EBTs beware: new Part 7A exclusions for share plans are restrictive and complex

The first draft of Finance Bill 2011 includes a new Part 7A of the Income Tax (Earnings and Pensions) Act 2003, based on previously published draft legislation to tackle disguised remuneration tax avoidance. Various amendments and new exclusions for deferred remuneration and employee share and share option plans have been added to Part 7A, but some important new exclusions are restrictive and complex.

From 6 April 2011, trustees of employee benefit trusts (EBTs) will need to take great care over any steps related to share or share option plans and other deferred remuneration. (Free access.)

PLC Share Schemes & Incentives

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The first draft of Finance Bill 2011 (strictly Finance (No.3) Bill 2010-11) includes a new Part 7A of the Income Tax (Earnings and Pensions) Act 2003, based on previously published draft legislation to tackle tax avoidance schemes referred to by the government as disguised remuneration. Part 7A is expected to apply from 6 April 2011. Various new exclusions for deferred remuneration and employee share and share option plans have been added to the latest version of Part 7A, as promised by HMRC and in the 2011 Budget. However, some of the most important exclusions are restrictive and complex. There will be vigorous lobbying by companies and share plan professionals for further amendments to Part 7A, but obviously the final form of the legislation cannot be predicted. As a result, from 6 April 2011, companies, share plan advisers, trustees of employee benefit trusts (EBTs) and other relevant third parties should take great care that any steps related to share and share option plans and other forms of deferred remuneration clearly fall completely outside Part 7A, or within the Part 7A exemptions as currently drafted.

Points of potential difficulty for existing plans under which share awards and share options are satisfied using shares in an EBT include:

  • The likely need to amend plan rules to meet the terms of new Part 7A exclusions before new awards which fall within the exclusions can be made.

  • The possible need to amend or replace existing awards or options (including any granted before 6 April 2011) before shares to satisfy them are earmarked within an EBT, where earmarking has not already happened.

Actions in respect of EBT shares that could fall outside the exclusions and so give rise to a Part 7A charge include:

  • Earmarking for options (other than some EMI options and SAYE options) with exercise prices below grant market value.

  • Earmarking for share awards and options that have vesting or lapse dates more than five years after the date of grant.

  • Earmarking for share awards and options that allow early vesting for any reason other than death.

  • Operation of deferred payment share plans under which shares are acquired from an EBT.

  • Use of an EBT to support several different types of share plan, if these include any statutory tax-favoured plans.

  • Earmarking shares for awards and options within the Part 7A exclusions that are not then granted within three months after the earmarking.

  • An EBT earmarking more shares than required for awards which fall within an exclusion.

  • An EBT earmarking money or assets on or after 6 April 2011, but for awards that will be made only if Part 7A is enacted with "improved" exclusions. Under the legislation as drafted, even this could be a step taxable under Part 7A.

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Contents

Background

On 9 December 2010, HM Revenue & Customs (HMRC) published draft legislation to tackle certain arrangements for providing benefits to employees using trusts (including employee benefit trusts (www.practicallaw.com/6-205-8072) (EBTs) (and similar arrangements) and employer-financed retirement benefit schemes (www.practicallaw.com/6-205-6493) (EFRBS)), or other intermediaries, in a way that sought to avoid or defer liabilities to income tax and National Insurance contributions (NICs). These arrangements were referred to by HMRC as disguised remuneration avoidance schemes. The main draft legislation was a proposed new Part 7A (Part 7A) of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). (For more information, see Legal update, Draft anti-avoidance provisions to tax disguised remuneration (including EBT benefits and EFRBS) (www.practicallaw.com/3-504-1876) and Practice note, Disguised remuneration: Part 7A of the Income Tax (Earnings and Pensions) Act 2003 (www.practicallaw.com/4-504-5317).)

Practitioners raised concerns that the draft legislation was very broadly drawn and could potentially catch many straightforward arrangements (including normal employee share and share option plans) that had no tax avoidance purpose. In response to these concerns, HMRC published guidance on 21 February 2011 in the form of frequently asked questions (FAQs) (for more information, see Legal update, HMRC publishes FAQs on draft anti-avoidance legislation on disguised remuneration (www.practicallaw.com/5-504-8928) and Practice note, Disguised remuneration: Part 7A of the Income Tax (Earnings and Pensions) Act 2003 (www.practicallaw.com/4-504-5317)). The FAQs confirmed that HMRC intended to amend the legislation to create safe harbours for certain types of arrangement.

The 2011 Budget documents stated that Part 7A would be amended to add exclusions from the new Part 7A rules for some arrangements that cannot be used for tax avoidance, including:

  • Group company transactions.

  • Genuine deferred remuneration arrangements.

  • Employment-related securities schemes in addition to those already exempted in the original draft legislation.

  • Certain types of short-term loan.

For more information about the 2011 Budget statements on Part 7A, see Legal update, 2011 Budget: HMRC confirms Part 7A (disguised remuneration) draft legislation to be amended (www.practicallaw.com/8-505-3758).

HMRC published revised frequently asked questions on the new version of Part 7A on 4 April 2011. For more information, see Legal update, HMRC publishes revised FAQs on draft Part 7A ITEPA 2003 (www.practicallaw.com/8-505-5823).

 

Potential significance of Part 7A and FB 2011 amendments

Issues for share plans supported by EBTs

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:

For a discussion of the potential impact of the revised legislation on share plans, see Ask the team: impact of revised Part 7A ITEPA 2003 (disguised remuneration) on share plans (www.practicallaw.com/4-505-5778).

Risks of accidental Part 7A charges

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).

Changes to expected tax treatment for employees with assets already in trust sub-funds

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:

  • The tax treatment of any benefits delivered to them or their families out of the trust, or any new steps taken in respect of "their" trust assets, on or after 6 April 2011, may be very different from their original expectations.

  • Care will needed over any future steps in respect of the trust property, even within the trust, as there is only limited grandfathering (www.practicallaw.com/1-422-1827) for assets already within trust sub-funds.

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

 

Scope of update: pensions aspects not covered

This update focuses on issues of relevance to the provision of deferred remuneration (other than pension savings and retirement benefits) and the operation of employee share and share option schemes. It does not cover the pensions-specific aspects of Part 7A.

 

New version of Part 7A: amendments and new exclusions

The first draft of Finance Bill 2011 includes a new version of Part 7A, based on the previously published draft legislation. The new version of Part 7A is set out in paragraph 1 of Schedule 2 to the bill, referred to in clause 26 of the bill (strictly, the bill is Finance (No.3) Bill 2010-11, which will become the Finance Act 2011 when enacted). The revised Part 7A is expected to apply from 6 April 2011. Various amendments and new exclusions for deferred remuneration and employee share and share option plans have been added to the latest version of Part 7A, as promised in the FAQs and the 2011 Budget. Although these new exclusions are meant to help companies run employee share and share options plans for which shares are held in EBTs, the exclusions are quite restrictive and in some respects inconsistent with current share plan market practice. As a result, it may be difficult for companies to take advantage of these exclusions in their current form and share plans may require amendment. The main Finance Bill 2011 amendments and exclusions relevant to share plans are considered in the following sections.

