A recently published case before the Special Commissioners shows the danger of receiving (and giving!) negligent tax advice in relation to employee share options.

The case of Employee v Revenue and Customs Commissioners [2008] STC (SCD) 688, involved an employee who was caught out in the dot com boom. His employment ceased in April 2000 after which he had 90 days to exercise his options. He exercised eight options between April and July 2000 selling all the shares in four cases and retaining the remaining shares. The company’s share price duly plummeted.

The gains on the exercise of options where he had retained the shares was £1.2 million yet, by the time he came to prepare his tax return, the value of the option shares was far less than the £500,000 income tax liability he faced (which was payable through self-assessment).

Some might regard his predicament as unjust, others might just say he made a bad investment decision. Either way, the law is quite clear then and now, income tax is due on the exercise of options on the market value of the shares at that time of exercise less the exercise price paid irrespective of whether the shares are sold afterwards or retained.

The employee’s tax adviser, however, seemed to think otherwise and entered into no names correspondence with HMRC arguing that tax was only due on realised gains, no gain could be “realised” until the shares were sold. HMRC rejected this suggestion emphatically yet the tax adviser prepared a return without declaring the £1.2 million gain (although it was referred to somewhat unclearly in one paragraph of a covering letter accompanying the return).

Six years passed before HMRC realised the under-declaration of tax by comparing the share scheme returns of the company with the employee’s tax return. By then, HMRC were out of time to raise assessments unless they could show the under-declaration was due to:

  • the negligence of the taxpayer or his advisers; or
  • they could not reasonably be expected to be aware of the income on the basis of the information provided.

HMRC raised assessments, the taxpayer appealed and lost on all counts. There are instances where the tax treatment of a particular transaction is unclear. In these circumstances it is up to the adviser to make full and accurate disclosure of the facts supported by a reasoned argument using HMRC’s COP 10 procedure. In this case, however, there was really no legitimate scope for debate and the disclosure was deliberately unclear and inadequate. Worse still, the adviser had already entered into correspondence with HMRC and was aware of their views. The Special Commissioners found that the standards of compliance fell below the standards that could reasonably be expected of a competent adviser and amounted to negligence in this case.