UMV). In this case, relief fromdouble taxation is afforded, on a “just and reasonable” basis, from this later general earnings chargeby reason of s.554Z13—see 22A.50 above. If the shares have increased in value between the earlierearmarking and the later transfer, the increase will still be subject to a general earnings charge.

If the earmarked shares are transferred for consideration, relief from a Pt 7A charge on that later“relevant step” will, if the consideration is paid “before, at or about” the time when the shares aretransferred, be afforded under s.554Z8 (see 22A.47). However, no relief is available, by way ofrepayment or otherwise, in respect of the earlier earmarking charge. In particular, relief is not

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available under any of s.554Z5—see 22A.44, s.554Z13—see 22A.50, or s.554Z14—see 22A.51. Thisis, on any reasonable view, unfair and a trap for the unwary (see 22A.47).

One answer might be to ensure that the invitation to acquire shares is made by the employercompany (or another member of the same 51 per cent group) and that, whilst the EBT trustee isasked to agree to transfer or sell the shares when requested to do so, it is not told in advance of thenames and individual numbers of shares involved so that, on the basis of HMRC’s published practice,there is no earmarking by the EBT (see EIM 45100 and 45110).

Share offers on an “all-employee” basis

It has been suggested that a separate exclusion, in s.554G, which relates to certain employee benefitpackages made available to all employees on a “similar terms” basis, might exclude from Pt 7A anoffer to all employees on a “similar terms” basis. However, it is unclear whether either the“earmarking” or transfer of shares by, for example, an EBT to employees pursuant to such an offer(whether or not the shares are offered by way of gift or for a consideration) would amount to a “step… taken for the sole purpose of a transaction which [the relevant third person] entered into in theordinary course of [its] business”, as required by s.554G(1)(b). Even if this be the case, it may provedifficult for the terms of the offer to satisfy the restrictive requirements of that section.

Deferred payment for share acquisitions from an EBT (or other “relevant thirdperson”)

If, for example, an employee agrees to purchase shares from an employees’ trust (or other relevantperson) for a consideration equal to their market value, but the whole or part of that amount is toremain left outstanding unpaid:

(a)there will be a “relevant step” taken by reason of the transfer of the shares (per s.554C(1)(b) or(c)); and

(b)unless the requirements of s.554H or s.554J are satisfied or the shares are subject to ashort-term risk of forfeiture (so the step is excluded by s.554N(1)), the relevant step will not beexcluded (from giving rise to a Pt 7A charge).

The reduction in chargeable amount afforded by s.554Z8 (consideration given for relevant step) willnot apply because the consideration passing from the employee is not paid “before, or at about” thetime of transfer of the shares (see 22A.47) and therefore a Pt 7A charge will immediately arise. Theamount on which tax is charged under Pt 7A will be a deductible amount in determining the amount ofthe “notional loan” for the purposes of the charges under Chapter 3C of Pt 7 (see s.446T(3)(f)) (whichmeans, in practice, that where there is a Pt 7A charge there will be no Chapter 3C charge). However,this does not counter the penal effect of having a Pt 7A charge arise on the value of the shares onacquisition when, under the normal Pt 7 provisions, such a charge would, if the undervalue is paid infull when, or before, the shares are sold, be avoided altogether.

If the full amount left outstanding unpaid is in fact subsequently paid to the EBT, an application forrelief cannot be made pursuant to s.554Z14 (relief where earmarking not followed by further relevantstep) because the Pt 7A charge on transfer of the shares arises under s.554C, not s.554B(earmarking) and this relief applies only if the Pt 7A charge was an earmarking charge.

