Corporation tax relief for lapsed share options – taxpayers win at the Supreme Court

HMRC lost their appeal in NCL Investments Ltd, meaning that IFRS 2 debits were deductible as trading expenses for certain accounting periods.

Corporation tax relief for lapsed share options – taxpayers win at the Supreme Court

The Supreme Court has upheld the unanimous decisions of the Court of Appeal (CA) and tax tribunals that accounting charges associated with employee share options were deductible when calculating trading profits. Subsequent legislation has made clear that no deduction would now be available in the particular circumstances considered by the Supreme Court, although the decision will be welcomed by those other employers still disputing the availability of relief in respect of lapsed employee share options in periods that ended prior to 20 March 2013. The decision is also of more general importance because of the guidance it provides on a number of fundamental questions around how companies should calculate their taxable trading profits.


The taxpayers recognised accounting charges under International Financial Reporting Standard 2 (IFRS 2) in respect of share options granted to their employees by an employee benefit trust (EBT).

The options lapsed without being exercised, so no corporation tax relief was available under the specific statutory rules for employee share schemes. The employing companies therefore instead claimed corporation tax relief in respect of the accounting debits under the general rule that the profits of a trade subject to corporation tax are those calculated in accordance with Generally Accepted Accounting Practice (GAAP) “subject to any adjustment required or authorised by law”.

HMRC’s position, however, was that on various grounds the law did in fact require an adjustment to the accounting profit so as to deny relief for the debits recognised under IFRS 2.

The Supreme Court decision

On appeal to the Supreme Court, HMRC relied on essentially the same arguments which had previously been rejected by the First-tier Tribunal (FTT), the Upper Tribunal (UT) and the CA. That the Supreme Court would take the same position was generally expected, but although largely adopting the same reasoning as the earlier decisions, the latest judgment – coming with the authority of the Supreme Court – has a number of points of interest, as summarised below.

Is it necessary to adjust for judge-made rules of law?

HMRC argued that the 1940 decision of the House of Lords in Lowry v Consolidated African Selection Trust Ltd (denying the taxpayer corporation tax relief for issuing shares to employees for less than their market value) established a judge-made rule of law which required an adjustment to be made to accounting profits in respect of the IFRS 2 debits.

Whilst accepting the possibility that a judge-made rule of law could require an adjustment to accounting profits, the Supreme Court held that it would need to be “a rule which it is clear applies notwithstanding that the company’s profits have been calculated in accordance with generally accepted accounting principles.”

The decision in Lowry (which pre-dated the statutory reliance on GAAP when calculating taxable profits and did not make any explicit finding in relation to accounting principles) simply did not meet this test. Moreover, the Supreme Court’s endorsement of the view that there is no general theoretical basis for the courts to calculate profits other than GAAP suggests that the number of judge-made rules which would meet the test is likely to be small.

Should GAAP be generally accepted for tax?

HMRC sought to draw a distinction between accounting practices directed at preserving the integrity of the company’s balance sheet and those directed at computing profit. As it was profits that were the exclusive concern for corporation tax purposes, HMRC’s view was that a rule of law could be inferred which required adjustments to be made to disregard the impact of accounting practices falling in the first category (of which IFRS 2 was said to be an example).

The Supreme Court did not accept that a company’s balance sheet and profit and loss account were separate and severable as HMRC’s argument suggested and concluded that the distinction HMRC sought to rely on was not a valid one. The widespread use of International Accounting Standards means that HMRC’s line of argument on this point had potentially far-reaching implications and the Supreme Court’s robust rejection of it will therefore be met by a sigh of relief from many companies.

Must expenses be ‘incurred’?

No deduction is allowed for “expenses not incurred wholly and exclusively for the purposes of the trade”. HMRC argued that this means in particular that in order to be deductible, expenses must have been ‘incurred’, which in turn required that there be an economic cost to the company.

In rejecting this interpretation, the Supreme Court has laid to rest the lingering uncertainty created by certain comments of the UT in Ingenious Games which HMRC had relied on as supporting its position on this point.

The statutory provision in question had been rewritten in 2009 in connection with the Tax Law Rewrite Project and HMRC had also sought to rely on case law dealing with the differently worded predecessor provision. The Supreme Court found that the different wording made that reliance inappropriate in this case, but explicitly left open the general question as to when it might be appropriate to refer to case law on earlier incarnations of particular tax provisions. In so doing it appears to have distanced itself from comments on this subject in the earlier case of R (on the application of Derry) v HMRC and could invite speculation as to whether the Tax Law Rewrite Project may have caused changes in the effect of the law in more instances than previously thought.

Purposeless debits?

With ‘substance over form’ accounting creating the potential for a divergence between the legal transactions a company enters into and how these are represented in its accounts, a perennial problem from a tax perspective is how questions regarding the company’s purpose in relation to those accounting entries should be answered. Here HMRC argued that as the decision to grant the relevant options had in fact been made by the parent company and the trustee of the EBT, it was impossible to ascribe any ‘purposes’ to the IFRS 2 debits on the part of the employing companies.

Importantly the Supreme Court disagreed, holding that the FTT’s finding of fact that the debits were incurred for the purposes of the companies’ trades was one it was entitled to make and that no grounds for challenging it had been made. The Supreme Court’s endorsement of the CA’s observations on this point adds additional emphasis to the need to understand the rationale underlying the accounting treatment when approaching issues of this kind.

When does a capital contribution cause an expense to be capital in nature?

No corporation tax deduction is allowed for items of a capital nature.

HMRC argued that the debits were simply the corresponding entries needed to match the ‘capital contribution’ from the parent company which IFRS 2 required the employers to recognise on grant of the options. On HMRC’s analysis this meant that the debits themselves were necessarily capital in nature.

The UK tax treatment of transactions accounted for as capital contributions has long been an area subject to technical uncertainty. The Supreme Court’s rejection of HMRC’s argument and emphasis that what mattered was the character of the debits themselves will therefore be of interest to anybody analysing the tax consequences of intra-group arrangements resulting in the recognition of capital contributions.

What is an ‘employee benefit contribution’?

If related to an ‘employee benefit contribution’, relief for the accounting debits would have been deferred indefinitely. In a section of its judgment relevant to anybody analysing the scope of these rules, the Supreme Court rejected HMRC’s argument that there had been an ‘employee benefit contribution’ because a ‘result’ of either the grant of the options or the acquisition of shares by the EBT to settle the options was that property was ‘held’ under an employee benefit scheme in the relevant sense.