Clause 416: Notional interest treated as paid if amount charged for beneficial loan

1791.     This clause is the equivalent of clause 184, interest treated as paid, in the benefits code and is written in the same terms.

1792.     It allows relief in respect of the benefit of a loan which falls within this Chapter, but prevents it from being treated as real interest paid under deduction of tax.

Part 7: Employment Income: share-related income and exemptions

Overview

1793.     This Part contains the provisions concerning the income tax treatment of share-related remuneration. The Chapters in this Part reflect the major divisions in the legislation relating to shares acquired by employees:

• Chapter 1 is introductory;

• Chapters 2 to 5 deal with topics whose principal purpose is to impose charges to tax by providing that certain share-related benefits count as employment income (see background in paragraphs 1797 to 1807); and

• Chapters 6 to 9 deal with income tax aspects of the various schemes and plans that confer tax advantages (see background in paragraphs 1808 and 1809). The clauses in these Chapters are supplemented in each case by a Schedule (see background in paragraph 1810) containing the administrative provisions for the scheme or plan in question.

1794.     Chapter 10 deals with a different topic: the exemption given to employees in connection with priority share allocations for employees when an offer of shares to the public is made. The material in Chapter 10 derives from section 68 of FA 1988.

1795.     This Part also contains a final chapter (Chapter 11) which contains supplementary provisions relating to employee benefit trusts.

1796.     This Part does not include any provisions dealing with the tax consequences of an employee acquiring employment related shares at less than market value. This topic is dealt with in section 162 of ICTA, which treats the acquisition of shares at less than market value as a notional loan to the employee, and uses the rules for beneficial loans to give a cash equivalent of the benefit. Section 162 also sets out the tax charge that arises when employment-related shares are disposed of for more than market value, treating the excess over market value as emoluments. Because of the relationship between section 162 and the rules on beneficial loans, those provisions appear, in this Bill, as part of the benefits code, in Chapters 8 and 9 of Part 3, following on from the chapter concerning the treatment of employment-related loans. There is a cross-reference to Chapters 8 and 9 of Part 3 in clause 418(1) of this Bill.

Background

1797.     Companies have often wished to reward employees by allowing them to acquire shares in the company on advantageous terms. As a matter of legal form, the company may achieve this objective in any one of three ways, for the employee may be given:

• shares (if the company issues its own shares direct to the employee);

• a purely monetary benefit (if the company allows the employee to acquire shares on advantageous terms); or

• an option (if the company grants the employee an option to buy shares in the company at some future date).

1798.     It is well established that if an employee is given shares, or is allowed to acquire shares on advantageous terms, the amount of the advantage is chargeable to income tax as an earning from the employment. The leading case is Weight (HM Inspector of Taxes) - v - Salmon (1935) 19 TC 174 (HL), where the taxpayer took up opportunities given to him to apply for unissued shares in the company at their par value, which was always less than their market value. The House of Lords held that the difference was an emolument of the taxpayer's employment. In the words of the basic charge to income tax under Schedule E, as it stood at that time, the taxpayer, who was a person "having or exercising an office or employment of profit" had received a "profit" from that office.

1799.     As a means of avoiding the charge to tax on such arrangements, established by the decision in Weight - v - Salmon, share option schemes became increasingly popular. These schemes differed; but, typically, a company granted to employees, for a nominal sum, an option to buy a stated number of shares at a stated price, which was normally their market value at the date of the grant. If the price of the company's shares rose, an employee could exercise the option and acquire shares at less than the market value then current.

1800.     The efficacy of share option schemes was tested in the case of Abbott - v - Philbin (HM Inspector of Taxes) (1960) 39 TC 82 (HL), [1960] 2 All ER 763, where the House of Lords had to consider two assessments to income tax for different years of assessment. The first assessment was for the year in which the taxpayer received the option. The decision regarding that assessment was that the taxpayer did receive an emolument during that year of assessment, but that the taxpayer obtained no benefit from it at that time, because the option was to buy at what was then the market value. The second assessment was for the year in which the taxpayer exercised the option. The House of Lords held, for that later year of assessment, that the advantage that arose was not a perquisite or profit from the office or employment during the year of assessment. Instead it was an advantage which accrued to the taxpayer as the holder of a legal right that he had acquired in an earlier year. (It might well have been possible to say that the taxpayer had made a gain from the disposal of an asset - the option - but capital gains tax was only introduced by FA 1965.).

