HMRC recently published new guidance in its Business Income Manual on the availability of Corporation Tax relief for cash cancelled or net-settled employee share options.
These new pages set out HMRC's views on:
- The interaction between the accounting rules for share based payments (SBPs);
- The statutory basis for Corporation Tax relief in relation to employee shares under Part 12 CTA 2009;
- The general principles for Corporation Tax relief; and
- The income tax treatment of employees who receive SBPs.
The guidance includes a number of helpful examples which illustrate how the rules operate in practice.
It is likely that well informed clients will find that this new guidance merely confirms the accounting and tax treatment they are already applying, but this is a complex and often misunderstood area so the clarification of HMRC's position is appreciated.
Corporation Tax deductibility for share options
Corporation Tax deductibility in relation to share options often requires bespoke advice following an assessment of the relevant facts.
In very high level terms:
- The accounting principles usually require the employer company to recognise an expense in the accounts equal to the fair value of the option as at the date of grant, spread over the vesting period of the option (i.e. an SBP expense);
- UK legislation denies any deduction for Corporation Tax purposes for any SBP expense (s1038 CTA 2009), meaning that the employer must "add back" these amounts for the purpose of calculating taxable profits against which Corporation Tax is payable; and
- UK legislation provides a statutory basis for Corporation Tax deductibility when shares are acquired by employees (including in connection with the exercise of share options) and the relevant conditions are met (Part 12 CTA 2009). The amount of the deduction is the market value of the shares acquired, less any amount paid by the employee for the shares and the share option.
Cash cancelled share options
HMRC's new guidance confirms its views of the accounting and tax treatment where share options are cancelled in consideration for cash paid to the employee:
- The accounting principles will require the employer to reflect the cancellation as an acceleration of the vesting of the option and so include an expense for the SBP that would otherwise have been spread over the remainder of the vesting period;
- Any amount paid to the employee will be subject to tax (and NICs) as employment income;
- Amounts recognised as an SBP expense under accounting principles for the accounting period in which the share options are cancelled will be allowable as a deduction for Corporation Tax purposes to the extent such amounts relate to the options that have been cash cancelled because a corresponding charge to tax has arisen (s1038A(7) CTA 2009);
- If the employer makes a cash cancellation payment that is greater than the fair value of the option at cancellation, HMRC would expect the excess to be charged to the profit and loss account as a separate item which would be deductible under general principles (as a separate deduction) but there would be no relief available for the excess if it is charged to equity under applicable accounting principles;
- If within the statutory time period allowed for such amendment, previous years' Corporation Tax returns may be amended to take a deduction for the amount of SBP expense recognised in those earlier periods which relate to the cancelled option (but otherwise the UK tax rules correctly denied any deduction for these earlier period SBP expenses, and the cancellation will not resurrect these); and
- The maximum cumulative deduction for the cancelled options over all available periods will be the lower of the SBP expenses relating to the cancelled options and the amount on which the employee is subject to charge as employment income.
Net settled share options
‘Net settlement’ is an arrangement where the company reduces the number of shares it issues or transfers to an employee upon the exercise of an option in order to 'fund' the payment of the exercise price and/or tax liabilities (PAYE and NICs) relating to the option exercise.
The company will then effectively waive the exercise price and/or pay the tax liabilities to HMRC directly and the employee receives the number of shares which reflects this net amount after such deductions.
Many companies choose to do this to prevent unnecessary shareholder dilution arising from non-tax advantaged share plans.
HMRC's new guidance confirms its views of the accounting and tax treatment of net settled share options:
- A statutory deduction against taxable profits for Corporation Tax purposes will arise to the employer in the period the options are exercised in respect of the option shares which are acquired on exercise (the amount of the deduction being the market value of such shares);
- No statutory deduction is available in respect of the portion of the shares that have not been acquired by the employee as a result of the net settlement;
- Tax (and NICs) will arise in respect of the "full benefit of the option";
- amounts recognised as an SBP expense under accounting principles for the accounting period in which the share options are net settled will be allowable as a deduction for Corporation Tax purposes to the extent such amounts relate to the options that have been net settled rather than acquired because a corresponding charge to tax has arisen (s1038A(7) CTA 2009);
- If within the statutory time period allowed for such amendment, previous years' Corporation Tax returns may be amended to take a deduction for the amount of SBP expense recognised in those earlier periods which relate to the net-settled portion of the option (but otherwise the UK tax rules correctly denied any deduction for these earlier period SBP expenses); and
- The maximum cumulative deduction for the net settled options over all available periods will be the lower of (i) the SBP expenses relating to the net settled options and (ii) the amount on which the employee is subject to charge as employment income in respect of the net settled portion of the option (and for this purpose the amount subject to charge will need to be apportioned on a fair and reasonable basis between the acquired option shares and the net settled portion).
'Sell to cover' or 'gross settling'
'Seller to cover' or 'gross settling' is the arrangement by which a certain number of option shares are sold by or on behalf of the employee immediately after exercise of the option in order to fund the payment of the exercise price and/or tax (and NIC) liabilities.
The guidance also confirms HMRC's view that these arrangements will be treated for accounting and tax purposes like an ordinary exercise in full of the option, with a statutory Corporation Tax deduction arising to the employer on the full market value of the option shares – including those that are sold to fund the exercise price and/or tax (and NICs).
This new guidance is a helpful clarification of HMRC's views on this complex and often misunderstood area.
Employers who have cash cancelled or net settled employee share options should review the new guidance and may need to revise their Corporation Tax position or amend previous years' Corporation Tax return to account for any excess relief they have claimed in the past where they have taken a different view to that in HMRC's guidance.
Employers may also need to consider whether the window remains open to adjust previous returns to claim additional deductions for SBP expenses charged to previous accounting periods which may no longer be denied due to a later cash cancellation or net settlement.
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