The final scope of Part 7A and the usability and clarity of the exclusions within it are important for share plans practice, as many companies currently rely on shares acquired by or held in EBTs to satisfy share awards and share options granted under their employee share plans. This is the main focus of this update.

Any decision by an employer or trustee to stop using EBT shares to meet already scheduled or expected share plan commitments, in order to prevent Part 7A charges before vesting of awards or exercise of options, could be quite disruptive, as:

Any unwitting step by an employer, or by EBT trustees, which results in an unexpected Part 7A income tax charge may be expensive and also damaging to the trustees' relationship with the employer and the employer's relationship with the affected employee. It could also lead to problems with liability for, and recovery of, PAYE and NICs. Accidental Part 7A charges could arise on a variety of normal EBT activities, such as a company funding an EBT to buy shares for future awards, or an EBT earmarking money or shares for a share plan award or for other deferred remuneration.

Fortunately, there is now a provision in Finance Bill 2011 for relief in respect of a previous Part 7A earmarking charge, if steps are taken to ensure the earmarked asset will no longer provide any benefit to the employee (see New provision for relief for an earmarking charge if no further relevant step will be taken).

Employees and directors with money or assets already earmarked for them within trusts (or similar arrangements) in connection with their employment or office may find that:

There has been little change to this aspect of the proposals as a result of the publication of the Finance Bill 2011.

The comments in this update reflect the views of the PLC Share Schemes & Incentives professional support team, based on the draft legislation. Obviously, the application of Part 7A has not yet been tested in practice or in court and you may not agree with some of our views. We are keen to hear from readers about their thoughts on the scope, application and likely impact of Part 7A. If you would like to comment or raise any issues you are particularly interested in, please e-mail PLC Share Schemes & Incentives.

One of the most difficult aspects of Part 7A for share plans is the potential for a tax charge when a relevant third person earmarks (however informally) any sum of money or asset for a later relevant step. In the original draft Part 7A (2010 Part 7A), the definition of earmarking as a relevant step referred only to "earmarks (however informally)". There was no definition of "earmark" (draft section 554B(1), ITEPA 2003, 2010 Part 7A).

Under the latest version (in which the section is now headed "earmarking etc" rather than just "earmarking"), earmarking is still a relevant step and there is still no definition of the term (draft section 554B(1)(a), ITEPA 2003, Part 7A). However, in addition, section 554B specifies that a relevant step will be taken if "a sum of money or asset otherwise starts being held by or on behalf of [a relevant third person], specifically with a view, so far as [that relevant third person] is concerned, to a later relevant step being taken by" any person (draft section 554B(1)(b), ITEPA 2003, Part 7A).

[PLC comment: This change extends the (already broad) scope of earmarking and makes it more likely that earmarking can take place without the trustees of an EBT even knowing for which employees it is intended that sums of money or assets are held for future steps (for example, if the employer ask the trustees to agree to satisfy awards that it plans to grant to a certain number of beneficiaries over in aggregate a certain number of shares, without giving the trustees full details). This will probably make it more difficult to warehouse shares in an EBT to satisfy planned share and share option plan awards without triggering a Part 7A charge, unless one of the Part 7A exclusions applies.]

For a Part 7A charge to arise, a "relevant third person" must take a "relevant step" for the purposes of an arrangement subject to Part 7A. Such an arrangement will relate to an employee, referred to as A, and an employer, referred to as B.

In the original 2010 Part 7A, and in the latest version, both employee A and employer B can be a "relevant third person" in their formal capacity as a trustee (if any). However, in 2010 Part 7A, the meaning of trustee for this purpose included any person who holds, or on whose behalf is held, or who manages, any money or asset under an arrangement which otherwise has no trustees (draft section 554A(8), ITEPA 2003, 2010 Part 7A). This would have the effect of bringing arrangements under which the employer or employee held or managed money or an asset within 2010 Part 7A that otherwise would not fall within it. As a result, there was some uncertainty as to whether 2010 Part 7A might apply unexpectedly to some direct transactions between employees and employers over which there should be no avoidance concerns, but where a Part 7A charge could be most inconvenient. This provision has now been removed (draft section 554A, ITEPA 2003, Part 7A).

In many cases, a parent company of an employer, or another company in the same group as an employer, provides pay or benefits to an employee. For example, it is very common for a group parent company to be the only company making share and share option awards to employees within its group, including the employees of its subsidiaries. It is also quite common for a group member to act as the employer of individuals who provide services as employees or officers to other group companies. As a result, since persons other than employee A and employer B could be relevant third persons without expressly being trustees, there were concerns that many ordinary commercial pay and benefits transactions would technically fall within 2010 Part 7A.

This has now been addressed and in the latest version of Part 7A, the following are not relevant third persons:

(Draft section 554A (8) - (9), ITEPA 2003, Part 7A.)

However, non-trustee group companies and non-trustee LLP subsidiaries will still be relevant third persons when taking any relevant step which is directly or indirectly connected with a tax avoidance arrangement (draft section 554A(10), ITEPA 2003, Part 7A).