Send PLC your views and questions on the amended Part 7A

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.

Amended scope of earmarking of money or asset

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.]

Employer or employee not a trustee if simply holding or managing money or assets for an arrangement

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).

Group company transactions generally excluded

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:

  • Any other member of the same group of companies as employer B (if B is a company) except to the extent that the group member takes a relevant step in its capacity as a trustee.

  • Any wholly-owned subsidiary of employer B, if B is a limited liability partnership (LLP), except to the extent that the subsidiary takes a relevant step in its capacity as a trustee.

(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).

New exclusion for earmarking or holding shares for tax-favoured plans

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).

Excluded share arrangements: definition and restrictions on the exclusion

Excluded share arrangements are any arrangements for a person other than the trustees of a SIP, a CSOP scheme organiser, an SAYE scheme organiser or a grantor of EMI options to hold shares solely for the purposes of the relevant share plan or share options, that are not connected with tax avoidance (draft section 554E(2), ITEPA 2003, Part 7A).

However, the exclusion does not apply if immediately before or after the relevant step, the total number of shares of any type held by the relevant person (and any other persons) for the relevant plan or options exceeds the maximum number which might reasonably be expected to be required for that purpose over the period of five years from the date of the relevant step (draft section 554E (3) - (4), ITEPA 2003, Part 7A). Presumably, there will then be an unexpected Part 7A charge arising on the relevant step and payable by those employees who are the intended beneficiaries of the awards or options for which shares were earmarked in the relevant step on which the limit was breached.

There will also be a Part 7A charge if a relevant step has fallen within the exclusion, and money or assets earmarked or held as a result of that step cease to be held solely for the relevant tax-favoured plan or options, but continue to be earmarked, or held for a future step, in favour of employee A (draft section 554E (6) - (7), ITEPA 2003, Part 7A). [PLC comment: These circumstances seem rather unlikely. The provision may have been included to block an avoidance scheme design opportunity.]

Excluded share arrangements: potential problems

The new exclusion appears to be intended to make it clear that earmarking steps ancillary to the making of SIP awards or the grant of tax-favoured options are also excluded from Part 7A. However, there are some potential difficulties with the new exclusion:

  • As a result of the restriction relating to the number of shares held, companies and trustees will have to carefully track the number of shares held for the purposes of a tax-favoured plan on a rolling basis, regularly comparing this with an updated estimate of the plan's reasonable requirements over the next five years. This seems unnecessarily complicated and also rather unclear. HMRC guidance on what it considers to be a reasonable basis for a five year rolling estimate will be highly desirable.

    It seems that a Part 7A charge arising from a breach of this restriction is likely to happen long before the affected employees could possibly benefit from the relevant award or option and regardless of whether or not they ever do. The taxable value involved could also be significant. For example, an individual can hold an EMI option over shares with a grant market value of £120,000 and a significant value of shares can be subject to a single SAYE option (see Practice note, SAYE options: maximum savings, exercise price and share value (www.practicallaw.com/9-381-2681)). Although there may be relief for the exercise price (see New provision for relief for option exercise price in computing a Part 7A charge), EMI options can be granted with an exercise price below the grant market value (or even have no exercise price) and SAYE options are usually granted with an exercise price set at up to a 20% discount to the grant market value.

    In the context of tax-favoured share and option plans, the imposition of Part 7A charges in these circumstances seems harsh, especially for all-employee plans such as SIPs and SAYE option schemes. The most likely trigger of these liabilities would seem to be an administrative failing on the part of the employer or trustees over which the affected employees would have no control.

    Presumably, this restriction has been included to prevent excessively generous earmarking for tax-favoured arrangements being used to shelter shares which may then be then used for some other purpose.

  • The requirements for an arrangement to grant a particular type of award (which applies to EMI options only, as the other types of award are made under specifically approved plans which are only for the making of awards of that type), or to hold shares for a particular type of award, to be solely for the relevant purpose also seems unnecessarily restrictive. Sometimes EBTs hold shares which the trustees have agreed may be used to satisfy several different types of option (possibly unapproved, CSOP and EMI options) and other types of share award as well. The new exclusion for "excluded share arrangements" seems to be drafted in a way that at the least requires great care to be taken to delineate separate and specific arrangements within one trust and may require the creation of separate trusts instead. (It may be necessary to be careful not to take earmarking steps in respect of shares for plans outside the exemption for tax-favoured plans when defining separate arrangements within one EBT.)

    It is also quite common for:

    • EMI options to be granted under plans which allow for the grant of both EMI and unapproved options.

    • an option to be deliberately granted that is in part an EMI option and in part unapproved.

    • options to be granted with the intention that they will be EMI options, but that do not qualify as such (in whole or in part), in which case they will automatically be unapproved options.

  • There will be some concerns that the loss of approval of an HMRC-approved SIP, CSOP or SAYE option scheme, or a disqualifying event in respect of an EMI option, could cause an immediate Part 7A charge if shares continue to be earmarked under an associated excluded share arrangement. However, we think that, although the issue certainly needs to be explored, this may not be a major problem for the following reasons:

    • section 554E(2)(b) specifies that the purpose for which shares are held under an excluded share arrangement for a SIP must be "to be awarded under" the SIP. Once awarded those shares would move into the SIP trust itself. As a result, it appears that loss of approval of the SIP should not cause a Part 7A charge in respect of SIP shares that have already been awarded. However, it does seem possible that loss of approval could cause a Part 7A charge on any shares held in a SIP excluded share arrangement to satisfy pending SIP awards. This is a practical possibility, as the number of shares needed for SIP awards can take some time to calculate exactly, especially in the case of partnership shares and associated matching shares where there is an accumulation period, or free share awards with a performance condition. It may be necessary to include precautionary provisions in the excluded share arrangement to end the holding of shares for any kind of SIP award automatically on loss of approval.

    • section 554E(2)(b) specifies that the purpose for which shares are held under an excluded share arrangement for tax-favoured options must be "to be issued pursuant to options granted [PLC emphasis] under" an approved CSOP or SAYE option scheme, or an arrangement for the grant of EMI options. As a result, it appears that loss of approval of an option plan, or a disqualifying event, should not affect shares held within an excluded share arrangement related to options, as long as the options were granted under an approved plan or under an arrangement to grant EMI options.

New exclusion for MPs

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.]

New exclusion for earmarking money or assets to pay deferred remuneration

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.

Conditions of the deferred remuneration exclusion

The section 554H exclusion is subject to several restrictions, including:

  • The remuneration must not be available to A before a vesting date which is not more than five years after the award date.

    (Draft section 554H(1)(c)(i) and (1)(d), ITEPA 2003, Part 7A.)

