INTM464140 - Transfer pricing: types of transactions

Groups often use share-based compensation plans as an important part of their remuneration packages. Such plans come in all shapes and sizes. Sometimes they are open only to senior executives, though increasingly they are open to employees at all levels and in all locations in the firm. The compensation may be in the form of a straightforward award of shares, sometimes in addition to the employee’s other bonuses, sometimes conditional upon the employee sacrificing part of their cash bonus. Shares may be offered at market value or at a discount to their market value at the date the award is made. The shares may vest in the employee immediately, or they may vest only after a period of time, perhaps three years, has lapsed. There are ‘phantom’ share schemes where the employee is awarded not actual shares but cash linked to increases in value of the actual shares. Finally there are a variety of share option plans.

Transfer pricing issues can arise on any share-based compensation plan where the beneficiaries are employees of companies based in different locations. The guidance primarily discusses employee share options as they give rise to the most difficult valuation issues. The principles of pricing share options are applicable to other forms of share-based compensation.

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What are share options?

Share options generally

A person who purchases (is granted) a share option pays an amount (an option premium) for the right (the option) to purchase a set number of shares at a set price (the strike price) at a date (or within a range of dates) in the future, irrespective of the value of the shares at that future date. Exercising this right (paying the strike price and acquiring the shares) is known as exercising the option.

The option premium is calculated by reference to the value of shares at the date of grant and takes into account such factors as the volatility of the shares, expected interest rates, dividend flows, duration to maturity etc.

Employee share options

Employees who receive share options do not pay the option premium, only the strike price if they decide to exercise the option. The employees thus receive an asset (the option) at undervalue. If a third party supplied goods or services to a company’s employees free of charge, it would only do so if the company made good the amount the employees were spared. In principle share options are no different. At arm's length, the employer company would need to pay the person granting the option. The difficulty with share options is in establishing how much the employer company would be prepared to pay.

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Summary of treatment

Different treatment applies to share options for accounting periods starting before 1 January 2003, and those starting after 1 January 2003 The text below sets out our treatment of share options for these two periods separately.

Open and closed years up to 31 December 2002

Subject to the exceptions described in Tax Bulletin 63, the period of concern runs from 1 January 1997 (within the six-year time limit) to 31 December 2002.

Strictly all open years may be subject to transfer pricing enquiry. However, recognising that earlier years can be open for something quite unconnected with transfer pricing and recognising also that an option exercised in (say) 1992 may have been granted as early as 1982, the following practice is being adopted. Enquiries into options and other share schemes can be made into:-

all open years within the normal 6 year time limit,
earlier open years where the reason the accounts are open is transfer pricing (not necessarily on share options),
earlier open years where there have been ongoing enquiries into options prior to the Waterloo decision (this condition is to prevent companies from saying that although enquiries into share options for years 1997 onwards had been going on for years HM Revenue & Customs had not explicitly raised an enquiry into the earlier years left open),
closed years where an enquiry into options was concluded on the basis of misleading information supplied by the company.

Accounting periods starting before 1 January 2003

Following the Waterloo decision, HMRC will accept that an intra-group recharge paid by a subsidiary in respect of share options granted to its employees is allowable as a deduction for the period for which the recharge is made, if it is calculated on an arm’s length basis as set out in the Tax Bulletin article and relates to employees who work exclusively for UK entities.

The Commissioners’ analysis of the nature of the facility provided by the parent company in the Waterloo case means that the recharge is not capital expenditure and will be wholly and exclusively for the purposes of the subsidiary’s trade if it relates to employees who work exclusively for it (ICTA88/S74(1)). As the recharge is not a payment of emoluments or potential emoluments, but is payment for 'the total facility for giving benefits to employees in the form of share options', FA89/S43 will not apply to defer the timing of any deduction.

Accounting periods starting on or after 1 January 2003

For periods starting on or after 1 January 2003, FA03/SCH23 will apply to many employee share schemes. The interaction between this legislation and transfer pricing rules is discussed at INTM464150.

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Background to Tax Bulletin 63

The transfer pricing issues arising from global share option plans were considered by the Special Commissioners in the Waterloo case (SpC 301). In one sense the decision was of very narrow application - it considered the meaning of the phrase ‘business facilities of whatever kind’ in the now repealed ICTA88/S770 in the sole context of a UK headed group granting options to employees of overseas subsidiaries. But in another sense it has very wide application. Following publication of the Special Commissioners' decision HMRC received numerous requests from business and their advisors for clarification on a number of related issues. Tax Bulletin 63 was intended as a response to these wider concerns.

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From Waterloo to Tax Bulletin 63

In a number of areas, Tax Bulletin TB63 goes beyond the potentially narrow remit of the Waterloo decision. The chief elaborations are set out here.

Other share-based compensation - Waterloo considered only share options, but it seems clear that if granting options over shares to employees of affiliates is the making of a business facility of whatever kind then the same is true of other forms of share-based compensation.

Schedule 28AA - Waterloo did not consider the application of ICTA88/SCH28AA to global share option plans, but HMRC’s view is that ICTA88/SCH28AA is of wider application than SICTA88/S770. This is particularly so where, as in Waterloo, the arrangement involved a series of legal transactions involving third party intermediaries (the trusts).