This general exclusion for non-trust group company transactions is helpful. However, as currently drafted, some specific new exclusions for earmarking by trustees to satisfy awards of deferred remuneration, share plan awards and share options (other than awards and options under tax-favoured share plans) apply only to awards made by the employer itself and not to awards made by other group companies, trustees or non-trustee shareholders, even if made under a scheme set up by the employer's group (see New exclusion for earmarking money or assets to pay deferred remuneration, New exclusion for earmarking of shares to satisfy share awards or phantom share awards, New exclusion for earmarking of shares to satisfy exit-only phantom share awards and New exclusion for earmarking of shares to satisfy share options or phantom share options).

2010 Part 7A included exclusions for any relevant steps taken under various types of tax-favoured share and share option plans and arrangements, namely:

(Draft section 554E(1), ITEPA 2003, 2010 Part 7A.)

These exclusions are still set out in the latest version of Part 7A (draft section 554E(1)(a) - (d), ITEPA 2003, Part 7A), but an additional exclusion has been added for "excluded share arrangements" (draft section 554E(1)(e), ITEPA 2003, Part 7A).

Part 7A includes a new exclusion for steps taken by the Independent Parliamentary Standards Authority in relation to an MP (draft section 554E (8), ITEPA 2003, Part 7A).

[PLC comment: This may well be a practical necessity, as a result of the way MPs are paid and supported in their work and the very broad drafting of Part 7A. Given political sensitivities over MPs' expenses and pay, it may also be something that the government understandably wanted in the bill as introduced to parliament, rather than leaving it to be raised during the legislative process in the House of Commons. But it may generate some wry comment from employers and advisers who might feel that similarly straightforward exclusions should have been drafted for their own practical and commercial needs.]

There is a new exclusion for relevant steps within draft section 554B, ITEPA 2003 (earmarking or holding for a later step) taken by a relevant third person in respect of money or an asset which only represents part or all of any deferred remuneration awarded to employee A by employer B (draft section 554H, ITEPA 2003, Part 7A). The exclusion is not restricted to money or assets of any particular description.

There is a new exclusion for relevant steps within draft section 554B, ITEPA 2003 (earmarking or holding for a later step) taken by a relevant third person in respect of shares to be used to satisfy deferred share awards or deferred phantom share awards made (before the earmarking) or to be made (after the earmarking) to employee A by employer B (draft section 554J, ITEPA 2003, Part 7A). (The term "phantom share award" is not used in Part 7A, but section 554J applies to an award of "a sum of money the amount of which is to be determined by reference to the market value of shares at the time" of payment. For a discussion of a similar kind of award, see Ask the team: Using phantom share options. We think the provisions in Part 7A which relate to phantom share awards and phantom share options are the first provisions in the UK tax legislation to refer so explicitly to these types of award.)

This is one of three exclusions for employee share schemes - they are all titled "Exclusions: earmarking for employee share schemes", and numbered (1), (2) and (3). This exclusion is numbered (1) and appears to be intended to cover performance share plan (PSP) (also commonly called long term incentive plan or LTIP) awards or similar awards of shares, or any cash-settled arrangements which operate in a similar way.

In many respects, this exclusion is similar to the deferred remuneration exclusion in draft section 554H (see New exclusion for earmarking to pay deferred remuneration) and the share option exclusion in draft section 554L (see New exclusion for earmarking of shares to satisfy share options or phantom share options).

There is a new exclusion from Part 7A for relevant steps within section 554B (earmarking or holding for a later step) taken by a relevant third person in respect of shares to be used to satisfy phantom share awards made (before the earmarking) or to be made (after the earmarking) to employee A by employer B (draft section 554K, ITEPA 2003, Part 7A). (The term "phantom share award" is not used in Part 7A, but section 554K applies to an award of "a sum of money the amount of which is to be determined by reference to the market value of shares at the time" of payment. For a discussion of a similar kind of award, see Ask the team: Using phantom share options.)

This is one of three exclusions intended for employee share schemes - they are all titled "Exclusions: earmarking for employee share schemes", and numbered (1), (2) or (3). This exclusion is numbered (2) and is intended to cov er only cash-settled awards that will vest on an exit event.

There is a new exclusion from Part 7A for relevant steps within draft section 554B, ITEPA 2003 (earmarking or holding for a later step) taken by a relevant third person in respect of shares to be used to satisfy share options or phantom share options and granted (before the earmarking) or to be granted (after the earmarking) to employee A by employer B (draft section 554L, ITEPA 2003, Part 7A). (The term "phantom share option" is not used in Part 7A, but section 554L applies to the award of a "relevant share option", which is defined to include "a right to receive a sum of money the amount of which is to be determined by reference to the market value" of shares at the time of payment. For a discussion of phantom share options, see Ask the team: Using phantom share options.)

This is one of three exclusions intended for employee share schemes - they are all titled "Exclusions: earmarking for employee share schemes", and numbered (1), (2) and (3). This exclusion is numbered (3) and is intended to cover share options and phantom share options.

In the original 2010 Part 7A, there was a provision that the Part 7A charging provisions (Chapter 2 of Part 7A) would not apply "by reason of ... an acquisition of an employment-related securities option if section 475(1) applies to the acquisition".

