Out of the crooked timber of Schedule 22, Finance Act 2003, no straight thing was ever made
On 3 February 2010, the Supreme Court released its first decision in a tax case: Grays Timber Products Limited v Her Majesty’s Revenue & Customs  UKSC 4. The decision is of relevance to those who advise on arrangements for directors to own, or benefit from, shares in their companies, and provides welcome clarity for practitioners on the meaning of market value under Part 7 of the Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”). Part 7 ITEPA was amended substantially by Schedule 22, Finance Act 2003 shortly after Royal Assent, and this is the first time that these notoriously complex provisions have been considered judicially. It seems that their Lordships would not be too disappointed if it is the last time also, Lord Walker expressing the hope that “Parliament may find time to review the complex and obscure provisions”.
Under a subscription and shareholders agreement (the “subscription agreement”), Mr. Gibson, the Managing Director of Grays Timber Products (“GTP”), subscribed for shares in the parent company of GTP that, in the event of a takeover, entitled him, under the subscription agreement, to a larger part of the consideration than the proportion that would be due otherwise for his percentage holding. On takeover, HMRC claimed that GTP was liable for income tax (under PAYE) and national insurance contributions on the enhanced consideration that Mr Gibson received, under Chapter 3D of Part 7. In determining whether the shares were sold at above market value, the question to decide was whether the shares should be valued simply as ordinary shares or whether the special rights in the subscription agreement should be taken into account. If the latter, then it was necessary to determine the effect of the special rights on the valuation.
The key issue that was considered by the courts was the definition of ‘market value’ for the purpose of Part 7 of ITEPA 2003 (Chapter 3D of which imposes an income tax charge on any amount by which consideration received for a disposal of employment-related securities exceeds the market value of the securities).
The definition of “market value” for these purposes is based on a long line of different statutory provisions and case law decisions going back over a century. Very broadly, the approach to take in calculating the market value of shares is to determine what a hypothetical purchaser would pay on the open market to “stand in the shoes” of the vendor. As the Supreme Court makes clear, this “homely metaphor” is designed to emphasise that a valuer should first determine the position a hypothetical purchaser would be in after a notional acquisition of the shares on the open market, and then determine what the purchaser would be prepared to pay to be in that position. What it does not mean is that the hypothetical purchaser should be treated as being in exactly the same position as the vendor. In particular, rights which are personal to the vendor must not be taken into account where they are worthless to a hypothetical purchaser.
In determining whether any particular right (such as Mr Gibson’s rights under the subscription agreement) should be taken into account in calculating the value of the shares, it is irrelevant whether such a right is “intrinsic” or “extrinsic” to the shares. What matters is whether the right is personal to the vendor or whether it would still be of value to a hypothetical purchaser immediately after they acquired the shares on the open market. In the instant case, because the rights under the shareholders agreement were clearly personal to Mr Gibson only, they should not be taken into account in valuing the shares. They would not be acquired by the hypothetical purchaser and were of no value to such a purchaser – accordingly a hypothetical vendor would receive nothing extra on account of them. The market valuation of the shares should not therefore take account of the actual sale at a special price enhanced for reasons related to Mr Gibson’s employment as Managing Director. Thus, Mr Gibson received more than the market value for his shares; and GTP was liable for income tax and national insurance contributions on the enhanced consideration that Mr Gibson received.
The decision of the Supreme Court clarifies a matter that had been the subject of much debate amongst tax practitioners, namely precisely what rights should be taken into account in trying to calculate the market value of a share. It is now clear that it does not matter whether a right is “intrinsic” or “extrinsic” to the share; what matters is whether the right “runs” with the share, in the sense that after a sale of the share a hypothetical purchaser would benefit from that right.
Hartley Foster is a partner and Matthew Wentworth a barrister and legal advisor in Olswang’s Tax Group