    However, any provision for payment before the vesting date if A dies can be ignored.

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

  • The terms of the award must be such that:

    • it will be revoked if specified conditions are not met on or before the vesting date.

    • at the time of award there must be a reasonable chance that the award will be so revoked.

    (Draft section 554H(1)(c)(ii) and (e), ITEPA 2003, Part 7A.)

    Again, provisions for payment before the vesting date if A dies can be ignored.

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

    It is also permissible (but not necessary) for B to include provisions for partial revocation if certain conditions are not met, as well as the mandatory full revocation provision.

    (Draft section 554H(3), ITEPA 2003, Part 7A.)

  • There must be no connection with a tax avoidance arrangement.

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

  • The main purpose of the award must not be the provision of EFRBS relevant benefits (as defined in section 393(2) of ITEPA 2003 (but ignoring section 393B(2)(a)).

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

Deferred remuneration exclusion: later default Part 7A charges

If the section 554H exclusion applies, there will be a later Part 7A charge:

  • When the money or asset which represents part or all of the deferred remuneration in a relevant third person's hands ceases to represent that remuneration (because the award will be paid with some other sum or asset, or has been revoked), but continues to be earmarked, or held for a future step, in favour of A.

    (Draft section 554H(5) - (7) and (14), ITEPA 2003, Part 7A.)

  • At the end of the vesting date, to the extent that the deferred remuneration has not:

    • already been paid to A as PAYE employment income.

    • ceased to be payable on the revocation of the award, following which no further relevant step will be taken in respect of money or assets which either represented the deferred remuneration, or are derived from money or assets which did.

    (Draft section 554H(5), (8) - (13) and (14), ITEPA 2003, Part 7A.)

Deferred remuneration exclusion: potential problems

While an exclusion for genuine deferred remuneration arrangements is of course welcome, there are some potential problems with the new section 554H exclusion:

  • The exclusion appears to apply only if the deferred remuneration is awarded by employer B. A wider exclusion which also covered awards by other group companies (and possibly by scheme trustees of a scheme set up by the employer or group) might be more practical.

  • The exclusion does not appear to apply to anything earmarked for an expected award of deferred remuneration and so cannot be relied upon before an award is made. In this respect, the exclusion differs from the exclusions for employee share schemes (see 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).

  • There does not seem to be sufficient justification for imposing a general five year vesting deadline. If the arrangement is genuine and not for avoidance, why is there any need to impose a statutory time limit with no regard to the employer's commercial needs?

    In this context, it is worth noting that EU directive referred to as CRD 3 and the related FSA remuneration code require a minimum deferral period of three to five years, with a retention period to follow that. These provisions also require financial services firms to tailor their deferral schemes to their own business cycles and risk horizons and the nature of the employee's role. (For more information on CRD 3 and the FSA remuneration code, see Practice notes, CRD 3 (www.practicallaw.com/5-503-2593) and Revised FSA remuneration code: frequently asked questions (www.practicallaw.com/4-504-0659).)

  • The requirement for an absolute revocation condition, with revocation reasonably likely, also seems rather restrictive and possibly impractical. Thinking again of the important developing area of deferral under CRD 3 and the FSA remuneration code, at the point where bonuses are deferred, they should already have been earned in respect of a certain level of risk-adjusted performance achieved over the initial performance period. While they should be subject to clawback or malus arrangements (referred to in the context of CRD 3 and the remuneration code as "ex-post risk adjustment") during deferral, it will probably often not be reasonably likely at the time of award that they will be completely revoked during deferral. The shorter the deferral period, the less likely complete revocation will be.

    CRD 3 and the FSA remuneration code also envisage pro-rata vesting over the deferral period, but Part 7A requires cliff vesting at the end of the vesting period. Combining the two would seem to require the division of bonus amounts into tranches subject to different vesting periods with staggered end points, but as a result the first-vesting tranche would be particularly likely to vest and so particularly difficult to fit within Part 7A.

    On the other hand, this provision may be welcomed by employers, at least in the sense that it may support the continued application of a fairly rigid rule that bonus amounts not paid out (including amounts deferred for performance periods that ended a few years ago) will be lost on termination of employment. This has been standard market practice but seems likely to become more difficult to impose on employees where bonuses are subject to long deferral periods after the relevant performance period.

  • The exclusion is not restricted to the earmarking of shares (unlike the three employee share schemes exclusions). It is one of the Part 7A provisions that may be helpful to employers and trustees operating incentive plans using securities and securities options other than shares and share options, or using securities other than shares in other forms of deferred remuneration (for a discussion of the variety of securities that might be used, at least in the opinion of those who drafted the relevant parts of ITEPA 2003, see Practice note, Employment-related securities (www.practicallaw.com/6-376-2197)). This may make section 554J especially relevant to some financial services firms' compliance with CRD 3 and the FSA remuneration code.

  • The carve-out for provisions dealing with the employee's death is welcome, but similar provisions could also be justified for termination due to ill-health or redundancy, although there may be less of an imperative for early vesting in those circumstances. Early vesting on a takeover or other corporate transaction is often an issue for share awards and share options (and this is discussed further below in the context of the relevant exclusions) but it is not clear that it will need to be taken into account for deferred remuneration schemes, unless they involve securities of the employer that the purchaser wishes to acquire.

  • These issues may not be insurmountable. For example, care could be taken about which deferred sums are held by third parties and which are held by group companies, but not acting as trustees or under an avoidance arrangement (though employees would probably prefer deferred remuneration to be held by a trustee). However, employers making use of third parties to hold deferred remuneration will need to carefully review their arrangements. It may be particularly urgent, but possibly difficult, to adjust any existing contractual arrangements that require a step falling within Part 7A to be taken soon after 5 April 2011.

  • In the case of deferral arrangements adopted to satisfy the FSA remuneration code, if unexpected Part 7A charges arise, employers could be justifiably extremely unhappy with the timing and complexity of the new legislation, as the affected deferral arrangement would have no tax avoidance purpose and may have only just been adopted to satisfy other hastily introduced new regulations with a different policy goal.

New exclusion for earmarking of shares to satisfy share awards or phantom share awards

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 (www.practicallaw.com/1-503-9087). 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 (www.practicallaw.com/5-204-1204) (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).

Conditions of the share award exclusion

The section 554J exclusion is subject to several restrictions, including:

  • Employer B must be a company.

    (Draft section 554I(3), ITEPA 2003, Part 7A.)

    [PLC comment: Presumably this is to prevent shares and share options being used as a Part 7A avoidance mechanism by non-corporate employers.]

  • The award shares, or cash, must not be available to A before a vesting date which is not more than five years after the award date.

    (Draft section 554J(1)(c)(i) and (1)(d), ITEPA 2003, Part 7A.)

    However, any provision for receipt of shares or payment before the vesting date if A dies can be ignored.

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

  • The terms of the award must be such that:

    • it will be revoked if specified conditions are not met on or before the vesting date.