(Draft section 554H(1)(b), ITEPA 2003, 2010 Part 7A.)

This has now been amended to specify that the Part 7A charging provisions (Chapter 2 of Part 7A) will not apply "by reason of a relevant step the subject of which is an employment-related securities option if-

(a) by virtue of the step, the option is acquired by a person, and

(b) section 475(1) applies, or would apply apart from section 474(1), to the acquisition."

(Draft section 554M(2), ITEPA 2003, Part 7A.)

Section 475(1), ITEPA 2003 excludes an income tax charge on acquisition of an employment-related securities option (with a minor exception for certain CSOP options). Section 474(1), ITEPA 2003 excludes all of Chapter 5 of Part 7 of ITEPA 2003 (the special provisions for taxation of employment-related securities option) if the relevant employee is not UK resident. Draft section 554M(2), ITEPA 2003 therefore excludes relevant steps on the grant of an employment-related securities option whether or not the employee is UK resident. One point to beware of is that an option will not be an employment-related securities option if acquired pursuant to a tax or NICs avoidance arrangement (section 420(8), ITEPA 2003).

There is a new exclusion from Part 7A for short-term loans made by a relevant third person to allow an employee to exercise a share option.

(Draft section 554M(7) - (11), ITEPA 2003, Part 7A.)

Arrangements of this description are a type of cashless exercise facility. Very often, employee share options have the exercise price set at the market value of the shares under option at the time of grant. Without a cashless exercise facility of some kind, a market value option over shares with significant value at the time of grant will obviously require the employee to have sufficient liquid cash to fund exercise, even if the current value of the shares is much higher than the exercise price and the option shares would be readily saleable immediately after exercise. However, a cashless exercise facility which operates by way of a loan might give rise to a Part 7A charge, as payments by way of loan from a third party will be relevant steps if "taken ... in pursuance of" an arrangement "concerned ... with the provision of rewards or recognition ... in connection with A's employment by B" (draft section 554A, ITEPA 2003, Part 7A) which obviously includes arrangements connected with an employee share option. Many such loans will not fall within a Part 7A exclusion such as that for commercial transactions (draft section 554F, ITEPA 2003, Part 7A). While there are financial firms which offer commercial cashless exercise facilities, at present cashless exercise facilities are also offered by some EBTs.

The main limitations of the new exclusion for cashless exercise loans are:

There is a new exclusion for certain employee car ownership schemes, as promised in the 2011 Budget.

(Draft section 554N, ITEPA 2003, Part 7A.)

Finance Bill 2011 includes new provisions under which the option exercise price due under a relevant option will be taken into account in certain circumstances in computing any Part 7A earmarking charge which relates to that option.

(Draft section 554Z6, ITEPA 2003, Part 7A.)

Relief under section 554Z6 is a potentially important feature of Part 7A, as:

The provisions for credit to be given in computing a Part 7A tax charge for consideration given by employee A to the relevant third person in respect of a taxable step have been amended (see draft section 554Z7, ITEPA 2003, Part 7A).

Part 7A raises serious difficulties for share plans under which payment for shares by the employee is deferred, or to be paid in instalments, at least if the shares are to be acquired from a relevant third person and not directly from the employer or any other group company. This is because Part 7A as set out in the Finance Bill 2011 gives credit for cash consideration given by the employee only if paid "before, or at or about, the time" of the transfer of the shares to the employee (draft section 554Z7(5), ITEPA 2003, Part 7A). This is only a slight improvement on the original 2010 Part 7A provision for credit to be given for cash consideration only if paid before the transfer to the employee (draft section 554O(1), ITEPA 2003, Part 7A).

For more information on deferred payment share plans, see Practice note, Nil paid share schemes: an overview.

Finance Bill 2011 includes a new provision for relief to be given (to employee A, or if A has died, his personal representatives) in respect of Part 7A income tax paid on a previous earmarking step.

(Draft section 554Z13, ITEPA 2003, Part 7A.)

The conditions for the relief are:

(Draft section 554Z13(1) - (4), ITEPA 2003, Part 7A.)

If satisfied that the conditions of the section are met, HMRC must give such relief as it "considers just and reasonable" in respect of the previous Part 7A tax charge and any amount charged to income tax under section 222 of ITEPA 2003 as a result of that primary tax liability.

(Draft section 554Z13(5)-(9), ITEPA 2003, Part 7A.)

[PLC comment: This new section is potentially very helpful, as it appears to allow the unwinding of an unwitting earmarking step, and will also allow relief if an award lapses unpaid after an intentional earmarking step. It is striking that the relief also covers any associated section 222 liability. Although this is welcome, section 222 liabilities can affect employees very harshly in other contexts too - see, for example, Legal update, Court of Appeal dismisses appeal against tax charge under section 144A ICTA 1998 (section 222 ITEPA 2003). Relief may be justifiable in the case of Part 7A earmarking charge as, once the subject of the earmarking can no longer be used to benefit the employee, he will receive nothing at all in respect of the value on which he has paid income tax.]