The recent case of Chilcott, Griffiths and Evolution Group Services v Revenue & Customs has highlighted a pitfall for employers and employees where PAYE is not properly operated on the exercise of employee share options or other share-related income.
Typically, PAYE is operated by the employer deducting the tax due from the proceeds of the sale of the shares. The problem is that where the right amount is not or cannot be deducted and the employee subsequently fails within the relevant timeframe to put the employer in funds to cover the PAYE due, further tax (and not just interest and penalties) automatically becomes chargeable on the amount still due from the employee.
Until 2003, there was a 30-day deadline for the employee to put the employer in funds, but this has since been extended to 90 days. However, what is surprising and causes this tax to be seen as particularly unfair is that this additional charge will still arise even if the employee reimburses the employer after the 90-day deadline or pays the tax himself.
In the Chilcott case, which confirmed that the additional charge was due, PAYE was not paid over by employees in time because of uncertainty on the part of the employer as to whether tax was due at all on exercise of the options.
However, uncertainty over how much PAYE to deduct can also arise in a number of more common situations, including where there are overseas duties. This article looks at the Chilcott case and its impact in other situations.
The Chilcott case
Share options were granted to two directors who were founder shareholders. When the directors exercised their options, the company did not account for PAYE believing the options were acquired by the directors as founders rather than as employees and that therefore the gains were not taxable as employment income.
It was subsequently conceded that they were employee options and the directors themselves paid the Revenue the relevant amount of income tax due on the exercise of the options under self-assessment. However, this was some time after the statutory time limit for reimbursement of PAYE and in any case their payment was a payment to the Revenue, not to their employer.
Where an employee has not put the employer in funds to account for PAYE within 90 days, section 222 of the Income Tax (Earnings and Pensions) Act 2003 imposes an additional income tax charge on the amount of the shortfall. The employee therefore has to pay tax not just on the exercise gain he has made but also on the tax itself!
Many would regard this as unfair. If an employer does not properly subject a cash bonus to PAYE, all that is additionally payable are interest and penalties. However, with share-related income, while the employer has liabilities as well (not discussed in Chilcott) the unpaid tax is treated as additional income (even if the employee subsequently puts the employer in funds for the PAYE). It is difficult to see why PAYE non-compliance with share schemes is so harshly treated compared with other forms of PAYE income.
Indeed, the directors argued that this charge was penal and/or that it amounted to double taxation and so should not be payable. However, the Special Commissioner rejected the directors' arguments that the further charge was penal since the statutory charge did not involve any penalty; rather the provision simply imposed a charge to tax if the various preconditions set out were fulfilled. The Special Commissioner was similarly unreceptive to the taxpayers' claim of double taxation as the extra charge was explained to be a form of surcharge, imposed because of the directors' late reimbursement.
Accordingly, the extra tax was payable. The tax due on the exercise of the options was £827,743 (which the directors had paid) and so, at a tax rate of 40%, the extra tax payable by the directors was £331,097. This amounted to an effective tax rate of 56%. Unusually though, the additional tax is a self-assessment liability of the employee and so the employer did not have to collect it through the PAYE system.
Impact on employers
The facts in Chilcott were rather unusual and the company adopted what seems in retrospect a particularly aggressive approach in claiming that there was no employment income tax charge at all. However, common situations where PAYE might not be operated in full include:
- Private companies, where employee share options are only subject to PAYE if they are "readily convertible assets" at the time of exercise.
- Although it will be clear in exit situations where there is a buyer for the company that the shares are then readily convertible assets, it is debatable whether the shares are readily convertible where there are just provisions in the articles of association where the company can find a buyer for leavers' shares or an employee trust is available to buy shares. Employers and employees therefore need to be cautious about not operating PAYE in these cases. Further problems can also arise in relation to valuation of private company shares.Approved option schemes where it is believed that gains are sheltered by virtue of the scheme but it is then discovered approval has been lost or does not apply (e.g. because the Revenue disputes share values when options were awarded or other statutory conditions are not satisfied on exercise).
- Non-resident employees and other employees not permanently in the UK.In simple terms, income will be split between UK and non-UK duties over the vesting term of the option or award. In many cases, PAYE obligations only apply in respect of the UK duties and so employers will apportion the gain for UK tax purposes. The danger is that a failure to subject a sufficient proportion of the share award to UK tax and PAYE on exercise/vesting can give rise to the additional charge simply because the right amount of PAYE has not been accounted for. In many cases the now 90 day window for setting up the correct amount should give enough time, but where day-counting and double tax treaties need to be considered, these further complexities make the deadline tight.
- The charge applies to all share-related income, not just options. For example, it would apply on exits where there is uncertainty on whether the particular shareholder arrangements for employees give rise to an income tax charge (eg a ratchet or other forms of employee preference).
- We have experience of how to preserve the employees' position without paying over the full amount of PAYE to the Revenue. In all cases, the problems arise even if the employee is completely unaware of the underdeduction (although in the Chilcott case, the directors clearly supported the company's stance).
There are three final points to note:
First, although the additional charge is one for employees to pay through their tax return under self-assessment, employers still have a reporting requirement and also have to pay employee's and employer's NICs on the unreimbursed PAYE. However, even if the employer does not have to pay the extra tax, employees are not likely to thank their employers for visiting an extra tax charge on them if they relied on their employers to deal with PAYE properly only to discover that the employer made a mistake.
Secondly, the PAYE charge is worked out on the basis of what the employer's "best estimate" of the tax is. So, if the employer calculates it on the basis of all available evidence but the evidence of the position subsequently changes, this in itself does not mean that the amount of PAYE deducted was wrong. This may be particularly relevant where there have been overseas duties.
Finally, the Revenue do not always impose a further tax charge where the employee fails to put the employer in funds to meet PAYE within the statutory time limit. However, this case shows that there is always a risk of the Revenue taking the point.
Case reference
J E Chilcott (1); R I Griffiths (2); Evolution Group Services Ltd (3) v Revenue & Customs [2008] UKSPC SPC00727 (18 December 2008)
This article originally appeared in Law-Now, CMS Cameron McKenna's Free Online Information Service. To register for Law-Now, simply visit www.law-now.com and select the 'Register' link in the main navigation.