    • at the time of award there must be a reasonable chance that the award will be so revoked.

    (Draft section 554J(1)(c)(ii) and (e), ITEPA 2003, Part 7A.)

    Again, provisions for receipt of shares or payment before the vesting date if A dies can be ignored.

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

    It is also permissible (but not necessary) for B to include provisions for partial revocation if certain conditions are not met, as well as the mandatory full revocation provision.

    (Draft section 554J(3), ITEPA 2003, Part 7A.)

  • The number of shares earmarked or held must not be more than the maximum number reasonably required to meet the award.

    (Draft section 554J(4)(b), ITEPA 2003, Part 7A.)

  • There must be no connection with a tax avoidance arrangement.

    (Draft section 554J(4)(c), ITEPA 2003, Part 7A.)

  • The main purpose of the award must not be the provision of EFRBS relevant benefits (as defined in section 393(2) of ITEPA 2003 (but ignoring section 393B(2)(a)).

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

Share award exclusion: later default Part 7A charges

If the section 554J exclusion applies, there will be a later Part 7A charge:

  • Three months after the relevant step, if:

    • the relevant step is taken before an award is made.

    • the award is not made before that date.

    • on that date shares are still earmarked, or held for a future step, in favour of A.

    (Draft section 554J(5) - (6) and (14), ITEPA 2003, Part 7A.)

    [PLC comment: Presumably, this provision is intended to prevent the exclusion being used to safely earmark shares for an employee with no real intention of making an award within the exclusion.

    It would seem relatively easy to carelessly fall foul of this provision. When earmarking for an expected award of this type and relying on this exclusion, it will be important that the terms of the earmarking automatically bring it to an end completely within three months if no award is actually made.]

  • When the shares cease to be held to meet the award or expected award, but continue to be earmarked, or held for a future step, in favour of A.

    (Draft section 554J(7) - (8) and (14), ITEPA 2003, Part 7A.)

  • If an award is made (and in the case of an expected award made after the earmarking, it is made within three months of the earmarking), at the end of the vesting date, to the extent that:

    • in the case of a share award, the shares have not been already been received by A giving rise to employment income which is chargeable to income tax or exempt.

    • in the case of a phantom share award, cash has not already been paid to A as employment income which is chargeable to income tax or exempt, and either that cash represents the proceeds of disposal of the shares, or, if the cash is paid from another source, there will be no further step in respect of the shares or anything derived from them to benefit A.

    • the shares have not ceased to be deliverable to A, or the cash to be payable to A, on a revocation of the award ofollowing which no further relevant step will be taken in respect of the shares or any money or assets derived from them.

    (Draft section 554J(9) - (13) and (14), ITEPA 2003, Part 7A.)

Share award exclusion: potential problems

There are some potential problems with the new section 554J exclusion, which are similar to some of those raised by the new exclusion for deferred remuneration (see Deferred remuneration exclusion: potential problems):

  • There are requirements in the exclusion which are not likely to be met by the rules of existing share plans. As a result, it may not be possible to make awards which fall within the exclusion until plans are amended, at least if it will be necessary for those awards to be satisfied with EBT shares and another exclusion is not available. (For a discussion of another possibly relevant exclusion, see Amended exclusion for steps on grant of an employment-related securities option. Another possibly relevant exclusion may be somewhat more flexible for application to existing plans than the section 554J exclusion, but overall it is also likely to raise the same problem - see New exclusion for earmarking of shares to satisfy share options or phantom share options.)

  • The exclusion appears to apply only to share awards or phantom share awards made by employer B. A wider exclusion which also covered awards by other group companies (and possibly by individual shareholders, or scheme trustees, under a scheme set up by the employer or group) might be more practical, especially as:

    • plans are often operated at the group level, with awards made by the parent company only.

    • larger companies, with complex group structures, are likely to use EBTs to hold shares to satisfy share plan awards.

  • There does not seem to be sufficient justification for imposing a general five year exercise or lapse deadline. If the employee share option plan is genuine and not for avoidance, why is there any need to impose a statutory time limit with no regard to the employer's commercial needs?

    In this context, it is worth noting that CRD 3 and the FSA's remuneration code require a minimum deferral period of three to five years, with a retention period to follow that, which also applies to the vesting periods of share plan awards (see for example, SYSC19A.3.24 G, FSA Handbook). These provisions also require financial services firms to tailor their deferral schemes to their own business cycles and risk horizons and the nature of the employee's role.

  • The carve-out for provisions dealing with early vesting on the employee's death is welcome, but similar provisions could also be justified for early vesting:

    • on a change of control, on which it is general for share award terms to permit some degree of early vesting, to allow employees to participate in a disposal as shareholders.

    • on termination due to ill-health or redundancy (although there may be less of an imperative for early vesting in those circumstances).

  • As discussed below (see The share option exclusion may be more flexible than the share award exclusion):

    • the section 554L exclusion for share option plans may be more flexible than the section 554J exclusion for share awards.

    • it seems possible that at least some PSP awards might fall within section 554L as well as section 554J.

New exclusion for earmarking of shares to satisfy exit-only phantom share awards

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 (www.practicallaw.com/1-503-9087).)

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.

Conditions of the exit-only phantom share award exclusion

The section 554K exclusion is subject to several restrictions, including:

  • Employer B must be a company.

    (Draft section 554I(3), ITEPA 2003, Part 7A.)

    [PLC comment: Presumably this is to prevent share awards and share options being used as an avoidance mechanism by non-corporate employers.]

  • Payments under the phantom share awards must be payable only on:

    • the admission of shares of the type subject to the awards to trading on any stock exchange.

    • a sale of all (or a substantial proportion) of the shares of the type subject to the awards to persons none of whom are connected with the sellers.

    (Draft section 554K(1)(c) and (2), ITEPA 2003, Part 7A.)

    However, provisions for receipt of payment before an exit event if A dies can be ignored.

    (Draft section 554K(3), ITEPA 2003, Part 7A.)

  • The shares subject to the award must be shares in a trading company.

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

    [PLC comment: It would probably be helpful if this could be widened to include shares in the parent company of a trading group. It is not clear why this exclusion is restricted to trading companies.]

  • The shares subject to the award must not be admitted to trading on any stock exchange.

    (Draft section 554K(4)(b), ITEPA 2003, Part 7A.)

  • The number of shares earmarked or held must not be more than the maximum number reasonably required to meet the award.

    (Draft section 554K(4)(c), ITEPA 2003, Part 7A.)

  • There must be no connection with a tax avoidance arrangement.

    (Draft section 554K(4)(d), ITEPA 2003, Part 7A.)

  • The main purpose of the award must not be the provision of EFRBS relevant benefits (as defined in section 393(2) of ITEPA 2003 (but ignoring section 393B(2)(a)).