1801.     Legislation to counteract the effect of the decision in Abbott - v - Philbin was enacted as section 25 of FA 1966, which imposed a charge to income tax when the option was exercised. This legislation was later re-enacted, and eventually became sections 135 to 140 of ICTA 1988. It now constitutes Chapter 5 of this Part of this Bill.

1802.     As a means of avoiding a charge under section 25 of FA 1966, share incentive schemes became increasingly popular. These schemes differed; but, typically, a company awarded shares subject to restrictions to employees. The restrictions might (for example) have the result that the shares carried no rights to receive dividends or to vote. The shares, consequently, might be expected to have only a low value. At a later date (or dates) the restrictions would be removed. The consequent increase in value, however, was not subject to the share option rules in section 25 of FA 1966: for the employee did not realise a gain by exercising an option to acquire shares. The shares were already owned.

1803.     Legislation to counteract share incentive schemes by charging the employee to income tax on the increase in the value of the shares was introduced in FA 1972. That legislation was considerably amended over the years; and successor legislation was introduced by sections 77 to 89 of FA 1988. That legislation is rewritten in Chapter 4 of this Part of this Bill.

1804.     At a later stage, long-term incentive plans came increasingly to be used. These schemes also differed; but, typically, a company awarded shares to employees, at no cost or at nominal cost, in circumstances where the employee was only able to enjoy the benefit of those shares if performance conditions specified at the time of the award were met. Some time later, after the performance conditions had been met, the employee would become fully entitled to enjoy the benefit of them.

1805.     It was initially assumed that there was no charge on the initial award of the shares, but that a charge arose when the employee became entitled to enjoy the full benefit of the shares. Prevailing practice reflected this assumption. However, the view was taken later that a charge arose on the initial award of the shares but not at the later time when the employee became fully entitled to enjoy the benefit of the shares.

1806.     Legislation was accordingly introduced in section 50 of FA 1998, which provided for sections 140A to 140C to be inserted into ICTA. The new legislation broadly restored the position to the previous practice - this time on a statutory basis. This legislation now constitutes Chapter 2 of this Part of this Bill.

1807.     Further legislation was introduced in section 51 of FA 1998, which provided for sections 140D to 140F to be inserted into ICTA. This legislation was aimed at counteracting possible tax avoidance where there was a conversion of one class of shares into another. As a result of such a conversion it was possible to devise structures under which employees could be provided with valuable shares as a form of remuneration without the full value of the shares being brought into charge to income tax. This legislation imposed a charge to income tax at the time of conversion. This legislation now constitutes Chapter 3 of this Part of this Bill.

1808.     But not all of the legislation relating to employees who acquire shares or options in the companies for which they work is of the type so far described. Various Governments have decided that they wish to confer various advantages on a range of schemes and plans. This has meant additional legislation to set out:

• the characteristics to be possessed by the scheme or plan before it may be approved;

• the tax advantages that an approved scheme or plan possesses;

• any procedure to be undertaken before the scheme or plan may be approved;

• any tax charges that will apply if the shares or options are removed from the scheme or plan (or other "inappropriate" actions are undertaken); and

• any supplementary provisions.

1809.     There are currently five different schemes or plans in existence:

• Approved profit sharing ("APS") schemes. The legislation relating to these schemes was originally contained in FA 1978; and that legislation was consolidated in sections 186 and 187 of, and Schedules 9 and 10 to, ICTA. These schemes are being phased out and they are not included in this Bill. There is a cross-reference to these schemes in clause 418(3).

• Approved save as you earn ("SAYE") option schemes. The legislation relating to these schemes was originally contained in FA 1980; and that legislation was consolidated in sections 185 and 187 of, and Schedule 9 to, ICTA. The legislation relating to these schemes now constitutes Chapter 7 of this Part and Schedule 3.

