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Tax – Optional?

An interesting development occurred in a recent case heard by the Court of Appeal, Mansworth •Jelley, which, unfortunately, given the size of the sums involved, had no connection with me.

In the case before the court, the taxpayer received share options from his employer company when he was not resident in the UK. Later, after he had become UK-resident, he exercised the options and sold the shares. Jelley argued that he did not make any capital gain in those circumstances for the following reasons.

S17(1)(a) of the Taxation of Chargeable Gains Act 1992 provides that an acquisition or disposal shall be treated as made at market value where it is made in connection with employment or otherwise than by a bargain at arm&#39s length. Thus, the original options must be treated as acquired for their market value.

S144 provides that where an option is exercised, the grant and exercise are treated as a single transaction. Therefore, the market value rules must apply equally to the exercise of the option, leaving the taxpayer with shares having a base cost equal to their market value at their acquisition.

The Inland Revenue has announced that it accepts the decision and will not be appealing further. The Revenue has accepted that, where shares or other assets are acquired by options granted otherwise than by a bargain at arm&#39s length or because of employment, their acquisition cost is treated as the market value of the shares or other assets at the time the option is exercised. Where there is a grant of an option followed by exercise, the transaction must take its character from the grant of the option.

The Revenue interpretation of this decision allows employees to claim market value base cost in shares acquired on exercise of an unapproved or enterprise management incentive scheme option, regardless of how much they paid for the shares on exercise.

The result of the Revenue interpretation is that employees will potentially be able to get double tax relief on any gains made on their unapproved or EMI share options. This would work as follows:

If the employee receives an option with an exercise price of £1 and exercises when the shares are worth £3, he will have a gain of £2, chargeable to UK income tax. This will be part of his base cost in the shares acquired. However, the Revenue now says the employee&#39s base cost will also comprise the market value of the shares at the time they exercise the option (a further £3). Therefore, if the Revenue press release is right, the employee will have a base cost of £5. Were he to sell the shares the following week for their market value of £4, he will have a capital loss of £1 – which is clearly a surprising result.

One area which does not seem to cause the sorts of issues raised by this court case is where owners of a business grant options to each other to buy the share of a deceased or critically-ill owner.

The issue is that the surviving or continuing owners are unlikely to have enough funds to enable them to buy the share of the deceased or critically-ill owner. They can usually solve this by ensuring that each owner has enough life and critical-illness cover.

In choosing a provider, many factors will be important. Currently, the main issues are the changes to critical-illness definitions for cancer and the loss of guaranteed premium rates throughout life. It is essential, however, that these policies are held under suitably drafted trusts for the benefit of the other owners, to provide enough funds in their hands to buy the share of the departing owner.

Security can be given to all parties by ensuring that the shares can be sold and will be purchased. One approach to this is to use a binding contract for sale. However, it is recommended that each owner gives an option to the other owners to purchase the departing owner&#39s share in the event of their death or critical illness.

This cross-option approach achieves the desired result without jeopardising the inheritance tax business property relief that is generally available.

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