UK subsidiaries paying non-UK parent companies - Waterloo did not consider the case of a non-UK parent company granting options to employees of UK companies, but the location of the parent company is not relevant to the analysis. If a non-UK subsidiary receives a business facility when its parent grants options to its employees, then a UK subsidiary is receiving a business facility when its employees are in receipt of options granted by the non-UK parent company.

Pricing - The Waterloo case was intended to be heard in two parts. The first was to consider the point of principle - was there a business facility. The second was to consider the price. In the event the Special Commissioners, whilst acknowledging that they had not been asked at that stage to consider pricing, did comment in some detail on pricing. In HMRC’s view it was extremely unlikely that the Special Commissioners would have changed their approach had the case come before them again for pricing.

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Waterloo plc v CIR Special Commissioners' Decision (SpC301)

Facts

Waterloo established two trusts in connection with its employee share option scheme and made an interest free loan to the trustees so that they could purchase convertible loan stock and shares and grant options in respect of those shares to employees of Waterloo’s subsidiaries. When options were exercised the employees paid the strike price to the trustees who then repaid the loan. Waterloo also undertook to issue shares to the trustees at the option price so that options could be satisfied in the event that the trustees exhausted their reserve of shares.

Point at issue

Whether business facilities were provided within the meaning of ICTA88/S773(4).

Decision

The Commissioners found that there was a business facility which ‘was more than the grant of interest free loans by Waterloo to the trustee; what Waterloo gave was the total facility for giving benefits to employees in the form of options’ (para 51). Waterloo devised, set up, funded and operated a facility whereby the employees of its subsidiary companies were able to receive valuable share options. The facility was not just the making of the interest free loan, nor was it just the selling of shares to employees at a price below market value. The facility was the total package and it is the total package that needs to be examined and priced. The distinction between the ‘total facility’ and the constituent transactions such as the loan is important and has implications beyond share options though these are not considered here. It is consistent with the Inland Revenue’s submission that ‘the phrase ‘business facility’ is a commercial not a legal term, and … that where a commercial term is used in legislation, the test of ordinary business might require an aggregation of transactions which transcended their juristic individuality’ (para 57).

The arm's length price

Although not asked to consider pricing, the Special Commissioners commented that ‘it would be relatively simple’ to price the facility by reference to the costs of the provider of the facility; and went on to enumerate the types of costs to be included (para 102). HMRC takes the view that the Commissioners would have been extremely unlikely to endorse pricing by reference to the employee’s gain on exercise (the difference between the market value at the date of exercise and the exercise price - known as ‘the spread’). This is because the costs of Waterloo were related largely to interest rates not to the increase in share price over the period of the option.

Where Waterloo issued new shares there is an argument that, under accountancy standards applicable in the years of the appeals, the company did not incur a cost. Arguably no charge should be made. It might appear on such reasoning that where a company issues shares in support of options granted to employees of its subsidiaries then the full amount of any charge made to the subsidiaries would be disallowed. However, parties acting at arm’s length are prepared to pay for something of value to them even if there is no cost to the provider.Indeed, the Special Commissioners allude to one example elsewhere in the decision when they accepted the giving of bank guarantees as the provision of a business facility (para 52).

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HM Revenue & Customs Approach: the importance of hedging strategies

Any enterprise which grants share options to its employees does so in the expectation that the value of the shares will rise. After all the whole point of share-based compensation is to incentivise employees to work in ways which enhance the value of the shares. In the minds of those responsible for employee share plans the very act of granting options is a factor which should contribute to an increase in the value of the underlying shares. Against such a background a prudent business would look to hedge in some way the exposure to the expected share price increases. This presumption is borne out by the difficulty in finding groups that wait until options are exercised before buying shares in the market, thereby exposing themselves to increases in the share price. It is sometimes argued that, since share price increases are linked to profit increases, there is no need for the prudent business to hedge actively - the correlation between share prices and profits supposedly providing its own natural hedge. If this proposition were valid -and the difficulty of finding groups who have acted upon it suggest otherwise - then any correlation that exists between share price and profits would be stronger at a group consolidated level than at the level of the individual operating entity. It follows that if the group as a whole adopts an active hedging strategy of some sort then so should the subsidiary, which does not have the same correlation between its stand-alone profits and the group’s share price.

Using group policy in this way as a starting point for the subsidiary’s policy is in line with OECD guidance on group hedging strategies for dealing with foreign exchange or interest rate exposures which states:

‘When addressing the issue of the extent to which a party to a transaction bears any …risk, it will normally be necessary to consider the extent, if any, to which the taxpayer and/or the MNE group have a business strategy which deals with the minimisation or management of such risks’ (OECD Transfer Pricing Guidelines para 1.27)

Where exceptionally the group as a whole does not have a hedging strategy, HMRC will consider whether the same unhedged strategy is appropriate for the subsidiary, bearing in mind that individual entities may not have the same correlation between profits and the group’s share price as the group as a whole.