• Approved company share option plans ("CSOPs"). The legislation relating to these schemes was originally contained in FA 1984; and that legislation was consolidated in sections 185 and 187 of, and Schedule 9 to, ICTA. These schemes were then much affected by section 114 of FA 1996. The legislation relating to these schemes now constitutes Chapter 8 of this Part and Schedule 4.

• Share incentive plans ("SIPs"). The legislation relating to these schemes is principally contained in Schedule 8 to FA 2000, under the name "Employee share ownership plans". The legislation relating to these schemes now constitutes Chapter 6 of this Part and Schedule 2.

• Enterprise management incentives ("EMI"). The legislation relating to the options that qualify as EMI is principally contained in Schedule 14 to FA 2000. That legislation now constitutes Chapter 9 of this Part and Schedule 5 to this Bill.

Arrangement of material for share schemes

1810.     This Bill provides for a "code" for each of SIPs, SAYE schemes, CSOPs and EMIs. That "code" includes all the legislation relating to the particular scheme or plan, covering the tax advantages and any consequential tax charges plus all the rules relating to the qualification criteria and administration of the scheme or plan in question. The material in each "code" has been divided into two principal categories. The material dealing with the tax advantages and consequential tax charges has been placed in the main run of clauses in this Part of this Bill; but the administrative provisions have been placed in the supporting Schedules 2 to 5 to this Bill.

1811.     This approach is intended to streamline the legislation pertinent to the actual tax advantages offered, and any consequential tax charges, so that all the information with a direct impact on an employee's tax liability appears in one place in the body of this Bill.

1812.     The provisions relating to the qualification criteria for each code are likely to be relevant to different sets of people (e.g. the company setting up the scheme and its advisers). It therefore seems logical to separate these out and to place them in a Schedule separate from the main run of clauses concerning the taxation of employment income.

Chapter 1: Introduction

Overview

1813.     This short introductory Chapter consists of five clauses:

• Clause 417 is concerned with the scope of this Part of the Bill;

• Clause 418 is concerned with other provisions relating to share related income;

• Clause 419 introduces the provisions that impose duties to provide information to the Inland Revenue;

• Clause 420 deals with a computational matter of general application;

• Clause 421 deals with the application of this Part to office-holders.

Clause 417: Scope of Part 7

1814.     This clause, which is a drafting addition, introduces the provisions of this Part of this Bill. Those provisions contain special rules relating to employees or directors who acquire shares in companies, or options relating to such shares, in connection with their office or employment (see subsection (1)).

1815.     Subsection (2) then lists nearly all the chapters in this Part that follow this introductory Chapter. Of these, it may be said that Chapters 2 to 5 are primarily concerned with charges to income tax that may arise in certain circumstances. Chapters 6 to 9 then deal with the plans and schemes under which employees and directors may be offered shares or options on advantageous terms. And, finally, Chapter 10 deals with a particular income tax exemption that arises when employees or directors benefit from a priority allocation of shares.

1816.     Subsection (3) lists the chapters in this Part that provide for amounts to count as employment income; and subsection (4) lists the chapters in this Part that provide for exemptions and reliefs from income tax. Subsection (5) records that there is also a supplementary chapter (Chapter 11) which contains provisions about employee benefit trusts.

Clause 418: Other provisions about share-related income and exemptions

1817.     This clause, which is another drafting addition, sets out where other provisions dealing with share related income and exemptions may be found.

1818.     Subsections (1) and (2) list other provisions of this Bill that deal with share-related income and exemptions.

1819.     Subsection (3) deals with approved profit sharing schemes ("APS schemes"). This subsection explains that, in view of the phasing out of these schemes, the legislation relating to APS schemes has not been rewritten in this Bill. That legislation will accordingly continue to apply while APS schemes continue.

1820.     Subsection (4) preserves the effect of sections 138 to 140 of ICTA where shares or interests in shares were acquired before 26 October 1987.

