Transfer pricing: Types of transactions: share options: Application of the arbitrage receipts rule to the provision of share plans
The arbitrage rules
General guidance on the arbitrage receipts rule (FA(No.2)2005/S26) is available at INTM595500.
In the context of employee share plans, the three main conditions set out in FA(No.2)2005/S26 that need to be considered are that:
- there is a “qualifying payment”, which increases a company’s capital value as represented by its value to its shareholders (as explained in the more general guidance on the arbitrage rules),
- at least some amount of that payment is available as a deduction to the Employer anywhere in the world, and
- the company and the Employer (i.e. the Group) expected a benefit to arise because at least part of the payment is not taxable.
Payments reflecting the true economic substance and economic value of what is provided
In the context of the provision of employee share schemes, in general HMRC do not consider that these conditions will be satisfied in respect of a payment, if the amount of any tax deduction available to the payer (the Employer) is appropriate in relation to the economic substance of what is provided and does not exceed the economic value of what is provided.
This will only be the case where the deduction is in line with transfer pricing rules and the rest of this guidance. (HMRC accept that the IFRS 2/FRS 20 ‘fair value’ of the award will not exceed the economic value of what is provided, if the amount of the payment made is adjusted to reflect the awards that actually vest. For example, an adjustment to reflect awards that lapse may be made by a reverse payment in respect of options that do not vest based on the fair value of those options at that time - see also the section above headed “Options not vesting”.)
HMRC will only issue a Notice under FA(No.2)2005/S26 where the overall tax implications for the group are more favourable than would be appropriate in the light of the true economic substance and economic value of the provision.
Some particular examples include:
- the company (or the company’s trust) grant share options and the Employer makes a payment in excess of the fair value at the time of grant and a tax deduction for an amount in excess of that fair value is available, while the payment is not fully taxable as income or gains of the company. (For example, the Employer makes a deductible payment at the time of exercise of the spread - the difference between the exercise price and the market value at the time of exercise - and this exceeds the fair value of the options at the time of grant.)
- the company (or the company’s trust) grant share options with non market vesting conditions attached and the Employer makes a deductible payment of an amount calculated by reference to the fair value at the time of grant, but based on a larger number of options than actually vest - unless it is the practice to take action that has the effect of correcting for the outcome of the vesting conditions to an appropriate extent. (See the section above headed “Options not vesting”.)
Where the Employer obtains a tax deduction for more than the economic value, and any part of the payment is not taxable as income or gains of the company, then the arbitrage rules would apply. The effect of a Notice would be to require the company to compute its income or gains for tax purposes as if it had received taxable income equal to any untaxed amount for which a deduction was available to the payer.
Employer’s deduction based on statutory relief rather than payment
If the only deduction available is a statutory deduction that is independent of and not conditional on or linked to the payment in any way (e.g. a deduction provided for under FA2003/SCH23 or similar legislation), then the tests will not be satisfied and the arbitrage receipts rule will not apply.
The arbitrage receipts rule applies where the benefit was anticipated in advance. HMRC considers that the test of whether a benefit was expected has to be applied whenever:
- new options are granted, or
- payment arrangements are changed, or
- payments are made other than to satisfy pre-existing (pre-16 March 2005) contractual obligations.
Where intra-group payments are made after 16th March 2005 in respect of options that have been granted in the past, it will be necessary to consider the context of the tax treatment anticipated at the later of:
- time that the agreement was made to make the intra-group payment, or
- the date of grant of the options.
In the event that at the relevant time the group expected that either:
- the Employer would not obtain any deduction for the payment, or
- that the receipt would be fully taxable,
then the arbitrage rules would not apply.
A clearance procedure is available for companies who want advice about whether the legislation will apply to planned transactions. Details of the procedure and who to contact are set out in the arbitrage guidance at INTM596550.