A windfall for option holders?

An Inland Revenue statement following its defeat in the Court of Appeal changes the way sales of shares acquired through unapproved share option exercises are taxed for capital gains tax purposes. This could mean refunds for taxpayers if amended tax returns are lodged in time.

The exercise of unapproved share options is normally charged to income tax on the difference between the market value of the shares at the time of the exercise and the option price paid. If these shares were subsequently sold then capital gains tax would be payable on the difference between the sale proceeds and the option price paid on exercise, but with a tax credit for the amount charged to income tax. In effect, this meant that capital gains tax would only be payable on any rise in the share price since the date of exercise. However, under the Revenue's interpretation of the Court of Appeal decision in the case of Mansworth v Jelley, the capital gains tax position will subtly change, so that capital gains tax will be paid on the difference between the sale proceeds and the market value of the shares at exercise. This in itself would not change the amount of tax payable, except for the fact that the credit for the amount charged to income tax will be given on top of this.

Therefore, capital gains tax will only be payable on the sale of shares acquired from the exercise of an unapproved option if the share price rises more in the period between the exercise and the sale than it did throughout the period the option has been held. In most cases, this will be extremely unlikely. Where shares are sold immediately after exercise without any significant change in price, a capital gains tax loss will arise.

It should be noted that the position of companies and trustees of employee benefit trusts who grant and satisfy the exercise of share options are also affected. The disposal proceeds of shares transferred or issued are also treated as being the market value of the asset at the time the option is exercised.

The Revenue, have said that option holders who exercised unapproved options and subsequently sold those shares in the 2000/2001 tax year can amend their tax return and reclaim any capital gains tax overpaid, before 31 January 2003. Those taxpayers who sold such shares in the 2001/2002 tax year have until 31 January 2004 to submit an amended return. For those returns submitted before 12 December 2002, the Revenue will not take any action to implement the new rules and therefore the onus is very much on the taxpayer to submit an amended return. It may be possible for claims to be made in respect of tax years dating back to 1996/1997, although the position for these may be more difficult.

The Tax Faculty of the Institute of Chartered Accountants in England and Wales have issued a guidance note for their members. They recommend that taxpayers who have exercised unapproved employee share options lodge protective claims before the 31 January deadline. It appears that those who exercised unapproved employee options within the last 6 years may be able to reclaim tax if the appropriate claims are lodged.

Companies and employee benefit trusts which have transferred shares to employees may have greater than anticipated capital gains tax liabilities, but only for periods for which tax returns have not been filed by 12 December 2002.

Where the effect of the Revenue's statement is that taxpayers capital gains are turned into capital losses these can be claimed without the need for an error or mistake claim within 5 years and 10 months of the end of the tax year.

Commentators are divided as to whether the Revenue's statement correctly reflects the technical basis of the Court of Appeal's decision and this is an area where further changes may well be made.

For more information regarding this matter please contact Kate Kelleher (Tel: 020 7367 2860), Toby Locke (Tel: 020 7367 2411) or Sue El Hachmi (Tel: 020 7367 2565) of the Corporate Tax Department in the London office.