A software company granted a replacement share option during a refinancing. By then, the person benefiting from the option was its executive chairman. Was the gain taxable as employment income even if the company’s commercial reason for the grant was to replace an earlier entitlement? The answer depended on a provision that treats certain options as employment-related regardless of motive.
Vermilion Holdings Ltd was the holding company of a software business. In a 2006 funding exercise it granted Quest Advantage Ltd, a company owned by Marcus Noble and Scott Carnegie, an option to acquire ordinary shares representing up to 2.5 per cent of Vermilion’s share capital. By early 2007 the business was short of working capital. Further investment depended on several changes, including Mr Noble’s appointment as executive chairman and a reduction in the existing option entitlements.
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The 2006 option was not varied. On 2 July 2007 Vermilion and Quest executed a new option agreement. Quest could subscribe for a new class of F ordinary shares, up to 1.5 per cent of the issued equity share capital. No consideration was paid, and the 2006 option lapsed. In June 2016 the option was novated from Quest to Mr Noble, who exercised it. The gain was £636,238. Mr Noble and Vermilion asked HM Revenue and Customs to agree that it was liable to capital gains tax. On 14 December 2016 HMRC decided that the 2007 option was an employment-related securities option, so the gain counted as Mr Noble’s employment income. HMRC assessed Vermilion for 2016–17 to £285,148.76 in income tax under the PAYE regulations and £100,709.98 in National Insurance contributions. Vermilion had an indemnity from Mr Noble and appealed.
The statutory rule
Chapter 5 of Part 7 of the 2003 Act charges gains on certain securities options as employment income. Section 471(1) applies where the right or opportunity to acquire the option is available “by reason of an employment”. That is a causation test, and earlier cases show that judges can disagree about what counts as a sufficient reason. Section 471(3) is designed to avoid that inquiry. Where the employer, or a person connected with the employer, makes the right or opportunity available, it is treated as available by reason of the employment. The exception for a right made available by an individual in the normal course of domestic, family or personal relationships did not arise here.
Lord Hodge, with whom the other Justices agreed, said that the appeal turned on this deeming provision. The relevant question was not why Vermilion granted the option, but who conferred it and whether Mr Noble was then an employee.
The division below
The First-tier Tribunal, Dr Heidi Poon, held that the option was not employment-related. It found that Quest received the 2007 option because of the 2006 option, not because Mr Noble was a director. It treated section 471(3) as subordinate to section 471(1) and limited the deeming provision so that it would not contradict that factual conclusion or produce what it regarded as injustice or absurdity.
The Upper Tribunal held that the First-tier Tribunal had erred under section 471(1): Mr Noble’s employment as a director was a condition of the 2007 grant. It did not decide section 471(3). The Inner House allowed Vermilion’s appeal by a majority. Lord Malcolm and Lord Doherty considered that, viewed realistically, Mr Noble received the 2007 option because he gave up part of the 2006 entitlement, and that applying the deeming provision would be anomalous, absurd or unjust. Lord Carloway, the Lord President, dissented. He held that Vermilion had made the new option available after Mr Noble became its employee, that this involved no absurdity, and that the worthless-unless-refinanced 2006 option was of peripheral significance.
Why the deeming provision applied
The Supreme Court agreed with the Lord President. Applying guidance on deeming provisions in Fowler v Revenue and Customs Commissioners, Lord Hodge identified the purpose of section 471(3) as a bright-line rule. If an employer confers a securities option on an employee, it is conclusively treated as employment-related, unless the domestic exception applies. The decision-maker looks at the transaction to see who conferred the right, not at the employer’s motive.
In this case the correct question was: did Vermilion confer the 2007 option on Mr Noble’s nominee while Mr Noble was its employee? The answer is that it did.
The 2006 option had been cancelled, not varied. Vermilion conferred a new option over a different class of shares on Quest. That brought the grant within section 471(3). Vermilion’s reason for doing so was irrelevant once the provision applied.
Lord Hodge held that the First-tier Tribunal had put the cart before the horse by using its view of causation under section 471(1) to restrict the deeming rule. The purpose of section 471(3) is to make that causation inquiry unnecessary. Treating subsection (3) as unavailable wherever subsection (1) might point the other way would deprive the deeming provision of substance. The argument that Vermilion bestowed no right because the 2007 option merely diminished the 2006 entitlement failed for the same reason: it was a causation argument addressed to the wrong question.
The Court also rejected the suggestion that Price v Revenue and Customs Commissioners supported a narrower reading. In the hypothetical discussed there, the concern was whether a bank’s non-employee customers would be caught merely because the bank employed other people. It did not support the view that an option actually made available by an employer to its own employee falls outside section 471(3). Lord Hodge found no anomaly, absurdity or injustice in taxing this option as an employment-related securities option.
Verdict: The Supreme Court unanimously allowed HMRC’s appeal. The 2007 option is treated as an employment-related securities option under section 471(3), so the gain falls to be taxed as employment income rather than as a capital gain. The Court did not decide the separate causation question under section 471(1), because the deeming provision made that inquiry unnecessary.