One alternative might be to structure the acquisition of shares from the trustee by way of the grantand immediate exercise of a share option with an exercise price set at the market value (at the time ofgrant or, possibly, the time of exercise) of the shares and on terms that the exercise moneys may beleft outstanding unpaid for a defined period. The grant of such an option is an excluded relevant step(per s.554N(2)), but the associated earmarking of the shares, being itself a relevant step, will not beexcluded. Nevertheless, if all the requirements of s.554Z7 (exercise price of share options—see22A.46) are satisfied, the amount of the earmarking charge arising should be reduced to nil. The

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transfer of shares upon exercise of the option will be a relevant step per s.554C(1)(b) or (c). However,if (as would be intended) this is structured so that a small charge arises under s.476 (because suchacquisition is a “chargeable event” by virtue of which an amount counts as employment income of theemployee—see s.554N(4)), such transfer of shares should be excluded by virtue of s.554N(5)(a). Itfollows that some amount of chargeable gain (however small) must accrue upon exercise of theoption, i.e. the exercise price must be less (albeit only slightly less) than the market value of theshares at the time of exercise.

That said, it is likely to be difficult to avoid a distinct and separate earmarking by the trustee (of theshares to be offered on such deferred payment terms) in advance of the grant of such an option. If thegrant is made immediately upon receipt by the trustee of a recommendation by the employercompany to make such an offer, the parties will be reliant upon HMRC accepting that the invitationissued by the trustee to accept the grant of such an option, and the subsequent grant (if separated intime) are parts of a single transaction, albeit involving both an excluded option grant and a separateearmarking charge which is reduced to nil.

That an employer company and trustee of an employees’ trust should have to restructure suchcommercial transactions entered into, with no tax avoidance purpose, in this manner (with theassociated additional costs and paperwork) so as to avoid a penal tax charge is unfair andunreasonable. It is to be hoped that HMRC would not, in such circumstances, seek to argue thatarranging such acquisition in the alternative manner suggested means that any one of the “relevantsteps” involved is connected with a “tax avoidance arrangement”!

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Points Arising in Relation to Dealings by Employees’ Trusts

Sales of shares to an EBT

Sales of shares to an EBT

22A.54If on a sale of shares by an employee to an EBT for their full value paid in cash (which, dependingupon the facts, may well not be the case) the relevant step, i.e. the payment by the EBT trustee, is anemployment-linked arrangement concerned with the provision of rewards or recognition—per s.554A—the value of the relevant step (i.e. the amount of the cash consideration) will be reduced by themarket value of the shares transferred provided that the shares are transferred before, or at or about,the time the consideration is paid. If, under the terms of the sale back to the EBT (as, for example,may be provided by the articles of association), payment of the cash consideration is deferred untilsome time after the shares have been transferred, then this reduction will still apply as theconsideration passing from the employee (i.e. the shares) will have been transferred before therelevant step is taken (although care must be taken to avoid an earmarking charge in relation to thecash allocated by the EBT trustee with a view to payment being made to the employee—there is noequivalent reduction in relation to such an earmarking charge!).

If the employment-related shares are sold for a consideration which exceeds their market value sothat a charge to income tax arises under Chapter 3D of Pt 7 of ITEPA 2003 (see 7.36), the relevantstep will be excluded by virtue of s.554N(5)(c)—see 22A.44 above.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Points Arising in Relation to Share Options

Option rollovers

Option rollovers

22A.55If, at or following a takeover or reorganisation, shares (“old shares”) which have been earmarked byan employees’ trust are exchanged for shares in an acquiring company (“new shares”) and the optionin respect of which the “old shares” were earmarked (being an excluded option) remains in place,then HMRC has confirmed in its guidance that there will be no fallback charge in respect of the “oldshares” at that point in time. The new shares will be regarded as earmarked with a view to meetingthe subsisting award, with the specified “vesting date” (see 22A.28) set in relation to the award oroption, at the time it was made, remaining the occasion for a potential fallback charge. That said, theguidance is qualified by a requirement that the terms of the award or option over the old sharespermits the award or option to be satisfied using such new shares. As, apart from CSOP and SAYEoptions, there is otherwise no requirement to include in the terms of an option express provision for itto be satisfied using shares in an acquiring company, this is likely to mean that, going forward,unapproved option agreements will now make express provision for such an eventuality.

