Grays Timber Products Limited (Appellants) v Her Majesty's Revenue and Customs (Respondents) (Scotland)
Lord Hope, Deputy President
JUDGMENT GIVEN ON
3 February 2010
Heard on 14 and 15 December 2009
(Instructed by Biggart Baillie LLP)
David Johnston QC
(Instructed by HM Revenue and Customs)
"CHAPTER 3D – Securities Disposed of for More Than Market Value
"446X Application of this Chapter
This Chapter applies if –
(a) employment-related securities are disposed of by an associated person so that no associated person is any longer beneficially entitled to them, and
(b) the disposal is for a consideration which exceeds the market value of the employment-related securities at the time of the disposal.
446Y Amount treated as income
(1) Where this Chapter applies the amount determined under subsection (3) counts as employment income of the employee for the relevant tax year.
(2) The 'relevant tax year' is the tax year in which the disposal occurs.
(3) The amount is –
CD – MV – DA.
CD is the amount of the consideration given on the disposal,
MV is the market value of the employment-related securities at the time of the disposal, and
DA is the amount of any expenses incurred in connection with the disposal.
(1) In this Chapter 'market value' has the meaning indicated in section 421(1).
(2) For the purposes of this Chapter sections 421(2) and 421A apply for determining the amount of the consideration given for anything.
(3) In this Chapter –
'the employee', and
have the meaning indicated in section 421B(8).
(4) In this Chapter 'associated person' has the meaning indicated in section 421C."
It is common ground that Mr Gibson's shares were "employment-related securities". He was an "associated person" and no issue arises as to any other "associated person". The main area of controversy is "market value", which is defined by reference to the Taxation of Chargeable Gains Act 1992.
"I think that the conferring of a right of this kind as an incident of service is a profit or perquisite which is taxable as such in the year of receipt, so long as the right itself can fairly be given a monetary value, and it is no more relevant for this purpose whether the option is exercised or not in that year, than it would be if the advantage received were in the form of some tangible form of commercial property."
That was a case about share options, which are now dealt with separately in Chapter 5, but it illustrates the general approach that applied in the days when the taxation of employee benefits was very much simpler than it is now.
The subscription agreement and the sale agreement
"Mr Gibson wishes to subscribe up to 14,465 ordinary shares of £1 each in the share capital of [Group] and [Group] has agreed to issue such shares to him on the terms and conditions set out below."
"In the event of a Shares' Disposal taking place on or after the second anniversary of the Completion Date, Mr Gibson shall sell and the Shareholders shall procure that [Group] or that the purchaser in terms of the Shares' Disposal shall purchase Mr Gibson's Shares at a price equal to the aggregate of the sums calculated in accordance with (i) and (ii) below."
Item (i) was, in the event, £50,000. Item (ii) was one-third of D-(E+F), that is (D) the consideration (£6m) less the total of (E) the target net asset value of the company at the date of the disposal (approximately £1.46m) and (F) item (i) (£0.05m). The total consideration was therefore about £1.5m. HMRC's revised notice of determination proceeded on the basis that this sum exceeded the statutory market value of the shares by £1,059,737, and that the latter sum attracted income tax and NIC. Initially HMRC relied on Chapter 4 of Part 7 of ITEPA 2003, and only later on Chapter 3D, which led to an adjustment as mentioned in paras 1 and 50 of the Special Commissioner's decision. Clause 4.2.2 contained similar provisions applying on a sale of Group's business.
"The Shareholders acknowledge and accept that Mr Gibson is to become an executive director of [Timber Products] and shareholder of [Group] on the agreement that, if by reason of his efforts as such an executive director, Net Asset Value plus the Notional Goodwill exceeds the Target Net Asset Value on a return of his investment by share buy-back or the Consideration exceeds the Target Net Asset Value on a return of his investment on a sale, he will in certain circumstances and in accordance with clauses 3 and 4 be entitled to an agreed extra payment in addition to the return of his initial investment and, on such a sale, disproportionately greater than the amounts received by other shareholders or (sic) his percentage of the equity share capital of [Group]."
Further provisions in clause 6 ensured that these rights were not to be prejudiced by any distribution or reduction of Group's assets.
"The provisions of this Agreement shall prevail over the Articles (and any other Articles of Association of [Group] subsequently amending or replacing the same) such that if there is any conflict between the two the provisions of this Agreement shall prevail and rule to the exclusion of any such conflicting provisions of the Articles or such other Articles of Association."
"272 Valuation: general
(1) In this Act 'market value' in relation to any assets means the price which those assets might reasonably be expected to fetch on a sale in the open market.
(2) In estimating the market value of any assets no reduction shall be made in the estimate on account of the estimate being made on the assumption that the whole of the assets is to be placed on the market at one and the same time.
273 Unquoted shares and securities
(1) The provisions of subsection (3) below shall have effect in any case where, in relation to an asset to which this section applies, there falls to be determined by virtue of section 272(1) the price which the asset might reasonably be expected to fetch on a sale in the open market.
(2) The assets to which this section applies are shares and securities which are not quoted on a recognised stock exchange at the time as at which their market value for the purposes of tax on chargeable gains falls to be determined.
(3) For the purposes of a determination falling within subsection (1) above, it shall be assumed that, in the open market which is postulated for the purposes of that determination, there is available to any prospective purchaser of the asset in question all the information which a prudent prospective purchaser of the asset might reasonably require if he were proposing to purchase it from a willing vendor by private treaty and at arm's length."
