tax on share options - Concept for Gains made from shares and share options - subject to income tax

Money earned directly from employment is of course taxed as income, but can gains made from shares, share options, and the like be subject to income tax?

Income Tax (Earnings and Pensions) Act 2003 (ITEPA)

Under the Income Tax (Earnings and Pensions) Act 2003 (ITEPA), securities or securities options will be taxed as income where the right or opportunity to acquire the security or the option is available “by reason of an employment of that person…”pursuant to s421B(1) and s471(1) of ITEPA.

This would include situations where employees are, for example, granted shares in exchange for their services. However, less obviously, it will also include situations in which securities or options are made available by someone who just happens to be your employer, or someone connected with your employer, regardless of the reason. These situations will be caught by ITEPA, even if the opportunity does not arise because of one’s employment, due to a “deeming provision” in the Act. Sections 421B(3) and 471(3) of ITEPA says that when the opportunity is made available simply by an employer, or by a person connected to the employer, then it “is to be regarded … as available by reason of an employment…”.

Because of the apparent disconnect between the wording of the key provision in the ITEPA (“by reason of an employment”) and the broad brush applied by the deeming provision, it was unclear how the courts would treat the law in practice. Helpfully, the issue has now been considered by the courts in the recent Scottish case of Commissioners for His Majesty’s Revenue and Customs v Vermilion Holdings Ltd.

In Vermilion, a taxpayer was granted an option by a company which employed him as an executive director.  The option was granted to replace an option granted to the taxpayer before he was an employee, and therefore the new option was not granted because the taxpayer was an employee. Because he was not granted the option by reason of his employment, the taxpayer believed that he should pay capital gains tax on the gain he subsequently made. HMRC had a different view and claimed that the gain was taxable as income.

The case was considered by four different courts in succession, the First-Tier Tribunal, the Upper Tribunal, the Inner House of the Court of Session, and finally the Supreme Court. Each time it was heard the decision was reversed, until the Supreme Court gave the last word. Technically, the Supreme Court’s decision is binding only in Scotland because the case is a Scottish one. However, the decision would be considered persuasive authority in England and Wales.

The Supreme Court decided that there was no need to assess whether the facts fit within the meaning of “by reason of” an employment. The company that made the option available to the taxpayer was his employer, and therefore under the deeming provision it should be regarded as being by reason of his employment. It doesn’t matter whether the employment is in fact the reason for the security or option being made available, it is simply deemed to be the reason.

In reaching the decision, the Supreme Court referred to an earlier case from 2020 (Fowler v Revenue and Customs Commissioners) which offered some more general guidance on this sort of deeming provision. In Fowler, Lord Briggs JSC acknowledged that deeming provisions create ‘legal fictions’ (in other words, they declare that something is true for the purposes of the law, even when it is not strictly true). However, he said plainly that, when Parliament has chosen to create a legal fiction, the court should not “shrink” from applying that fiction to the inevitable consequences.

Are there any exceptions?

If you receive shares or options that are made available by your employer, or by a person connected with your employer, this will be taxed as income regardless of whether they were made available because of your employment. There are very few exceptions. There is a very limited exception to the deeming provision if the recipient is an individual and the right or opportunity is made available in the normal course of their domestic, family or personal relationships.

Please do get in touch with our Corporate team if you have any questions.

This article was jointly written by Catherine Carlton, partner, and Charles Jones, paralegal, in our Corporate team.