If the earmarked shares are exchanged for shares in an acquiring company, but the award or optionin respect of which the “old shares” were earmarked is replaced by a fresh award over the “newshares” and with a new specified “vesting date”:

(a)if the relevant old shares are no longer held by the trustee and the old award or option has beenrevoked in accordance with its terms, there will be no charge under Pt 7A in respect of theoriginal earmarking;

(b)if the new award and the earmarking of the new shares meet the requirements of ss.554J, 554K,554L or 554M (as appropriate), there will be no earmarking charge under Pt 7A at that time inrespect of an earmarking of the “new shares” to satisfy the new award. That said, it is unclear asto whether HMRC will accept that no charge arises if, because the original option had becomevested (i.e. immediately capable of exercise), the new option is likewise capable of immediateand unconditional exercise and therefore fails to meet the requirements of s.554L (fairnessdictates that they should!);

(c)however, if the period within which the new option may be exercised extends beyond that of theold option so as to circumvent the time limit of the relevant exclusion, then it appears that HMRCwould seek to apply the anti-avoidance provisions so that a Pt 7A charge would arise in respectof an earmarking of shares to satisfy the new award or option (although it is far from clear that, ifthe terms of the new award satisfy the requirements of the relevant section at the time ofearmarking, albeit with a period running from the date of award which extends beyond that set in

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relation to the original award, HMRC is justified in this view as the main purpose will presumablybe to afford an enhanced benefit, rather than avoid tax on that enhanced benefit.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Points Arising in Relation to Share Options

Fallback charges: cancellation or release of share options (or awards)

Fallback charges: cancellation or release of share options (or awards)

22A.56The statutory provisions respectively imposing “fallback” charges if an excluded share award or shareoption is released/revoked/ceases to be exercisable, differ in their terms:

•Section 554H(8) and (11) (deferred remuneration) impose an earmarking charge at the end ofthe specified “vesting date” unless, before that time (and assuming the shares/cash have notthen been transferred), the award is “revoked in accordance with the deferred remunerationterms”,

•likewise, s.554J(9) and (12) (conditional share awards) impose an earmarking charge at the endof the specified “vesting date” unless, before that time (and assuming the shares/cash have notthen vested and been transferred), the award (or any part of it) is “revoked in accordance withthe deferred award terms” and “correspondingly, the shares are no longer held by any person inrelation to the award”,

whereas:

•section 554K (exit only share awards) includes no such specific reference to the award beingrevoked in whole or in part, and

•section 554L(9), together with s.554L(12) and (13), impose an earmarking charge at the end ofthe later “final exercise date” (see 22A.28) unless either:

•before the end of the specified “vesting date”—i.e. the date when the option must normallyfirst become exercisable—(and assuming it has not been exercised), the option “ceases tobe exercisable by [the employee] (in whole or in part)” in accordance with the terms of theoption and “correspondingly, the shares are no longer held by any person in relation to therelevant share option”; or

•after the option has become exercisable before the end of the vesting date (and assuming it

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has not been exercised), it subsequently lapses (in whole or in part) before the end of thefinal exercise date,

•section 554M(8) and (11) (exit only share options) impose an earmarking charge unless theoption, having become exercisable because an exit event occurs (and assuming it is notexercised), “lapses (in whole or in part) at or before the end of [the exit period]” (see 22A.29) and“correspondingly, the shares are no longer held by any person in relation to the relevant shareoption”.