The definition in section 272 can be traced back to section 44 of the Finance Act 1965 and from there to the estate duty valuation provisions in section 7(5) of the Finance Act 1894. Both sides referred to many of the leading cases on the estate duty definition, including Attorney-General v Jameson  2 IR 218, Salvesen's Trustees v Inland Revenue Comrs 1930 SLT 387, Inland Revenue Comrs v Crossman  AC 26 (in which the House of Lords was divided by three to two) and Lynall v Inland Revenue Comrs  AC 680 (in which Crossman was challenged but unanimously upheld on the wider issue, but the taxpayer succeeded on the narrower issue as to access to information, so leading to the rule now embodied in section 273 of the 1992 Act). Reference was also made to Inland Revenue Comrs v Gray  STC 360, which was concerned with the same definition as used for the purposes of capital transfer tax (now inheritance tax).
"The Attorney-General and the defendants agree in saying that in this case there cannot be an actual sale in open market. Therefore, argues the former, we must assume that there is no restriction of any kind on the disposition of the shares and estimate that [sic] would be given therefor by a purchaser, who upon registration would have complete control over them. My objection to this mode of ascertaining the value is that the property bought in the imaginary sale would be a different property from that which Henry Jameson held at the time of his death. The defendants, on the other hand, contend that the only sale possible is a sale at which the highest price would be £100 per share, and that this ought to be the estimated value. My objection is that this estimate is not based on a sale in open market as required by the Act. Being unable to accept either solution, I go back to my own, which is in strict accordance with the language of the section. I assume that there is such a sale of the shares as is contemplated by article 11, the effect of which would be to place the purchaser in the same position as that occupied by Henry Jameson. An expert would have no difficulty in estimating their value on this basis. It would be less than the Crown claims, and more than the defendants offer; but I believe that it would be arrived at in accordance not only with the language of the Act, but with the methods usually employed in valuing property."
"The Act of Parliament requires, however, that the assumed sale, which is to guide the Commissioners in estimating the value, is to take place in the open market. Under these circumstances I think that there is no escape from the conclusion that any restrictions which prevent the shares being sold in an open market must be disregarded so far as the assumed sale under section 7(5) of the Act of 1894 is concerned. But, on the other hand, the terms of that subsection do not require or authorise the Commissioners to disregard such restrictions in considering the nature and value of the subject which the hypothetical buyer acquires at the assumed sale. Though he is deemed to buy in an open and unrestricted market, he buys a share which, after it is transferred to him, is subject to all the conditions in the articles of association, including the restrictions on the right of transfer, and this circumstance may affect the price which he would be willing to offer."
Intrinsic and extrinsic rights
"First, a company is an association of persons for an economic purpose, usually entered into with legal advice and some degree of formality. The terms of the association are contained in the articles of association and sometimes in collateral agreements between the shareholders."
Lord Hoffmann also stated at p 1101:
"But there may be later promises, by words or conduct, which it would be unfair to allow a member to ignore. Nor is it necessary that such promises should be independently enforceable as a matter of contract. A promise may be binding as a matter of justice and equity although for one reason or another (for example, because in favour of a third party) it would not be enforceable in law."
"Of course, individual shareholders may deal with their own interests by contract in such way as they may think fit. But such contracts, whether made by all or some only of the shareholders, would create personal obligations, or an exceptio personalis against themselves only, and would not become a regulation of the company, or be binding on the transferees of the parties to it, or upon new or non-assenting shareholders."
"Q: Market value is now based on the CGT definition. Does this mean that personal restrictions on the share no longer have to be taken into account in arriving at its value?
A: No. Even where there is, for example, a restriction on sale the shares must be valued as if that restriction would still apply to their hypothetical purchaser. It is the asset (as it is) that is being valued, not some other unrestricted asset."
Question 1(m) and its answer were:
"Q: The Inland Revenue has confirmed that 'market value' will take into account personal rights and restrictions and not just those rights and restrictions attaching to the shares. Can you confirm that this interpretation of 'market value' will be applied consistently throughout Schedule 22 [to the Finance Act 2003] and that you will not adopt a different interpretation for each Chapter of Part 7?
A: Market value will be determined on a consistent basis throughout Chapters 1 to 5 of Part 7."
Mr Johnston QC (appearing for HMRC in this Court, as he did in the Court of Session) was unable to explain or defend these answers. He said that they were not clear, but to my mind they are perfectly clear – and, on HMRC's case, clearly wrong.
Standing in the shareholders' shoes
"The purpose of section 7(5) ... is to value the property. 'It does not' as Lord Evershed said 'require you to assume that the sale ... has occurred.' It simply prescribes, as the criterion for value, price in the open market as between a willing seller and a willing buyer, which is a familiar basis for valuation."
Similarly, in this case, the valuation does not have to take account of the actual sale of Mr Gibson's shares at a special price enhanced for reasons related to Mr Gibson's special position as managing director.
"For the purposes of this Chapter employment-related securities are restricted securities or a restricted interest in securities if –
(a) there is any contract, agreement, arrangement or condition which makes provision to which any of subsections (2) to (4) applies, and
(b) the market value of the employment-related securities is less than it would be but for that provision."
He drew attention to the width of this definition. Furthermore, the calculation of the amount of the charge under that Chapter that section 428 takes account of what the market value of the employment-related securities would be immediately after the chargeable event but for any restrictions: section 428(2). This provision, said Mr Sherry, indicated that it was to be assumed for the purposes of this calculation that restrictions outside the articles as well as those contained within them could affect market value. He submitted that this approach should be carried forward consistently into Chapters 3, 3A, 3B, 3C and 3D. For example, section 436, which defines "convertible securities" for the purposes of Chapter 3, refers to a contract, agreement, arrangement or condition which makes provision for the conversion of the securities, which must be taken to be something found in the governing instrument and outside the articles. As in Chapter 2, this approach was carried through into the charging provisions under this Chapter: sections 437, 440.
LORD RODGER, LORD BROWN AND LORD KERR