UK - Pitfalls On The Exercise Of Employee Share Options - 2 Feb 2009

United Kingdom: PAYE: Pitfalls On The Exercise Of Employee Share Options

02 February 2009
Article by Nicholas Stretch and Isabel Pooley

http://www.mondaq.com/article.asp?articleid=73506&email_access=on&login=true

 The recent case of Chilcott, Griffiths and Evolution Group
Services v Revenue & Customs has highlighted a pitfall for
employers and employees where PAYE is not properly operated on the
exercise of employee share options or other share-related
income.

Typically, PAYE is operated by the employer deducting the tax
due from the proceeds of the sale of the shares. The problem is
that where the right amount is not or cannot be deducted and the
employee subsequently fails within the relevant timeframe to put
the employer in funds to cover the PAYE due, further tax (and not
just interest and penalties) automatically becomes chargeable on
the amount still due from the employee.

Until 2003, there was a 30-day deadline for the employee to put
the employer in funds, but this has since been extended to 90 days.
However, what is surprising and causes this tax to be seen as
particularly unfair is that this additional charge will still arise
even if the employee reimburses the employer after the 90-day
deadline or pays the tax himself.

In the Chilcott case, which confirmed that the
additional charge was due, PAYE was not paid over by employees in
time because of uncertainty on the part of the employer as to
whether tax was due at all on exercise of the options.

However, uncertainty over how much PAYE to deduct can also arise
in a number of more common situations, including where there are
overseas duties. This article looks at the Chilcott case
and its impact in other situations.

The Chilcott case

Share options were granted to two directors who were founder
shareholders. When the directors exercised their options, the
company did not account for PAYE believing the options were
acquired by the directors as founders rather than as employees and
that therefore the gains were not taxable as employment income.

It was subsequently conceded that they were employee options and
the directors themselves paid the Revenue the relevant amount of
income tax due on the exercise of the options under
self-assessment. However, this was some time after the statutory
time limit for reimbursement of PAYE and in any case their payment
was a payment to the Revenue, not to their employer.

Where an employee has not put the employer in funds to account
for PAYE within 90 days, section 222 of the Income Tax (Earnings
and Pensions) Act 2003 imposes an additional income tax charge on
the amount of the shortfall. The employee therefore has to pay tax
not just on the exercise gain he has made but also on the tax
itself

Many would regard this as unfair. If an employer does not
properly subject a cash bonus to PAYE, all that is additionally
payable are interest and penalties. However, with share-related
income, while the employer has liabilities as well (not discussed
in Chilcott) the unpaid tax is treated as additional
income (even if the employee subsequently puts the employer in
funds for the PAYE). It is difficult to see why PAYE non-compliance
with share schemes is so harshly treated compared with other forms
of PAYE income.

Indeed, the directors argued that this charge was penal and/or
that it amounted to double taxation and so should not be payable.
However, the Special Commissioner rejected the directors'
arguments that the further charge was penal since the statutory
charge did not involve any penalty; rather the provision simply
imposed a charge to tax if the various preconditions set out were
fulfilled. The Special Commissioner was similarly unreceptive to
the taxpayers' claim of double taxation as the extra charge was
explained to be a form of surcharge, imposed because of the
directors' late reimbursement.

Accordingly, the extra tax was payable. The tax due on the
exercise of the options was £827,743 (which the directors had
paid) and so, at a tax rate of 40%, the extra tax payable by the
directors was £331,097. This amounted to an effective tax
rate of 56%. Unusually though, the additional tax is a
self-assessment liability of the employee and so the employer did
not have to collect it through the PAYE system.

Impact on employers

The facts in Chilcott were rather unusual and the company
adopted what seems in retrospect a particularly aggressive approach
in claiming that there was no employment income tax charge at all.
However, common situations where PAYE might not be operated in full
include:

• Private companies, where employee share options are only
  subject to PAYE if they are "readily convertible assets"
  at the time of exercise. Although it will be clear in exit
  situations where there is a buyer for the company that the shares
  are then readily convertible assets, it is debatable whether the
  shares are readily convertible where there are just provisions in
  the articles of association where the company can find a buyer for
  leavers' shares or an employee trust is available to buy
  shares. Employers and employees therefore need to be cautious about
  not operating PAYE in these cases. Further problems can also arise
  in relation to valuation of private company shares.


• Approved option schemes where it is believed that gains are
  sheltered by virtue of the scheme but it is then discovered
  approval has been lost or does not apply (e.g. because the Revenue
  disputes share values when options were awarded or other statutory
  conditions are not satisfied on exercise).


• Non-resident employees and other employees not permanently in
  the UK. In simple terms, income will be split between UK and non-UK
  duties over the vesting term of the option or award. In many cases,
  PAYE obligations only apply in respect of the UK duties and so
  employers will apportion the gain for UK tax purposes. The danger
  is that a failure to subject a sufficient proportion of the share
  award to UK tax and PAYE on exercise/vesting can give rise to the
  additional charge simply because the right amount of PAYE has not
  been accounted for. In many cases the now 90 day window for setting
  up the correct amount should give enough time, but where
  day-counting and double tax treaties need to be considered, these
  further complexities make the deadline tight.


• The charge applies to all share-related income, not just
  options. For example, it would apply on exits where there is
  uncertainty on whether the particular shareholder arrangements for
  employees give rise to an income tax charge (eg a ratchet or other
  forms of employee preference). We have experience of how to
  preserve the employees' position without paying over the full
  amount of PAYE to the Revenue.


• In all cases, the problems arise even if the employee is
  completely unaware of the underdeduction (although in the Chilcott
  case, the directors clearly supported the company's
  stance).

There are three final points to note:

First, although the additional charge is one for employees to
pay through their tax return under self-assessment, employers still
have a reporting requirement and also have to pay employee's
and employer's NICs on the unreimbursed PAYE. However, even if
the employer does not have to pay the extra tax, employees are not
likely to thank their employers for visiting an extra tax charge on
them if they relied on their employers to deal with PAYE properly
only to discover that the employer made a mistake.

Secondly, the PAYE charge is worked out on the basis of what the
employer's "best estimate" of the tax is. So, if the
employer calculates it on the basis of all available evidence but
the evidence of the position subsequently changes, this in itself
does not mean that the amount of PAYE deducted was wrong. This may
be particularly relevant where there have been overseas duties.

Finally, the Revenue do not always impose a further tax charge
where the employee fails to put the employer in funds to meet PAYE
within the statutory time limit. However, this case shows that
there is always a risk of the Revenue taking the point.

Case reference

J E Chilcott (1); R I Griffiths (2); Evolution Group
Services Ltd (3) v Revenue & Customs [2008] UKSPC SPC00727 (18
December 2008)

To view the case, click here.

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The original publication date for this article was
28/01/2009.