Clause 419: Duties to provide information

1821.     This clause lists the provisions in this Part that impose duties to provide information to the Inland Revenue.

1822.     This clause is also a drafting addition, as, once again, it provides useful signposts to the various clauses that are relevant in this context. As these clauses are all placed near the end of the chapters in which they appear, they might otherwise be given insufficient attention.

Clause 420: Negative amounts treated as nil

1823.     The charges to income tax for which this Part of this Bill provides constitute "specific employment income" (see clauses 6(1) and 7(4) of this Bill). Under ICTA this income was charged to income tax under paragraph 5 of section 19(1) of that Act.

1824.     In this Part of this Bill, where deductions from a chargeable amount are permitted, the relevant provision signals this fact by using a formula.

1825.     This clause, which is new, gives effect to the general proposition that it is not possible for an allowable loss to arise under paragraph 5 of section 19(1) of ICTA. Deductions might reduce a chargeable amount to nil; but, beyond this point, they could not be used to create a negative amount and (accordingly) an allowable loss. See Note 43 in Annex 2.

Clause 421: Application of Part 7 to office-holders

1826.     The general rule is that the provisions of the employment income Parts apply equally to offices, unless the contrary is stated (see clause 5(1)). But, with one exception, the legislation rewritten in this Part does not apply to office-holders. This clause deals with these propositions for the whole of this Part of this Bill.

Chapter 2: Conditional interests in shares

Background

1827.     Where shares are awarded to employees by reason for their employment, their value (less anything paid for them) will generally be taxable as an emolument. If the shares have restrictions attached to them so that they are subject to risk of forfeiture (typically in the event of performance criteria not being met), the Inland Revenue view until 1998 was that there was not an emolument at the time of award and that liability only arose when the risk of forfeiture was lifted. Legal advice in 1998 showed that this view was wrong. Liability arose in the normal way at the time of award on the value of the shares taking into account the risk of forfeiture. No liability as an emolument arose at the time that the risk was lifted. Nor would the legislation in sections 77 to 88 of FA 1988 generally bite as there was no event giving rise to an immediate increase in value.

1828.     The legislation introduced by sections 140A to 140C of ICTA (together with supplementary provisions in sections 140G and 140H) is intended broadly to restore the position as it existed under the earlier practice. It applies to shares acquired on or after 17 March 1998. In essence the normal income tax emoluments charge on award is removed by section 140A unless the shares can still be subject to forfeiture more than five years after acquisition. The same section then imposes a charge (whether or not there is an emoluments charge) when the employee's interest ceases to be "only conditional", a term which is defined by section 140C. A number of situations are specifically excluded from counting as "only conditional" so that in those circumstances the normal rules of a charge on acquisition apply.

1829.     Sections 140G and 140H of ICTA contain supplementary provisions some of which apply solely to the provisions concerning conditional shares (sections 140A to 140C of ICTA), some of which apply solely to the provisions concerning convertible shares (sections 140D to 140F of ICTA) which were introduced at the same time and some which apply to both. In this Bill the provisions on convertible shares appear in Chapter 3. This does mean that those supplementary provisions which apply to both types of share have been duplicated, but the overall result is intended to be much easier to follow.

Clause 422: Application of this Chapter

1830.     Subsection (1) of this introductory clause derives from section 140A of ICTA and gives the two basic conditions for the provisions to apply. First, the shares must be acquired "as a director or employee" and that term is defined in clause 423. The second condition is that the employee's interest in the shares is "only conditional" as defined in clause 424. The fact that these provisions only apply to shares acquired on or after 17 March 1998 is made clear in Part 7 of Schedule 7 to which there is also a signpost in clause 418(1).

1831.     Subsection (2) is new and sets out a number of useful labels which make for less cumbersome drafting. The fact that this Chapter applies to prospective and former directors and employees is made clear by the reference to the expanded definition in clause 434(1).

Clause 423: Interests in shares acquired "as a director or employee"

1832.     Subsection (1) explains the circumstances in which shares are regarded as being acquired "as a director or employee". They are broadly equivalent to the circumstances in which a normal earnings charge would arise. The provision derives from section 140H(1) of ICTA. Subsection (1)(c) no longer says an assignment "to him" because if the assignment was to anyone else the shares would not have been acquired by E.