First, it is unclear as to why there is apparently inconsistency in the treatment of the lapse orrevocation of different types of award. Secondly, the requirement, in ss.554H, 554J and 554L, that theaward be revoked “in accordance with its terms” can be a trap for the unwary. It is unclear whether“revocation”—presumably being an act on the part of the person who first made the award—extendsto include a “release” of the award by the person to whom it was made. Likewise, in relation to ashare option intended to be excluded under s.554L, it is unclear whether, if the option is unilaterallyreleased by the optionholder, HMRC will accept that the option thereby ceases to be exercisable “inaccordance with its terms”. HMRC have stated in their guidance relating to s.554H (but not s.554J ors.554L) that, if such an award is revoked outside the deferred remuneration terms, a fallback chargewill apply, although relief may nevertheless be available under s.554Z14 (relief where earmarking notfollowed by further relevant step)—see 22A.51 —if the sum of money or asset representing theearmarked remuneration ceases to be held for the benefit of the employee to whom the award wasmade.

In principle, and to be consistent with the scheme of Pt 7A, it is suggested that the position in practiceshould be that if, at any time and for any reason, an award or share option is revoked, released,cancelled or forfeited, and the shares or other assets earmarked to satisfy that award or optionthereupon cease to be earmarked for the benefit of that employee, no fallback charge should arise atthat or any later time in relation to the original earmarking. That said, HMRC have not confirmed thisto be the case.

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Joint Share Ownership Plans

Joint Share Ownership Plans

22A.57An employee joint share ownership arrangement (“JSOP”) typically involves the following:

(a)an employee and a co-owner together subscribe for, or purchase either in the market or from anemployees’ trust, shares in the employer company or its holding company, such shares beingheld in undivided shares as beneficial joint owners upon and subject to the terms of a jointownership agreement (“JOA”), an election being made under ITEPA s.431(1) for the employeeto be treated as acquiring his interest at its unrestricted market value;

(b)the co-owner is either an offshore discretionary employees’ trust which satisfies therequirements of IHTA 1984 s.86, or is an offshore “purpose trust” established by a member ofthe employer company group;

(c)the JOA provides, inter alia, that, when the jointly owned shares are sold, the proceeds will bedivided between the joint owners such that (i) the employee receives growth above the initialmarket value (or a higher threshold), and (ii) the co-owner receives the balance;

(d)if the employee leaves, and/or target levels of performance are not met, the co-owner has theoption to require the employee to sell to the co-owner the employee’s interest in the jointlyowned shares for a consideration which may be equal to (if a “good leaver”) or less than (if a“bad leaver”) the market value of the employee’s interest at the time of leaving or failure to meetthe targets set;

(e)some (but not all) JOAs further provide that the employee, has an option (being an“employment-related securities option”) exercisable in defined circumstances, to acquire theco-owner’s interest in the jointly owned shares, so as to become the holder of the entirebeneficial interest in the shares (“the Employee’s Option”); and

(f)some JOAs also give both parties the right to call on the other to swap a proportion of theirrespective interests so that each “walks away” with the entire beneficial interest in a wholenumber of shares equal in value to their respective interests immediately before the swap.

Acquisition by an employee of an interest in jointly owned shares

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No charge arises under Pt 7A if the employee and a co-owner (such as an employees’ trust) togetheracquire the beneficial interest in a number of shares by way of subscription for new shares. Theacquisition by the co-owner (even if a “relevant third person”) of its interest as joint owner is not,without more, an “earmarking”, as it is a step taken neither with a view to a later relevant step beingtaken in relation to that asset (the co-owner’s interest as beneficial joint owner), nor does that assetstart to be held “specifically with a view, so far as [the co-owner] is concerned, to a later relevant stepbeing taken by [the co-owner] in relation to that asset” (per s.554B(1)(a) and (b)). Indeed, theunderlying basis of a JSOP is that the employee benefits from the growth in value of his interest in thejointly owned shares, and not from the value of the interest acquired, or retained, by the trustee.