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

Exit-only phantom share award exclusion: later default Part 7A charges

If the section 554K exclusion applies, there will be a later Part 7A charge:

  • Three months after the relevant step, if:

    • the relevant step is taken before an award is made.

    • the award is not made before that date.

    • on that date shares are still earmarked, or held for a future step, in favour of A.

    (Draft section 554K(5) - (6) and (13), ITEPA 2003, Part 7A.)

    [PLC comment: Presumably, this provision is meant to prevent the exclusion being used to safely earmark shares for an employee with no real intention of making an award within the exclusion.

    It would seem relatively easy to carelessly fall foul of this provision. When earmarking for an expected award of this type and relying on this exclusion, it will be important that the terms of the earmarking automatically bring it to an end completely within three months if no award is actually made.]

  • When the shares cease to be held to meet the award or expected award, but continue to be earmarked, or held for a future step, in favour of A.

    (Draft section 554K(7) - (8) and (13), ITEPA 2003, Part 7A.)

  • If an award is made (and in the case of an expected award made after the earmarking, if it is made within three months after the earmarking), and an exit event occurs, at the end of the date falling three months after the exit event, to the extent that cash has not already been paid to A as employment income which is chargeable to income tax or exempt, and either that cash represents the proceeds of disposal of the shares, or, if the cash is paid from another source, there will be no further step in respect of the shares or anything derived from them to benefit A.

    (Draft section 554K(10) - (12) and (13), ITEPA 2003, Part 7A.)

    [PLC comment: Unlike the exclusions for deferred remuneration and share awards (see New exclusion for earmarking to pay deferred remuneration and New exclusion for earmarking of shares to satisfy share awards or phantom share awards) section 554K does not expressly rule out a Part 7A charge in the event that an award is made but revoked before an exit event occurs (for example, because the employee leaves) and an exit event then occurs. Presumably this is an oversight. Hopefully, Part 7A charges will not arise for already lapsed awards on an exit event as a result of this.]

Exit-only phantom share award exclusion: PLC comment

The section 554K exclusion seems quite odd in some respects.

It does not allow for the delivery of shares under awards made under an exit-only share plan, only cash. It also leaves one wondering what provision is intended for exit-only share options, which are quite common and are at least sometimes satisfied with shares held in an EBT. The drafting of the section 554K exclusion does not rule out its application to an exit-only phantom share option scheme, as it applies to awards of sums of money "to be determined by reference to the market value of any relevant shares at the time the sum is to be paid", which does not specify that the amount must equal the full value of those shares and appears to leave room for the deduction of a notional exercise price (draft section 554K(1)(a), ITEPA 2003). However, "real" exit-only share options will not fall within the section 554K exemption and are also not catered for very efficiently by the section 554L exemption for share options and phantom share options, at least to the extent that the option terms do not impose a time limit of five years or less for the achievement of an exit (see New exclusion for earmarking of shares to satisfy share options or phantom share options).

Of the three employee share schemes exclusions, section 554K is the only one that does not include a time-based (five year) deadline for the vesting or revocation of awards, or the exercise, lapse or revocation of options, on which a default Part 7A charge will be imposed. That seems to reflect the likely uncertainty, at the time of grant, as to when an exit might be achieved.

The exclusion appears to apply only to phantom share awards made by employer B. As for some other new exclusions, a wider exclusion which also covered awards by other group companies (and possibly by individual shareholders, or scheme trustees, under a scheme set up by the employer or group) might be more practical.

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 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 (www.practicallaw.com/1-503-9087).)

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.

Conditions of the share option exclusion

The section 554L exclusion is subject to several restrictions, including:

  • Employer B has to be a company.

    (Draft section 554I(3), ITEPA 2003, Part 7A.)

    [PLC comment: Presumably this is to prevent shares and share options being used as an avoidance mechanism by non-corporate employers.]

  • The option or phantom option must not be exercisable by A before a vesting date which is not more than five years after the award date.

    (Draft section 554L(1)(c)(i) and (1)(d), ITEPA 2003, Part 7A.)

    However, any provision for payment before the vesting date if A dies can be ignored.

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

  • The terms of the option or phantom option must be such that:

    • it will be revoked if specified conditions are not met on or before the vesting date.

    • at the time of award there must be a reasonable chance that the award will be so revoked.

    (Draft section 554L(1)(c)(ii) and (e), ITEPA 2003, Part 7A.)

    Again, provisions for payment before the vesting date if A dies can be ignored.

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

    It is also permissible (but not necessary) for B to include provisions for partial revocation if certain conditions are not met before the vesting date, as well as the mandatory full revocation provision.

    (Draft section 554L(3), ITEPA 2003, Part 7A.)

  • The number of shares earmarked or held must not be more than the maximum number reasonably required to meet the award.

    (Draft section 554L(4)(b), ITEPA 2003, Part 7A.)

  • There must be no connection with a tax avoidance arrangement.

    (Draft section 554L(4)(c), ITEPA 2003, Part 7A.)

  • The main purpose of the award must not be the provision of EFRBS relevant benefits (as defined in section 393(2) of ITEPA 2003 (but ignoring section 393B(2)(a)).

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

Share option exclusion: later default Part 7A charges

If the section 554L exclusion applies, there will be a later Part 7A charge:

  • Three months after the relevant step, if:

    • the relevant step is taken before an option or phantom option is granted.

    • the option or phantom option is not granted before that date.

    • on that date shares are still earmarked, or held for a future step, in favour of A.

    (Draft section 554L(5) - (6) and (16), ITEPA 2003, Part 7A.)

    [PLC comment: Presumably, this provision is intended to prevent the exclusion being used to safely earmark shares for an employee with no real intention of granting an option or phantom option within the exclusion.

    It would seem relatively easy to carelessly fall foul of this provision. When earmarking for an expected award of this type and relying on this exclusion, it will be important that the terms of the earmarking automatically bring it to an end completely within three months if no award is actually made.]

  • When the shares cease to be held to satisfy the option or expected option, but continue to be earmarked, or held for a future step, in favour of A.

    (Draft section 554L(7) - (8) and (16), ITEPA 2003, Part 7A.)

  • If an option is granted (and in the case of an expected option granted after the earmarking, if it is granted within three months after the earmarking), at the end of the date falling five years after the date of grant, except to the extent that:

    • in the case of a share option, the option has been exercised and shares have been received as a result by A, giving rise to employment income which is chargeable to income tax or exempt.

    • in the case of a phantom share option, the phantom option has been exercised and cash has been paid to A as employment income which is chargeable to income tax or exempt, and that cash either represents the proceeds of disposal of the shares, or, if paid from another source, there will be no further relevant step in respect of the shares or anything derived from them.

    • the option or phantom option has ceased to be exercisable by A as a result of a revocation in accordance with its terms following which there will be no further relevant step in respect of the shares or anything derived from them.

    • the option or phantom option has become exercisable by A in accordance with its terms, but has lapsed before the end of the date falling five years after the date of grant, so that there will be no further relevant step in respect of the shares or anything derived from them.

