Termination Payments: EMI Judgement Day
The recent decision by the First-tier Tribunal in Reid v HMRC  UKFTT 182 (TC) is a timely reminder for employers and employees of the importance of carefully analysing the tax status of all elements of a termination payment. This case considers the refund of an option payment.
In this case, Mr Reid was a director who, shortly after joining the company, entered into an Enterprise Management Incentive (EMI) share option agreement with the company. Under the terms of the agreement Mr Reid paid £30,000 to the company in return for the grant of the options (this payment was not the exercise price). It was understood by both parties that the £30,000 (an unusually large consideration sum for a nil-cost EMI option) would be refunded if Mr Reid ceased to be employed by the company prior to exercising the options.
A few years later Mr Reid resigned and entered into a compromise agreement with the company. The compromise agreement stated that the company would pay Mr Reid the sum of £77,731 by way of compensation, less any income tax or national insurance that the employer was required by law to deduct (the "Termination Payment"). The compromise agreement contained no further detail regarding the Termination Payment other than to state that it included any statutory redundancy pay due to Mr Reid; no specific reference was made to the repayment of the £30,000 paid by Mr Reid for the grant EMI options.
Mr Reid subsequently filed his self-assessment tax return, claiming that the £30,000 he paid for the EMI option grant was refundable to him by the company and, as such, was not taxable. HMRC issued an assessment to Mr Reid for the income tax due on the undeclared £30,000 and Mr Reid appealed to the First-tier Tribunal.
In dismissing the appeal and concluding that the amount was taxable, the Tribunal found that, while there was an understanding between the parties that the £30,000 would be refunded on termination, it was unable to find in Mr Reid's favour because the compromise agreement did not characterise any part of the Termination Payment as a refund and, as the compromise agreement contained an entire agreement clause, it superseded all previous agreements and understandings between the parties. Therefore, in the Tribunal's opinion, the lack of any reference in the compromise agreement to the refund, combined with the entire agreement clause, resulted in the £30,000 becoming taxable when, if it had been paid on its own or identified separately in the compromise agreement, it may not have given rise to any tax liability.
As it stood the Tribunal could not consider the terms of the EMI scheme, only the payment in isolation. It was not strictly speaking, compensation for loss of office and therefore was taxable. As the payment was due under PAYE, it is for the employer to find this liability in the first instance and then seek to reclaim it from the director.
There are elements of this decision that are unclear and it remains to be seen whether it will be appealed. Nevertheless, the decision suggest that the compromise agreement made taxable a part of the payment that otherwise might not have been and is an important reminder that employers and employees should seek advice in relation to the tax consequences of termination payments, even where the tax treatment appears straightforward, and compromise agreements should, where appropriate, contain the reasons why the employer is paying each element of a termination payment to the employee. There is no such thing as a one size fits all legal document, be it a compromise agreement or share option agreement.
A further observation worth highlighting is that it is unusual for any payment to be required as consideration for the grant of an option. Payment is usually only required to exercise the option and then as consideration for buying the shares acquired. RM2 prepare option agreements as deeds and this means there is no requirement for an optionee to pay anything as considerations for the grant. Only solicitors can draft deeds. Where a contractual option agreement is prepared not as a deed (e.g. by an accountant) then there is a need for a consideration payment to be made to create a binding contractual agreement and, as evidenced by this case, this can create an unnecessary level of complexity.
If you would like further advice on this topic please contact Liz Hunter on 020 8949 5522.