9th November 2023
The case of Vermilion Holdings Ltd (Vermilion) v HMRC has recently been ruled by the Supreme Court in favour of HMRC.
In summary, an option over 2.5% of the company was originally granted for consultancy work performed, where no employment/directorship existed. Had no further changes occurred, this presumably would have been outside the scope of Pay As You Earn (PAYE)/National Insurance Contributions (NICs).
However, a refinancing round resulted in the original option being replaced, with the new option now being over 1.5% of the equity issued. Additionally (and crucially), the consultant in question was also appointed as executive chairman.
On eventual exercise of the option, Vermilion sought non-statutory clearance from HMRC that the exercise was outside of the scope of PAYE/NIC. This was on the basis that the original option was granted pre-employment and that the directorship taken up on grant of the new option was not relevant. Whilst this was not an unreasonable argument (and Vermilion won their case on this up to the Court of Session, the highest court in Scotland), the Supreme Court ruled that the ‘deeming provision’ below applies and the option exercise is subject to PAYE/NIC. This appears to apply a more literal interpretation of the deeming provision, even in the case where the new option replaces a non-employment related option as part of a refinancing round.
The law and interpretation of the deeming provision
In addition to factually assessing whether an option is granted by reason of employment (or holding an office such as a directorship), provisions also exist to deem the option to be employment related. Specifically, the law states ‘a right or opportunity to acquire a securities option made available by a person’s employer, is to be regarded as available by reason of an employment of that person unless:
- The person by whom the right or opportunity is made available is an individual; and
- The right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person’.
In summary, where an employment or directorship exists at the time of grant, the deeming provision makes it very difficult to argue that an option exercise is outside the scope of employment taxes.
Why is this case important?
It is sometimes unclear if an option has been granted by reason of an individual’s employment. Where an option is granted by reason of employment, the exercise of the option will result in Income Tax, and in many cases NICs. It is therefore tempting to argue that options may have been granted for non-employment reasons, such as pursuant to a consultancy contract or acquired in an individual’s capacity as an investor. The recent ruling in Vermilion v HMRC confirms just how difficult it is to make this argument.
The deeming provision for employment related options has an equivalent for employment related securities, which deems shares, loan notes and other securities as within the scope of employment taxes. Advice should be sought where shares, options, convertible loans or other instruments are issued as part of a financing round, especially where the recipient holds employment/directorship as it appears they will be within the scope of PAYE/NIC, even if they finance on the same terms as pure investors.
This case also demonstrates the importance of having robust tax indemnities drafted into the legal documents. Where PAYE/NICs are due, it is primarily the responsibility of the employer to withhold these amounts and pay them to HMRC. Having appropriate indemnities should ensure that the company can recover such amounts from the employee.