    (Draft section 554L(10) - (15) and (16), ITEPA 2003, Part 7A.)

Share option exclusion: potential problems

There are some potential problems with the new section 554L exclusion raises some difficulties, which are similar to those raised by the new exclusion for share awards (see New exclusion for earmarking of shares to satisfy share awards or phantom share awards):

  • There are requirements in the exclusion which are not likely to be met by the rules of existing share option plans. As a result, it may not be possible to grant options within the exclusion until plans are amended, at least if it will be necessary for those awards to be satisfied with EBT shares and another exclusion is not available. (For a discussion of another possibly relevant exclusion, see Amended exclusion for steps on grant of an employment-related securities option. However, the grant of options under unamended plan rules and with a market value exercise price may be facilitated by the relief available under section 554Z6 (see New provision for relief for option exercise price in computing a Part 7A charge).

  • The exclusion appears to apply only to share options or phantom share options awarded by employer B. A wider exclusion which also covered awards by other group companies (and possibly by individual shareholders, or scheme trustees, under a scheme set up by the employer or group) might be more practical, especially as:

    • option plans are often operated at the group level, with awards made by the parent company only.

    • larger companies, with complex group structures, are likely to use EBTs to hold shares to satisfy share options.

  • There does not seem to be sufficient justification for imposing a general five year deadline for exercise or lapse of options. If the employee share option plan is genuine and not for avoidance, why is there any need to impose a statutory time limit with no regard to the employer's commercial needs?

    This may be even more of an issue for share option plans than it is for performance share plans (PSPs). For PSP awards, the institutional shareholder expectation for listed companies, and widely adopted market practice for listed and other publicly traded companies, is a minimum, and also fairly standard, vesting period of three years. However, in the case of share options, it is common for the minimum vesting/performance period to be three years (and so the usual earliest exercise date to be three years after grant), but for the option to have a maximum life of up to ten years. If relying on the section 554L exclusion, share options will need to lapse at the latest on the fifth anniversary of grant to avoid a Part 7A charge at that time.

    (Of course, it will not always be necessary to rely on section 554L, since it will not be needed in the case of options to subscribe and may not be needed for options within the section 554M(2) exclusion (see Amended exclusion for steps on grant of an employment-related securities option). However, that also raises the issue of whether the anti-avoidance purpose of this legislation is a sufficient justification for imposing an effective difference in option terms between companies that need to rely on section 554L and those that do not.)

    Not only does this appear to unnecessarily restrict the freedom of employers to tailor rewards (which are not part of avoidance arrangements) to their own commercial needs, it also strikes to some extent at the very rationale for using options as employee incentives. While an employee holds an option, he has an ongoing interest in the capital of the company, without putting his money at risk through investment. This motivates him to seek to increase and maintain the share value and also to remain in employment with the company while he holds valuable unexercised options (as leavers usually lose their options on, or within a limited period after, termination). Given the prevalence of option exercise prices set at grant market value, in many growing companies the oldest unexercised options will have the greatest value as retention tools for two reasons: they will have the lowest exercise price, and they are also likely to be over a larger number of shares.

    As with the new deferred remuneration and share award exclusions, it is worth noting that CRD 3 and the FSA's remuneration code require a minimum deferral period of three to five years, with a retention period to follow that, which also applies to the vesting periods of share plan awards (see for example, SYSC19A.3.24 G, FSA Handbook). Although this is not explained in the remuneration code, in this context the term "long-term incentive plans" should be read as including share option plans. These provisions also require financial services firms to tailor their deferral schemes to their own business cycles and risk horizons and the nature of the employee's role.

    In addition, the FSA remuneration code includes guidance that "firms that have long-term incentive plans should structure them with vesting subject to appropriate performance conditions, and at least half of the award vesting after not less than five years [PLC emphasis] and the remainder after not less than three years" (SYSC19A.3.24(2) G, FSA Handbook). This recommendation originated with Sir David Walker's review of corporate governance in UK banks and other financial institutions (see Legal update, Final report of the Walker review of corporate governance and the banking crisis: remuneration and incentives aspects (www.practicallaw.com/3-500-8612)).

  • As mentioned previously (see Exit-only phantom share award exclusion: PLC comment), the five year deadline for exercise or lapse could be a particular difficulty for exit-only share options (other than phantom options which are covered by section 554K). These are frequently used by private companies seeking a sale or listing of the company.

  • The carve-out for provisions dealing with early vesting on the employee's death is welcome, but similar provisions could also be justified for early vesting:

    • on a change of control, on which it is general for share option terms to permit some degree of early vesting, to allow employees to participate in a disposal as shareholders.

    • on termination due to ill-health or redundancy (although there may be less of an imperative for early vesting in those circumstances).

The share option exclusion may be more flexible than the share award exclusion

There appears to be more scope within the new section 554L exclusion for share options to retain or approximate at least some features that are currently common in share plan rules and terms, than in the new section 554J exclusion for share awards.

The section 554J exclusion for share awards requires the award to include conditions which if not met require the whole award to be revoked, and also prevent early vesting for any reason other than the employee's death. There is no flexibility to delay vesting after this revocation period is over, as the revocation period itself is defined by the vesting date and a Part 7A charge will arise on the vesting date if shares continue to be earmarked (see New exclusion for earmarking of shares to satisfy share awards or phantom share awards).

In contrast, while the section 554L exclusion for share options similarly requires the option to include conditions which if not met require the whole option to be revoked, and also prevents early vesting for any reason other than the employee's death, it does not require the option to be exercised, or even exercisable, immediately after that vesting date and does not impose a Part 7A charge at the end of the vesting date. As a result, it appears it may be possible to specify separate forfeiture and performance periods, for example by setting:

  • A vesting date of, say, one year after grant and a revocation condition that employment must not terminate within that year (for any reason other than death).

  • An earliest normal exercise date (if continuing in employment) of three years after grant, subject to the satisfaction of performance conditions.

  • Provisions for early exercise (possibly pro-rated for time and performance) on a corporate event, or termination for ill-health or redundancy (or similar reasons) between one and three years after grant.

  • Provisions for the lapse of the option on termination for any other reason (apart from death) subject to a discretion for the company to permit exercise after termination later than one year after grant.

The only feature of section 554L which seems to at least imply some inconsistency with this analysis is the allowance for provisions for partial revocation if certain conditions are not met before the vesting date (draft section 554L(3), ITEPA 2003, Part 7A.) However, this does not appear to forbid any restrictions on exercise or retention of the option which apply after the vesting date, only to allow (but not require) certain conditions which would apply before the vesting date.

We would be especially interested to learn readers' views on this point (see Send PLC your views and questions on the amended Part 7A).

