Although it may go unnoticed by the world at large, HM Revenue & Customs (HMRC) recently issued a further release on the subject of the correct tax treatment of unapproved options. While this may appear a fairly dry subject at first, the history to the recent announcement is illuminating and highlights issues that are of concern to all taxpayers (and not just those who are affected by the recent announcement).
Mansworth (HMIT) v Jelley [2002]
Back in the late 1980s and the early 1990s, Colin Jelley, head of tax and financial planning at Skandia, exercised some options he had been granted a few years earlier and immediately sold the shares. A dispute arose between him and the Inland Revenue (the Revenue), as it then was, on the correct method of calculating his gain (and in particular on the amount he was entitled to deduct from the proceeds on account of the cost of acquisition of the shares). The dispute centred on the interaction between two provisions of the capital gains code:
- the first provided that where an asset was sold and acquired otherwise than by way of bargain at arm’s length, the consideration treated as paid for the asset was to be the market value of the asset; and
- the second provided that where an option was exercised, the grant and exercise should be treated as a single transaction.
The Revenue accepted that the grant of the option, being in respect of past service, was a bargain otherwise than at arm’s length. It contended, however, that the exercise of the option was a bargain at arm’s length. The result was that the cost of the shares, for tax purposes, was the amount paid on exercise (which, as is common, was in this case less than the shares’ market value).1 On the other hand, Jelley argued that both the grant and exercise were otherwise than by way of bargain at arm’s length and that the acquisition cost was therefore the market value of the shares at the time of exercise (with the result that no gain arose to Jelley). Both the High Court and the Court of Appeal agreed with the taxpayer and rejected the Revenue’s arguments.
The decision might well have never been heard of again. After all, in the Court of Appeal, Chadwick LJJ expressed the view that:
‘It is, perhaps, pertinent to note that the particular issue raised by this appear is unlikely to be of widespread concern.’1
However, the decision was raised again by the statement of practice issued by the Revenue following its defeat.
Shortly after the publication of the Court of Appeal, the Revenue issued guidance on the effect of the decision. It started, uncontroversially enough, by stating that the acquisition of the cost of the shares is their market value at the time of exercise. However, paragraph 3 dropped the proverbial bombshell by stating that the cost of the shares for tax purposes is their fair market value plus the amount on which income tax is charged on exercise of the shares. This throwaway comment, for which no justification was given and which appeared unsupported by the case itself, ensured that, at the stroke of a pen, most employees exercising an option would realise a capital loss that they could use to reduce their tax bill. The Revenue’s guidance was met with something approaching incredulity. Numerous commentators pointed out that the position produced a perverse economic result and seemed unsupported by both legislation and precedent.
Undeterred, the Revenue expanded on its guidance a couple of months later and even amended it to take account of some criticism of it made in Taxation magazine.3 The net effect was that several taxpayers were able to amend their tax returns to claim the benefit of the loss that the Revenue’s guidance had created.
Readers might be excused for thinking that this was all a bit of a storm in a teacup. The law was changed soon after the Revenue’s guidance was issued in 2003, with the result that the exercise of an option no longer gave rise to a completely artificial loss. And there things might have remained had it not been for a rather extraordinary release by HMRC earlier this year.
The release stated that HMRC had taken legal advice on the effect of Mansworth, which advice had confirmed what most people had realised some time ago: the Revenue’s interpretation of Mansworth was wrong. One wonders what led HMRC to seek advice on this subject and publish it more than six years after original press release. The recent release did beg the question of how the old guidance had been arrived at; presumably no advice was taken at the time.
For those not completely au fait with the complexities of the self assessment system, this release might be of interest in that it highlights the position they find themselves in where they make a self-assessment return that is regarded as correct, but subsequently turns out to have been made on an incorrect basis, eg because a court decision goes against what was understood to be the correct interpretation of a statutory provision. In general, where the time limit for the opening on an enquiry of the taxpayer’s return has not expired, the taxpayer will be free to amend it. However, where that time limit has passed, the taxpayer is prevented from re-opening their return if the return was made on the basis of the practice generally prevailing at the time. HMRC will also be free to amend the return where there is a current enquiry into it, even if that enquiry has nothing to do with the correct tax treatment of the exercise of an option.
Comment
HMRC’s repeated change of heart on the meaning and correct interpretation of Mansworth will no doubt have caused some embarrassment at HMRC. Some taxpayers will have benefited by being able to claim wholly artificial losses against real gains. For others, the change of heart will be an annoyance as they will be required, yet again, to amend their self-assessment returns. However, there is a more ironic postscript to all of this: HMRC is in the process of consulting with interested parties on the role of tax agents. The most recently published paper from HMRC deals at some length with the standard of competence that HMRC expects from tax agents and how HMRC will enforce such standards, its preferred method at the moment being to have a right to review the work of agents that it considers fall below the expected standard. Will it now be necessary to set up an agents’ representative body to review HMRC’s reaction to decided cases?
By Blaise Marin-Curtoud, partner, Jones Day.
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Mansworth (HMIT) v Jelley EWCA Civ 1829
- 1This article criticises HMRC for various changes of position. It is therefore only fair to point out that the arguments advanced by HMRC in Mansworth were consistent with long-held positions of HMRC that were known to taxpayers and their advisers.
- 2His view was based on the fact that some years before Mansworth, the law had been changed to provide that the acquisition of the option should not be treated as by way of bargain otherwise than at arm’s length, a view that seems to have got lost in the commotion following the guidance issued by HMRC.
- 3‘Jelley Wobbles’, Sue McDonald, p141, Taxation, 8 May 2003.