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In this post, Andre Anthony, a senior associate in the Tax team at CMS, comments on the decision of the UK Supreme Court in Commissioners for Her Majesty’s Revenue and Customs v NCL Investments Ltd and another [2022] UKSC 9. The Supreme Court was asked to consider whether accounting debits relating to the grant of share options to employees are a deductible expense for corporation tax purposes.

On 23 March 2022, the Supreme Court unanimously dismissed HMRC’s appeal against the decision of the Court of Appeal in Commissioners for Her Majesty’s Revenue and Customs v NCL Investments Ltd and another 2020 EWCA Civ 663.

Background

The appeal turns on whether accounting debits relating to the grant of share options to employees are a deductible expense for corporation tax purposes.

The taxpayers were wholly owned subsidiaries of a holding company, Smith & Williamson Holdings Ltd (“SWHL”). The taxpayers employed staff whom they made available to other companies within the corporate group for a fee.

In 2003, SWHL settled an employee benefit trust which gave employees a contractual right to acquire shares in SWHL for a specified price. When options were granted to employees of one of the taxpayers, it would recognise an indebtedness to SWHL equal to the fair value of the options, which was settled monthly (“the Recharge”). The taxpayers passed the cost of the Recharge to the group companies using the services of their employees as part of the charge made to those companies.

The grant of the options was governed by the accounting standard International Financial Reporting Standard 2 (“IFRS 2”). Pursuant to IFRS 2, on the grant of a share option to an employee, the relevant taxpayer was required to recognise a debit in its income statement equal to the fair value of the options, regardless of whether the taxpayer had to pay any amount to the holding company or the trustee of the employee benefit trust in relation to the grant of those options, and recognise a capital contribution received from the holding company as a credit on its balance sheet.

The taxpayers claimed the debits as deductions in the computation of the profits of their trade for the purposes of corporation tax. HMRC refused the corporation tax deduction and issued “closure notices” disallowing the deductions.

Decisions of the lower courts

At first instance, the taxpayers successfully appealed to the First-tier Tribunal against the closure notices. The First-tier Tribunal held that the taxpayers were entitled to claim deductions for corporation tax purposes as expenses against trading profits for ten accounting debits relating to the grant of share options to the taxpayers’ employees that were recognised in their respective income statements pursuant to IFRS 2. HMRC appealed to the Upper Tribunal.

The Upper Tribunal dismissed HMRC’s appeal on the following four grounds. First, the IFRS 2 debits were expenses incurred wholly and exclusively for the purposes of each taxpayer’s trade. Second, the Corporation Tax Act 2009 (the “Act”), s 54(1)(a) did not impose an additional requirement on what was an “expense” under the Act, ss 46 and 48. Third, the IFRS 2 debits were correctly categorised as revenue rather than capital items. Fourth, the Act s 1290 did not bar a corporation tax deduction whenever a company makes an outright payment to employees that are not subject to tax in the employee’s hands.

HMRC’s appealed against the decision of the Upper Tribunal to the Court of Appeal on the overall basis that the options could not be taken into account in the calculation of the taxpayers’ profits because there was no matching outflow of cash from the taxpayers.

In a unanimous decision, the Court of Appeal dismissed HMRC’s appeal, on two main grounds.

First, the Court of Appeal held that the combined effect of the Act, ss 46 and 48, was to define allowable expenses as those debits made in accordance with generally accepted accounting practice (“GAAP”) in calculating the profits of a trade. Those provisions did not require any further examination of whether such accounting debits were “expenses”. The use of “incurred” in the Act s 54(1)(a) did not impose any additional requirement.

The Court of Appeal agreed with the First-tier Tribunal that the debits in this case were required by IFRS 2 to reflect the consumption by the taxpayers of the services provided by the employees, who were in part remunerated by the grant of the options. The taxpayers consumed those services wholly and exclusively for the purposes of their trades.

Second, the Court of Appeal held that the Act, s 1290 did not apply to deny or defer allowance of the relevant debits in this case on the basis that the deductions claimed by the taxpayers were not deductions in respect of an “employee benefit contribution”. The benefit received by an employee was the option. It was the option that entitled the employee to acquire shares at a price that might be less than their market value. The acquisition of shares on exercise of the option was not the benefit received by the employee, but the fulfilment of an existing contractual entitlement.

The Supreme Court decision

In a unanimous decision, the Supreme Court dismissed HMRC’s appeal, on the same grounds as the courts below. The judgment was given by Lord Hamblen and Lady Rose, with whom Lord Reed, Lord Briggs and Lord Sales agreed.

The Supreme Court considered four issues, as follows:

  1. first, whether disregarding the debits is an “adjustment required or authorised by law” within the meaning of the Act, s 46(1);
  2. second, whether the deduction is disallowed by the Act, s 54(1)(a);
  3. third, whether the deduction is disallowed by the Act, s 53, which provides that no deduction is allowed for “items of a capital nature”; and
  4. fourth, whether the deduction is disallowed (or deferred) by the Act, s 1290.

On the first issue, the Supreme Court opined that there is no general theoretical basis to calculate profits other than in accordance with GAAP. Here the debits had been brought into account in calculating the profits in accordance with GAAP. As such, under the Act, s 48, they are treated as expenses for the purpose of the calculation of trading profits, whether or not an amount had actually been paid, subject to an “express provision to the contrary”. No such contrary provision had been identified by HMRC.

The Court held that there is no adjustment required or authorised by law to the effect that if profits in the profit and loss account are depressed because of an entry which is matching an entry in the balance sheet, then that is to be left out of account in calculating profits for corporation tax. Nor did the Court see any policy justification for drawing that distinction.

On the second issue, the Court held that the deduction is not disallowed by the Act, s 54(1)(a). It rejected HMRC’s contention that the Act, s 54 imports a further requirement as to what constitutes an “expense”, namely that it has to be shown to be “incurred”.

On the third issue, the Court agreed with the First-tier Tribunal that the debits were revenue in nature, not capital. The fact that the matching credit entry was a capital contribution does not change that. What matters is the character of the debits, not that of any corresponding credit. On this basis, the Court held that the deduction is not disallowed by the Act, s 53(1).

On the final issue, the Court held that the Act, s 1290 did not apply here because the grant of the option was not an “employee benefit contribution” within the meaning of the Act, s 1291, adopting the same reasoning as the lower courts on this issue.

Comment

This case considers the interaction between tax law and GAAP. It is rare for such a case to reach the Supreme Court.

While the Court of Appeal acknowledged that the “accounting treatment by the taxpayers of the grant of the options is central to the issues” and remarked that on these facts, IFRS 2 produced a “counter-intuitive” and “surprising” result by “requiring a debit to profit and loss account even though there is no outflow of funds but prohibiting a debit that does recognise an outflow of funds” (in respect of the Recharge), the Supreme Court did not express a view on this.

The facts of this case would have allowed the Supreme Court to explore more broadly the relationship between the principles of tax law and the current accounting standards. However, the Court did not further explore this theme, preferring instead to focus on the specific facts and issues relevant to the appeal.