Share option exclusion: possible application to performance share awards

As the section 554L exclusion may offer more flexibility for plan and award terms than section 554J (see Share option exclusion may be more flexible than the share award exclusion), it is worth considering whether PSP awards could fall within it, at least to the extent that they are structured as nil-cost options. We think that PSP awards can fall within the exclusion, as section 554L applies to plans under which "rights to acquire shares" may be granted by the employer, which by implication must at some point "be exercisable by" employee A, but it does not appear to contain any requirement for the actual payment of an exercise price.

It is already well-established that many PSP awards are securities options for the purposes of Part 7 of ITEPA 2003, even if they are not exercisable. (Securities options are defined in Part 7 as rights to acquire securities that are not acquired for tax avoidance (section 420(8), ITEPA 2003). For more information on this point, see Employment-related securities: Share options are usually not employment-related securities (www.practicallaw.com/6-376-2197).

Again, we would be especially interested to learn readers' views on this point (see Send PLC your views and questions on the amended Part 7A).

Amended exclusion for steps on grant of an employment-related securities option

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).

Does the exclusion cover the earmarking of shares on grant of an option by trustees?

Although the amended exclusion would appear to apply only to relevant steps taken at the time an employment-related securities option is acquired and not to any previous or subsequent earmarking of shares to satisfy the option, it may prevent any Part 7A earmarking charge in respect of shares held in an EBT when the trustees simply grant an option over some of those shares. This is because the grant of the option by the trustees appears to involve both:

  • The disposal to the employee of the newly created share option (a relevant step within draft section 554C (Relevant steps: payment of sum, transfer of asset etc), ITEPA 2003, Part 7A).

  • The earmarking of shares in the trust (at least if the trust holds a sufficient number of unallocated shares) to satisfy the later exercise of the option, on which they would be transferred to the employee (a relevant step within draft section 554B (Relevant steps: earmarking etc of sum of money or asset, ITEPA 2003, Part 7A).

The wording of section 554M(2) could be interpreted to exclude both of these steps, as they are two aspects of only one action by the trustees. However, before trustees rely on this, it would be helpful to know whether HMRC might insist on interpreting section 554M(2) as only excluding the disposal of the option but not any associated earmarking of the shares.

If section 554M(2) does offer protection from an earmarking charge on the grant of an option directly by the trustees of an EBT, performance share plans could also benefit from this, at least to the extent that awards under them are employment-related securities options (see Practice note, Employment-related securities: Share options are usually not employment-related securities (www.practicallaw.com/6-376-2197)).

We would be especially interested to learn readers' views on this point (see Send PLC your views and questions on the amended Part 7A).

New exclusion for loans made for cashless exercise of share options

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 (www.practicallaw.com/7-220-7953) 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:

  • The loan must be repaid by the end of the sixth day after the month in which the loan payment is made, failing which the amount outstanding will be subject to a Part 7A charge.

  • There are no provisions for any Part 7A charge which arises on late repayment to be refunded when the loan is actually repaid.

Exclusion for cashless exercise loans: PLC comment

The requirement for repayment by the sixth day of the following month may impose severe time pressure to achieve repayment of a cashless exercise loan for any option exercise taking place late in the month.

The inclusion of a provision exempting cashless exercise loans is welcome, but it is notable that there are no provisions to protect any other kind of loan that might be offered by a relevant third person for any non-avoidance purpose, other than the narrow exclusions for commercial transactions and employee benefit packages (see draft sections 554F and 554G, ITEPA 2003, Part 7A). This is probably because avoidance schemes using loans by trustees are a particular target of Part 7A, reflecting the nature of employment income avoidance schemes of great concern to HMRC (see Legal update, Special Commissioners' decision: Bonuses paid to EBTs were not subject to PAYE or NICs, but also not deductible for corporation tax (www.practicallaw.com/5-382-8759)) and this is reflected in the revised FAQs (see Legal update, HMRC publishes revised FAQs on draft Part 7A ITEPA 2003 (www.practicallaw.com/8-505-5823)).

New exclusion for certain employee car ownership schemes

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

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

New provision for relief for option exercise price in computing a Part 7A charge

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:

  • Without relief for the exercise price, any Part 7A charge could arise on the whole value of the shares earmarked to satisfy an option, even though the employee can only expect to realise the difference between the shares' value at the time of exercise and the exercise price.

  • These provisions may also offer sufficient relief in some cases for EBT shares to be earmarked to satisfy an option where the earmarking does not fall within one of the exclusions in Part 7A.

Part 7A relief for exercise price may be important if exclusions do not apply

Employers and trustees should only need to rely on draft section 554Z6, ITEPA 2003 to relieve all or part of a Part 7A charge if relevant exclusions in Part 7A do not apply, in particular:

Effect of Part 7A relief for exercise price on market value, discounted and nil-cost options

If draft sections 554L and 554M(2), ITEPA 2003 do not apply to exclude a Part 7A charge on an earmarking step taken in connection with a share option, for example because the option is capable of exercise more than five years after grant, then a Part 7A charge will arise immediately on the value of shares earmarked in connection with the option. Draft section 554Z6, ITEPA 2003 reduces the amount of the Part 7A charge in certain circumstances, by providing relief from the charge for the amount of any exercise price payable under the terms of the option (draft section 554Z6(3), ITEPA 2003):

  • For a market value option (that is, one with an exercise price equal to the market value of the shares at grant), this should have the effect of reducing the Part 7A charge to nil, as long as the earmarking takes place when the share value is equal to, or less than, the market value at the time of grant.

  • For a discounted option (that is, one with an exercise price less than the grant market value), relief under the section will reduce, but not completely relieve, a Part 7A earmarking charge.

  • For an option with no exercise price, that is, a nil-cost option, there would be no relief under the section and so a charge could still arise on the full value of the shares when earmarked. This could apply to any PSP award structured as a nil-cost employment-related securities option, at least if it does not fall within the exclusion in section 554J, ITEPA 2003 (see New exclusion for earmarking of shares to satisfy share awards or phantom share awards).

Part 7A relief for exercise price is not available for other types of securities options

Relief under draft section 554Z6, ITEPA 2003 applies only to share options or phantom share options, and not to employment-related securities options more generally (for a discussion of the definition of employment-related securities options in Part 7 of ITEPA 2003, see Practice note, Employment-related securities: Share options are usually not employment-related securities (www.practicallaw.com/6-376-2197)).

There does not seem to be any obvious reason to treat other employment-related securities options differently in this respect from share options.

Conditions of Part 7A relief for exercise price

Draft section 554Z6, ITEPA 2003 will apply in the following circumstances:

  • The relevant step is earmarking (within the meaning of draft section 554B, ITEPA 2003) of shares, either to satisfy a share option or phantom share option that has been granted already, or in anticipation of the grant of a share option or phantom share option.

    However, events that are taxable earmarking steps deemed to take place after the section 554L exclusion for earmarking for share options has applied and when either no option has been granted, or no option remains to be exercised (by virtue of sections 554L(6) and (8)) will not be relieved by section 554Z6. But a charge arising on a deemed earmarking step under draft section 554L(10), ITEPA 2003, on which the option remains in existence and capable of exercise more than five years after the date of grant, will be relieved under section 554Z6. For more details of these post-exclusion charging provisions, see New exclusion for earmarking of shares to satisfy share options or phantom share options.