1833.     Subsection (2) adds refinement to subsection (1) and derives from section 140H(2) of ICTA with only minor modifications.

1834.     Subsections (3) and (4) are based on section 140H(4) of ICTA and explain the treatment when one conditional or convertible interest is exchanged for another.

1835.     Subsection (5) derives from the opening words of section 140H(4) of ICTA.

1836.     Subsection (6) contains the definition of "convertible shares".

Clause 424: Meaning of interest being "only conditional"

1837.     Subsection (1), which derives from section 140C(1) of ICTA, defines when an interest in shares is "only conditional". While section 140C of ICTA says "for the purposes of sections 140A and 140B", the definition is applied more widely by section 140H(5) of ICTA. Hence the definition is now applied "for the purposes of this Chapter".

1838.     Subsection (2) summarises the exceptions from subsection (1) which if they are present do not have the effect of lifting the acquisition charge. The exceptions derive from subsections (2), (3), (3A) and (4) of section 140C of ICTA.

1839.     Subsection (3) derives from section 140C(5) of ICTA and expands on the circumstances falling within subsection (1)(a). They are not regarded as including cases in which the employee can exercise a right requiring a person to acquire the shares at undervalue.

1840.     Subsection (4) relates back to subsection (1)(b) and derives from the closing words of section 140C(1) of ICTA.

1841.     Subsection (5) is new and reflects the latest legal advice that the term "articles of association" includes foreign equivalents thus widening the circumstances in which an interest is not "only conditional". See Note 44 in Annex 2.

1842.     Subsection (6) is supplementary to subsections (2)(b) and (c) and derives from parts of section 140C(3) and 140C(3A) of ICTA.

1843.     Subsection (7) derives from section 140(6) of ICTA.

Clause 425: Cases where this Chapter does not apply

1844.     This clause derives from two rules presently in section 140H(3) of ICTA.

1845.     The source legislation specifies that these provisions only apply to Case I employments. Subsection (1) rewrites this rule by applying the equivalent test that the earnings must be within clause 15 or 21.

1846.     Subsection (2) explains that the test in subsection (1) is to be applied to the final year of employment in cases where the award is made after the employment has ceased.

Clause 426: No charge in respect of acquisition of employee's interest in certain circumstances

1847.     This clause concerns the five year rule and derives from section 140A(3) of ICTA. In the typical case the conditions apply for less than five years at which point the employee has an indefeasible interest in the shares. In those circumstances no charge as an emolument arises on acquisition but this does not affect any charges that may arise under section 135 of ICTA (where the shares are acquired by exercising an option) or section 162 of ICTA (where the shares are acquired at undervalue).

Clause 427: Charge on interest in shares ceasing to be only conditional or on disposal

1848.     Subsections (1) to (3) derive from section 140A(4) of ICTA which imposes a tax charge when the risk of forfeiture is lifted or on the earlier disposal of the shares.

1849.     Subsection (4) is new and acts as a signpost to a provision removing the charge for shares awarded under an approved share incentive plan.

Clause 428: Amount of charge

1850.     This clause brings together those rules in subsections (5), (7) and (9) of section 140A of ICTA which concern the calculation of the taxable charge under clause 427. A formula has been introduced in subsection (1) to make the provisions more user-friendly.

1851.     The deductible amount provided by section 140A(7)(b) of ICTA is any amount chargeable in respect of the acquisition of the interest. It is not immediately clear what is meant by that phrase and the approach adopted here is to specify what is allowable. The three charges that are relevant are detailed in sub-paragraphs (b), (c) and (d) of subsection (2). See Note 45 in Annex 2.

1852.     Subsection (3) provides that charges under sections 78 and 79 of FA 1988 are deductible. It derives from section 140A(7)(c) of ICTA. The opportunity has been taken to make it clear that a charge taken under the FA 1988 provisions is not a deductible amount if it is generated by the same event which gives rise to the charge under this Chapter. This is because the FA 1988 provisions are subject to section 140A of ICTA so that the latter takes priority.