In UBS AG v HMRC and DB Group Services (UK) Ltd v HMRC  UKSC 13, two cases which were heard together, the Supreme Court found in favour of HMRC by applying the so-called Ramsay principle.
The appeals concerned the effectiveness of bonus arrangements involving allocations of restricted securities to employees. The arrangements were designed to avoid the payment of income tax on bankers’ bonuses by taking advantage of exemptions contained in Chapter 2 of Part 7 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA), as amended by Schedule 22 to the Finance Act 2003. In particular, under section 425(2) of ITEPA, an exemption is conferred on the award to employees of "restricted securities", defined by section 423 as shares which are subject to provision for their forfeiture if a specified contingency occurs.
Under the arrangements, the respondent banks decided to award discretionary bonuses to their employees, but rather than paying the bonuses to them directly, the banks used the amount of the bonuses to pay for redeemable shares in offshore companies set up for the purposes of the arrangements. The shares were then awarded to the employees in place of the bonuses. Conditions were attached to the shares making them subject to forfeiture if a contingency occurred, so as to qualify for the exemption.
In the UBS case, the contingency was a specified rise in the FTSE 100 within three weeks. The contingency was unlikely to occur, and it was also hedged against so that the employees would lose out slightly, but not significantly, if that contingency did occur. In the DB case, the contingency was the employee being dismissed for misconduct or voluntarily resigning within six weeks. Once the exemptions had accrued, the shares were redeemable by the employees for cash. Employees could cash in their shares immediately, or two years later if they wished to qualify for a 10% capital gains tax rate.
HMRC was of the view that income tax and NICs should be charged as if the employees had been paid the bonuses allocated to them in cash. UBS and DB’s appeals to the First-tier Tribunal were dismissed.
The banks appealed to the Upper Tribunal and the appeals were heard together. The Upper Tribunal allowed UBS’s appeal. DB’s appeal was dismissed, on the basis that the arrangements failed to comply with a technical requirement for exemption.
The Court of Appeal dismissed HMRC’s appeal in the UBS case, and allowed DB’s appeal (the Court of Appeal's decision was discussed in our previous blog).
HMRC appealed to the Supreme Court.
The Supreme Court's decision
The Supreme Court unanimously allowed HMRC’s appeals (the leading judgment was given by Lord Reed with which Lords Neuberger, Mance, Carnwath and Hodge agreed).
The Court first considered whether a purposive interpretation of Schedule 2 to ITEPA was possible, and if so, how that would apply.
The Court considered whether the arrangements were in place for "a genuine business or commercial purpose", in accordance with the principle established in Ramsay.
It noted that Chapter 2, of Part 7 of ITEPA does not contain an explanation as to its purpose. However, the context for Chapter 2 provided some indication of what Parliament intended, and in particular, one of the intentions was to counteract opportunities for tax avoidance (paragraph 74). The purposes of Part 7 overall were broadly identified in Grays Timber Products Ltd v HMRC  UKSC 4 as being:
- to promote employee share ownership by encouraging share incentive schemes;
- since such schemes require benefits to be contingent on future performance, creating a problem if tax is charged on the acquisition of the shares, to wait and see in such cases until the contingency has fallen away; and
- to counteract consequent opportunities for tax avoidance.
The Court said that where a transaction (or an element of a composite transaction) has no purpose other than tax avoidance, it can usually be said that it is inconsistent with the fundamental characteristic of the applicable legislation under consideration.
The Court said that Parliament had not intended to encourage, by exemption from taxation, the award of shares to employees, when the award of such shares has no purpose other than the obtaining of the exemption itself. In the view of the Court, Parliament did not intend that section 423(2) should apply to restrictive conditions that have no business or commercial purpose, but are deliberately contrived solely to take advantage of the exemption.
In the UBS case, the Court found that the condition was completely arbitrary, and had no business or commercial rationale. Further, the economic effect of the restrictive condition was nullified by the hedging arrangements, except to an insignificant and pre-determined extent. Accordingly, the Court held that the condition should be disregarded, with the consequence that the shares were not to be treated as "restricted securities" within the meaning of section 423. The condition in the DB case operated only for a very short period, during which the possibility that it might be triggered lay largely within the control of the employee who would be adversely affected. It had no business or commercial purpose, and thus fell outside section 423.
Having concluded that the exemption did not apply, Lord Reed held that the proper basis for taxation of the bonuses was as shares, and not as cash. The shares did not simply function as a cash delivery mechanism and the amount of cash for which the shares might be redeemed was neither fixed nor ascertainable when the shares were acquired. The value of the shares had to be assessed as at the date of their acquisition, and the restrictive conditions must be taken into account, as ordinary taxation principles require the tax to be based on the shares’ true value.
HMRC had argued that the arrangements were simply vehicles for paying cash to employees free of income tax and NICs, but the Court rejected this argument as the employees did receive shares. In addition, for the purposes of determining the tax charge on acquisition under section 62 of ITEPA 2003, the restrictions on the shares did, to some extent, affect their value, and should therefore be taken into account.
This decision simply confirms that legislation must be construed purposively and applied to a realistic view of the facts and in this instance the Supreme Court reached a different conclusion to that of the Court of Appeal. In both cases the element of the employee incentive which the banks claimed gave a beneficial tax result was a restriction on shares allocated to their employees which they admitted had no commercial purpose other than to secure a tax benefit. As HMRC often argue in tax litigation that transactions were entered into with no commercial purpose other than to achieve a tax saving. In deciding whether a particular arrangement 'works' from a legislative perspective, taxpayers will no doubt wish to consider the commercial versus tax avoidance purpose.