  • The employer in the relevant arrangement is a company.

  • The employer operates an arrangement under which the employer can grant share options to the employee, or grant phantom options.

  • An exercise price is payable under the terms of the share option or phantom option.

  • The number of earmarked shares does not exceed the maximum number of shares that might reasonably be expected to be needed to satisfy the share option or phantom share option.

  • There must be no connection with a tax avoidance arrangement.

Part 7A relief for exercise price: later default Part 7A charges

If draft section 554Z6 operates to provide relief from a Part 7A charge when an earmarking takes place, there will be a subsequent charge if either:

  • The option that was expected to be granted is not granted within 3 months of the earmarking, and any of the earmarked shares remain earmarked.

  • The earmarked shares continue to be held in favour of the employee, but are no longer held solely for the purposes of satisfying an option or phantom option.

New provision for credit for consideration given by employee in the form of an asset

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).

Original Part 7A gave no credit for the value of assets sold by employees

The original 2010 Part 7A provided relief from a Part 7A charge where a relevant third person transferred an asset to the employee, or a person linked with the employee, in return for consideration from the employee in the form of money paid before the relevant step was taken. No relief was proposed to be given if, for example, a relevant third person made a payment to an employee in exchange for the transfer of an asset by the employee to the relevant third person. This could have produced a very unfair result when, as commonly happens under leaver provisions in share plans or company articles of association, an employee sold shares to an employee benefit trust for a payment equal to the shares' current market value, with no credit for the value of the shares transferred.

New Part 7A credit for employee asset transfers

A new draft section 554Z7, ITEPA 2003 now enables relief to be claimed for consideration given by the employee in the form of an asset. The relief has several restrictions, including:

  • The relevant step must involve the relevant third person transferring an asset, paying a sum of money or enabling a person to acquire an asset (that is, it is a relevant step under draft sections 554C(1)(a) to (c), ITEPA 2003).

    (Draft section 554Z7(1)(b) and (5), ITEPA 2003, Part 7A.)

  • The employee (or person linked with the employee) must provide consideration in the form of the transfer of an asset to the relevant third person (not by way of loan) “before, at or about” the time the relevant step is taken.

    (Draft section 554Z7(1)(c), ITEPA 2003, Part 7A.)

  • There must be no connection with a tax avoidance arrangement.

    (Draft section 554Z7(1)(d), ITEPA 2003, Part 7A.)

If these conditions are met, the value of the relevant step will be reduced by the value of the asset provided to the relevant third person in consideration (draft section 554Z7(2) and (6), ITEPA 2003, Part 7A).

Credit for employee asset transfers: presumed tax avoidance

Draft section 554Z7(3), ITEPA 2003 provides that a tax avoidance purpose will be presumed if:

  • Before the asset was provided as consideration, another person transferred the asset by way of loan to the employee or person linked with the employee.

  • “The asset is, or carries with it, any rights or interests under the relevant arrangement or any arrangement which is connected (directly or indirectly) with the relevant arrangement”.

[PLC comment: It is not clear what is meant by these provisions, especially the wording set out in the second bullet above. This may be intended to ensure that an employee cannot rely on section 554Z7 to sell any rights under an arrangement that would otherwise be taxable under Part 7A without incurring an income tax charge on the consideration received. HMRC’s Spotlight 11 referred to certain types of avoidance arrangement designed to circumvent Part 7A by taking advantage of provisions providing for credit for loans repaid before April 2012 (see Legal update, New HMRC avoidance spotlight on employee benefit trusts (www.practicallaw.com/8-505-0076)), and these avoidance schemes may be what section 554Z7(3) has been drafted to block.]

No Part 7A credit for deferred employee consideration: difficulties for some deferred payment plans

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 (www.practicallaw.com/7-381-1814).

New provision for relief for an earmarking charge if no further relevant step will be taken

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:

  • There has to be a relevant event (which is not in itself a relevant step) as a result of which no further Part 7A relevant step will be taken by any person in respect of the earmarked money or asset or anything arising or derived from it.

  • Within 4 years after that relevant event, an application for relief must be made to HMRC.

  • There must be no connection between the relevant event and a tax avoidance arrangement (including an arrangement to avoid tax by securing relief under section 554Z13).

(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) (www.practicallaw.com/9-504-3900). 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.]

 

Comment: hope for further amendments but take care in the meantime

Companies, advisers and EBT trustees will certainly welcome the delivery of the exclusions promised in the FAQs and the 2011 Budget, as some of these are necessary for mainstream deferred remuneration, share award and share option arrangements that are both widely used (and likely to be more widely used in future, especially by financial services firms) and not generally used for tax avoidance. But companies, advisers and trustees will also be disappointed and bemused by various details of some of the most important new exclusions, which seem excessively restrictive and complex, including features which do not appear to be obviously required for anti-avoidance purposes.

We can expect vigorous lobbying by companies and share plans professionals for further amendments to Part 7A. But obviously the success of lobbying cannot be predicted, especially as Part 7A is anti-avoidance legislation drafted in response to rather provocative avoidance schemes (for details of an example, see Legal update, Special Commissioners' decision: Bonuses paid to EBTs were not subject to PAYE or NICs, but also not deductible for corporation tax (www.practicallaw.com/5-382-8759)). HMRC and HM Treasury will have already considered how far they are prepared to go to meet the strongly expressed concerns of employers and tax and remuneration professionals following the publication of the original 2010 Part 7A. HMRC will have balanced these concerns against a perceived risk of providing openings for designing new tax avoidance schemes, although it does seem possible that HMRC may not have appreciated some of the practical issues that the new drafting might raise for mainstream commercial arrangements. As a result, from 6 April 2011, companies, share plan advisers, trustees of EBTs and other relevant third parties should take great care to ensure that any steps related to share and share option plans (and other forms of deferred remuneration) that could attract a Part 7A charge either:

  • Clearly fall within the Part 7A exclusions as currently drafted.

  • Are deferred pending the finalisation of Part 7A.

However, deferral may be risky and should be carefully considered and managed. There is the potential for an earmarking charge even if any future plans or steps regarding money or assets already held by an EBT (or any other third person) are made absolutely conditional upon the Part 7A exclusions being enacted in an acceptable final form. This is because any informal arrangement or plan to take steps at a future date could itself be a Part 7A taxable event, since as Part 7A is currently drafted relevant steps are expected to include any earmarking on or after 6 April 2011 with a view to future relevant steps (see Amended scope of earmarking of money or asset), even if those planned steps will only be taken "on or following the meeting of any condition" and that condition "might never be met".

(Draft section 554B(1) and (2)(b), ITEPA 2003, Part 7A.)

 

Sources

 
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