If the employee and the trust together acquire the beneficial interest in shares by purchase fromanother trust, then, in relation to the interest acquired by the employee, a charge would arise unders.554C(1)(b) or (c). However, on the basis that the employee either pays for, or incurs an immediatecharge to income tax under Chapter 1 of Pt 3 (general earnings charge), the amount on which the Pt7A charge is levied is reduced to nil—per s.554Z8(5) and (6) (insofar as the employee pays a sum ofmoney by the employee and the conditions for such relief are met—see 22A.47) or s.554Z5 (insofaras a general earnings charge arises). In relation to the interest acquired by the co-owner, there is—forthe reasons given in the preceding paragraph—no “earmarking” or other relevant step taken inrelation to the co-owner’s interest. So far as any vendor employees’ trust is concerned, s.554C(1)(b)or (c) do not apply because the co-owner (to whom, along with the employee, the beneficial interest istransferred) will not be a “relevant person” per s.554C(2).

The grant of the Employee’s Option (see (e) above) would be the grant of an employment-relatedsecurities option which is excluded by s.554N(2), but would, on the basis of HMRC’s current practice,involve an “earmarking” by the co-owner of the co-owner’s interest (as joint owner) which is thesubject matter of the option. Accordingly, care must be taken to ensure that the terms of such optionmeet the requirements of s.554L (or possibly s.554H) so that any such earmarking is excluded from aPt 7A charge.

Dividends on jointly owned shares

Typically, by the terms of a JOA, dividends on jointly owned shares are paid (if at all) to the respectivejoint owners pro rata to the values of their respective interests in the jointly owned shares at the timeof payment (typically when the shares go ex that div.). If the employee’s share of such a dividend ispaid out through the agency of the co-owning trust, this is by way of the trustee acting as agent onlyand not therefore within the scope of s.554C(1)(a) (payment of a sum to a relevant person). If theco-owner trust were to gift its share of such dividend to the employee, payment of such amount wouldbe a relevant step within s.554C(1)(a), albeit that as it would be charged to income tax as generalearnings (see 22.25), the value of such relevant step would be reduced to nil (per s.554Z6—see22A.45).

Disposal of jointly owned shares

A disposal of jointly owned shares, and the division and payment of the proceeds of sale to therespective joint owners, is not a “relevant step” taken by a “relevant third person” and will typically fallto be charged to CGT in accordance with general rules.

A transfer by the employee of his interest to the co-owner (e.g. if targets are not met, or the employeeleaves) will, if the trustee gives consideration for such transfer, be a “relevant step” per s.554C(1)(b).That said, if the consideration passing from the co-owner is paid at or after the employee transfers hisinterest to the co-owner, and such consideration does not exceed the market value of the employee’sinterest at the time of its transfer, the amount of any charge under Pt 7 should be reduced to nil (pers.554Z8—see 22A.47). Conceivably, if the employee exercises a “put option” to transfer his interest tothe co-owner, then, by reason of s.554C(2)(b), the trustee becomes a “relevant person” so that arelevant step is also taken by virtue of s.554C(1)(c) in relation to the transfer of the employee’sinterest to the trustee! That said, if the market value of the asset passing from the employee to thetrustee (i.e. the employee’s interest in the jointly owned shares) is at least equal to any value passingfrom the trustee to the employee, the amount of the charge is again reduced to nil—per s.554Z8(2).

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Employee Share SchemesVolume 1

Commentary

Chapter 22A

Employment income provided by third parties—“disguised remuneration”

Seeking Certainty—Applications for HMRC Clearance

Seeking Certainty—Applications for HMRC Clearance

22A.58Part 7A does not provide for a statutory clearance procedure. It follows that, in the event ofuncertainty as to the application of Pt 7A to specific factual circumstances, application may be madeto HMRC for a non-statutory clearance in accordance with the policy and procedure set out atClearance Services for Businesses on the HMRC website, which includes a checklist of thedocumentation and information which must accompany such an application. Applicants must set outwhere the uncertainty lies, the reasons for it and provide full background details and relevantdocumentation to enable HMRC to provide advice (see EIM 45005).

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