The Vermilion case: when is a securities option “employment-related”?

On 25 October 2023, the Supreme Court published its ruling in Vermilion Holdings.  The case confirms the court’s approach to determining when a securities option is “employment-related” for the purposes of section 471 Income Tax (Earnings and Pensions) Act 2003 (section 471).  The decision provides some clarity on the application of the “deeming provision” in section 471(3) which automatically treats a securities option as being employment-related unless a limited exception applies.  

The Supreme Court rejected the First Tier Tribunal’s (FTT) view that the deeming provision is subsidiary to the causal test in section 471(1).  Instead, it concluded that the deeming provision is a standalone test that should be applied first whenever there is an employment relationship at the time the securities option is made available.

This means whenever the right or opportunity to acquire a securities option is made available by an employer (or a person connected to the employer) to a person at a time when they are employed, the securities option will almost certainly automatically be employment-related unless the employer is an individual and the securities option was provided in the normal course of the domestic, family or personal relationships.  Any broader questions to determine why the employer awarded the securities option are irrelevant.  

What were the facts?

In 2006 Vermilion Holdings Ltd (Vermilion) granted a share option over 4.5% of its shares (2006 Option) to Mr N to be held by his nominee company: Quest Advantage Ltd (Quest).  Vermilion got into financial difficulties and in 2007, its investors agreed a rescue funding plan.  The investors agreed to bail out Vermilion if Mr N: (i) became a director of Vermilion, and (ii) accepted a new option over a smaller shareholding.  Instead of varying the 2006 Option, Vermilion granted Quest a new option to acquire 1.5% of Vermilion’s share capital (2007 Option).  The 2006 Option would lapse from the date of grant of the 2007 Option.  Importantly Vermilion granted the 2007 Option after it appointed Mr N as a director.

In 2016, the 2007 Option was novated and Mr N replaced Quest as the option holder. Mr N exercised the 2007 Option and applied to HMRC for non-statutory clearance that the gain was liable to capital gains tax as opposed to income tax.  HMRC considered the 2007 Option was an “employment-related securities option” and therefore the taxable amount was employment income of Mr N.

What was the issue?

The issue for the court was whether the 2007 Option was an employment-related securities option under section 471.  Section 471 defines the types of securities option which constitute “employment-related securities options”. The exercise of an employment-related securities option is brought within the charge to income tax instead of being subjected to capital gains tax.  Under section 471 there are two separate tests:

• Subsection (1) asks whether the right or opportunity to acquire the securities option is available by reason of an employment of that person or any other person.
• Under subsection (3), a right or opportunity to acquire a securities option is always treated as being employment-related where it is made available by a person’s employer, or a person connected with a person’s employer unless (a) the person by whom the right or opportunity is made available is an individual, and (b) the right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person.

Subsection (3) is often referred to as “the deeming provision” as it avoids questions of causation raised under the test in subsection (1).  Under subsection (3) a securities option is automatically “employment-related” unless the (narrow) exception under (a) and (b) applies.

Applying a “but for” test, the First Tier Tribunal (FTT) considered Vermilion did not make the 2007 Option available to Mr N by reason of his employment.  The FTT agreed with Vermilion that the 2007 Option emanated from the right which had existed under the 2006 Option rather than his appointment as director.  On that basis the test under subsection (1) was not met.  After that determination the FTT considered the deeming provision.  It held the court should limit the application of the deeming provision where a literal interpretation gave rise to any injustice or absurdity in its result.  

The taxpayer lost on appeal to the Upper Tribunal who found the FTT had erred in law.  The Court of Session allowed Vermilion’s appeal by a majority (The Lord President, Lord Carloway, dissenting) after which the Supreme Court heard the case.  

The Supreme Court decision

The Supreme Court considered it could decide the appeal by applying the deeming provision in section 471(3).  

In a pithy judgment, Lord Hodge said the deeming provision under section 471(3) is a standalone test.  The first question to address when approaching this issue is whether the deeming provision applies.  This is precisely because it circumvents the potentially more difficult questions of causation under section 471(1).  To subordinate the deeming provision to subsection (1) would effectively rob it of its purpose.  In enacting the deeming provision Parliament created a “bright line rule”: if a person’s employer provides the employee the right or opportunity to acquire a securities option, that right or opportunity is conclusively treated as employment-related (unless the exception applies).  

In other words, where someone is employed at the time when the securities option is made available, one should turn straight to the deeming provision and ignore the causal test under subsection (1).  The broader questions considered by the majority of the Inner House as to why the option was granted were not relevant.  Instead, the issue boiled down to a simple finding of fact: did Vermilion confer the 2007 Option on Mr N’s nominee while Mr N was its employee?  The answer is that it did and therefore the 2007 Option was an employment-related securities option.  

Both the FTT and the majority of the Inner House considered that the application of the deeming provision produced an absurd, anomalous, or unjust result.  Lord Hodge disagreed stating: “There is to my mind no anomaly, absurdity or injustice in giving effect to the deeming provision of section 471(3) in this case. As I have said, the purpose of section 471(3) is to circumvent the difficult issues that can arise in the application of section 471(1). The statutory provision makes clear that if an employer makes available to an employee a securities option, that option will be treated in the employee’s hands as an employment-related securities option and taxed accordingly. Vermilion, which at the relevant time was Mr Noble’s employer, made available to his nominee such an option. Vermilion’s reason for so doing is irrelevant when section 471(3) applies.”

What does this mean?

This was the first time the UK Supreme Court has reviewed the scope of Part 7 of ITEPA 2003.  Alongside providing clarity on section 471, the case will be useful in interpreting the near identical tests in section 421B and possibly other deeming provisions elsewhere in the Benefits Code.  

The Supreme Court’s approach means in most cases it should be straightforward to determine whether an award is employment-related.  

The decision also means the scope of section 471 is very broad.  For example, it is now clear that the rules catch non-executive directors (NEDs) who are already appointed when they receive awards.  Any arguments that such awards were granted for reasons other than their directorship (e.g. in return for investment, or in reward for services provided on a self-employed basis) will not be relevant where the deeming provision applies.  This has broader consequences.  For example, NEDs acquiring restricted securities should consider making a section 431 election.  

However, the deeming provision will not always be in point:

• The carve out for family and personal relationships allows the owner of a company to give or sell their shares to a friend or relative who is also for example a director of the company without necessarily falling within the scope of Part 7.  However, care should always be taken to examine the circumstances.  For example, the exception will not apply if the shares are received by an employee as an element of their remuneration and that individual also happens to be a friend or relative of the founder who is giving their shares.  In this instance the arrangement will be caught by the causal test under subsection (1).  
• As a standalone test, it appears subsection (3) will not catch former or future employees because the extension of “employment” to historic or prospective employment is expressed as applying to the causal test.  For those individuals, it will still be necessary to explore the reason why the shares or options were issued.