CooperVision: One in the Eye

First Tier Tribunal Decision Raises Questions on Employment-Related Securities and Tax Valuations

The tax case of CooperVision , heard recently by the First Tier Tribunal, feels like a case we’ll hear more about over the next couple of years.

This case concerns longstanding executives who had invested in a company and eventually acquired a majority holding between them. On exit, as majority shareholders they were able to negotiate a greater share of the consideration given for the acquisition of the company by a third party purchaser than was justified by their pro rata shareholding. The minority shareholders received correspondingly less. 

The question at issue was whether the excess was subject to income tax and NICs, at significantly higher rates than the capital gains tax which applies in the case of non-employee shareholders, on the basis that it represented the proceeds from the sale of employment related securities at above market value. The evidence seems to have been fairly clear that there was no intention by anyone involved to reward the executives for their employment services at the time of the exit.

Are employee shares always employment-related securities?

The first question addressed by the tribunal was whether the shares were employment-related securities. There are two alternative tests, a causation test and a deeming test, either of which can result in ERS treatment. 

The deeming test was recently considered by the Supreme Court in Vermilion in a judgment which has caused some concern due to the inflexible approach taken by the court. The deeming test deems, in most circumstances, shares acquired by an employee to be employment-related securities where the right or opportunity to acquire the shares is made available by the person’s employer (regardless of whether the same opportunity was made available to non-employees). The causation test, on the other hand, is concerned instead with whether the right or opportunity is available by reason of employment (regardless of who made it available).

The shares in issue in this case were acquired in four transactions. In the first transaction, both the deeming and causation tests were found to be met. In the second and third transactions, shares were acquired from fellow shareholders rather than from the company on issue and in that context only the causation test was considered relevant. It was found to be met because the transactions were linked to the first transaction.

In the fourth transaction, one of the other shareholders had decided to sell up and exit the business. It appears that the opportunity to acquire the shares was offered to all shareholders but was not taken up pro rata, with the executives acquiring more than their pro rata share. However, the transaction did not proceed as a sale. Instead the shares were bought back by the company at one price and the same number of new shares was issued to the shareholder group at a significantly lower price. 

The tribunal found that the deeming test was not satisfied because, viewed realistically, the right to acquire the shares was made available by the departing shareholder and not by the company. The causation test was not met because the shares were offered to all shareholders regardless of employment status.

It is also thought that the deeming test may be limited where it produces an unjust, absurd or anomalous result, but that possibility is not referenced in the CooperVision judgment. Instead this looks to be a rare example of the substance over form Ramsay doctrine being applied in the taxpayer’s favour.

Were the shares sold for more than market value?

Another Supreme Court decision, Grays Timber Products, carried the day on the market value issue. In that case, as a term of his subscription agreement, an executive acquired a contractual entitlement to receive a disproportionately large share of the proceeds on an exit. The court found that these were not part of the share rights since they were not valuable to a purchaser and so the excess part of the consideration on exit was consideration above market value subject to income tax. 

If the relevant rights had formed part of the share rights (for example by creating a new class of share with preferential economic rights) and a s.431 election had been made, tax would instead have arisen upfront by reference to the value of the shares at that time. In a deal that ultimately proves successful that is likely to be more efficient because the value at the time of acquisition reflects the uncertainty of the success of the venture as well as, potentially, liquidity and minority discounts.

There was no pre-agreement as to the split of the consideration in CooperVision; it was the product of negotiations around the sale. The advisers on the sale had been alive to the market value issue and ultimately the SPA had been split, with the executives selling under one agreement for the enhanced price and the other shareholders selling under a separate agreement at a lower price and on very slightly different terms (the agreements were, however, inter-conditional). 

The company argued that the best evidence of valuation was the actual transaction entered into at arm’s length with the actual purchaser. However, in the eyes of the tribunal, the valuation issue should be considered from the perspective of a hypothetical purchaser and such a purchaser would have no reason to value the shares differently simply because some had been held by majority shareholders with the power to block the deal.

The facts of the case are somewhat unusual in that management will more typically be minority shareholders. Minority discounts are a widely accepted feature of tax valuations. I don’t read the tribunal decision to challenge this. It seems that this will be an acceptable valuation method where only a minority package of shares forms part of the hypothetical sale that is being valued, but not where the hypothetical sale is part of a sale of the whole company. In the former case, the buyer will inherit the minority position but, in the latter case, it won’t. However, it is odd that the same shares in the hands of the minority seller suddenly jump in value for tax purposes at exit. 

It is perhaps a logical extension of the company’s line of argument that a sale by a minority shareholder who is an employee for pro rata consideration would actually be above market value (tag rights being extrinsic) and therefore taxable, but fortunately this is not the prevailing view.

It does seem harsh that causation isn’t a factor in the relevant rules because that does seem to be a point of distinction between the current case and Grays Timber. The rules simply assume that if employment-related securities are sold in excess of market value, the excess must be part of the reward for the executive’s employment. However, in this case, the shares acquired by the executives had presumably been subject to tax at the point of issue (if below market value) and fully 25 years had elapsed between acquisition and sale. 

The excess that the executives were able to obtain appears to be the result of their position as majority shareholders rather than of any desire to reward their services as director (as had been the case in Grays Timber).

Was the assessment time barred?

There was a final challenge for HMRC to overcome to win this case. The assessments were outside the normal four-year time limit. As a result, the claims were time barred unless they could demonstrate that the determination involved a “loss of income tax… brought about carelessly” by the company. 

The issue had arisen in the context of a major M&A transaction involving top accountancy and law firms. The accountancy firm had provided several pieces of advice in writing, including a fairly robust opinion, supporting the company’s position. However, in the eyes of the tribunal this wasn’t enough; a reasonable taxpayer would have scrutinised the advice and realised that it was not reliable. The company was therefore careless. 

What’s more, the tribunal thought that “the view of the market value test taken by the appellant is not one which any reasonable suitably qualified professional adviser would take”. Had the company sought advice based on full information, the tribunal thought, they would have been advised that they needed to account for the tax. As a result, the carelessness brought about the loss of tax and the assessments were valid.

Based on the description in the case, this seems to have been a fairly typical M&A process where advisers were in general agreement as to the issue (significant risk rather than definite liability) and the company had perhaps gone further than in many other cases in seeking a formal opinion rather than relying on a high level report and discussion with advisers. 

Although the test posed by the legislation to allow HMRC to access the longer time line sounds like a high bar where advice has been sought and followed, the tribunal’s interpretation suggests the circumstances may in fact be fairly limited in which relying on advice which is ultimately not accepted by the courts provides comfort on time limits. 

The finding on carelessness also has implications for what taxpayers need to do when relying on advice in order to protect themselves from penalties.

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