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Hedging Strategies

There are three hedging strategies open to a company granting options to employees over its shares:

issue new shares
buy shares in the market at or around the time options are granted
buy an option that mirrors the terms of the options granted to the employees

Strategies a. and c. are full hedges since they protect against both the rise and fall in the value of the underlying shares. Option b., on the other hand, is an imperfect hedge since, although it protects against an increase in the price of shares, it leaves the company exposed to falls in the value of the underlying shares. Strategy b. should nonetheless be regarded as an arm's length strategy, because it is how many groups actually do choose to hedge their exposure.

Subsidiaries, whose employees are granted options over the parent company’s shares, cannot use option a. Similarly, a company granting options over its own shares is unlikely to opt for strategy c. However, strategy c., giving the subsidiary as it does a full (rather than imperfect hedge), is a proxy for the full hedge achieved at group level by the issuing of new shares; and one measure of the amount a party acting at arm’s length would be prepared to pay is the cost of obtaining the same benefit by a different route.

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Payments and provisions for accounting periods starting before 1 January 2003

In many cases the quantum of the charge to the subsidiary is based on the increase in the value of shares from the period the option was granted to the date of exercise. Sometimes the charge is made only when the shares are exercised. Sometimes it is made over the period of the option as the price of the underlying shares goes up.

The only time when the payments or provisions measured by reference to increases in the value of the underlying shares can be considered as arm’s length is when the parent company does not hedge its exposure to the increase in share prices in any way. They usually do hedge though, either by buying shares in the market some time before the options are exercised or by issuing new shares. HMRC is not aware of any groups which have waited till the options are exercised before buying shares in the market, however, in consultations HMRC has been assured that such groups do exist. If the parent of the UK company has supported the scheme by buying shares in the market at the date of exercise inspectors should review carefully the company's reasons for doing this. They should then decide whether similar considerations make the same approach acceptable at separate entity level.

Should companies persist with a claim for a spread deduction when the parent company has hedged in some way, the case should be referred to Business International.

Tax Bulletin TB63 recommends two arm’s length approaches, imperfect hedging where shares are purchased in the market and full hedging where the price is the fair value of the options at the date of grant.

Fair value / Black Scholes pricing model

One way to establish an arm’s length price would be to calculate how much it would cost the subsidiary to purchase an option that mirrors the terms of the options granted to the employees (though legally such a transaction with the parent may not be permitted). It should be stressed that using option pricing models to calculate the arm's length price does not mean that the subsidiary has actually purchased an option (or paid an option premium) to the parent company. Rather the fair value is simply an ingredient in the pricing of the total facility, just as in the Waterloo case the facility was not the making of an interest free loan but the total facility of making valuable options available for the subsidiary's employees.

Economic models such as Black-Scholes are used to value options and depend on a number of variables - volatility of shares, interest rates, dividend flows, maturity of options, etc. Such variables, moreover, may change over time. HMRC understands that generally the price will be in the region of 25-35% of the value of the shares at time the option is granted but for nil-cost options could rise to 55-65%. In certain countries, the USA for example, companies may be required to disclose the fair value of employee share options in their accounts. Where such valuations exist they provide a good starting point for establishing the arm's length charge to the UK subsidiaries. More details on how to find and use such information are contained in Appendix A at the end of this section.

A hedging strategy priced on buying an option that mirrors the terms of the options granted to the employees should take account of the expected exercise rates. Again, if 60% of employees are expected to exercise the subsidiary employer would only require an option over a reduced number of shares. The fair value of the option would be spread over the vesting period of the employees’ share options.

When applying models such as Black-Scholes, companies should bear in mind that they were not primarily designed for pricing options with the long maturity dates typical of employee share options. As such, substantial adjustments must be made to the model with the result that it is not as accurate as it might otherwise be. Therefore companies using Black-Scholes as their primary pricing method may want to check the result using a market purchase price.

For companies without in-house expertise in pricing options pricing by reference to buying the shares in the market may be simpler than using Black-Scholes. Accordingly, even where the scheme is actually hedged by the issue of shares rather than buying them in the market, HMRC is prepared to accept a market purchase price, calculated along the lines of Table 1 (below); but assuming that the shares were purchased on the same day as the options were granted. However, and as indicated above, the share purchase model can become complicated where loans need to be written off and could become very difficult to apply when there are no actual loans or share disposal patterns to work from.

A foreign-owned group might wish to maximise the amount it is able to charge the UK subsidiary, particularly where the recharged amount is not taxable, so even where HMRC can accept their pricing model there may be disputes over such issues as the expected rate of exercise.

The higher the expected rate of exercise, the higher the amount of the recharge (because the greater the exposure to increases in share prices). Remember, as always in transfer pricing, it is not permissible to use hindsight. The test is what would have been reasonable to expect at the time the options were granted. If the scheme is well established there may be a good historical record of exercise rates, and establishing the rate of exercise in, say, 1997 may be relatively straightforward.

Where, on the other hand, the scheme is relatively new it will be necessary to look closely at the terms and conditions attaching to the options and also such factors as staff turnover among the population eligible for options. The length of time the option needs to be held will be one factor, as will performance conditions attaching. Such considerations may already have been factored into the Black Scholes model, so care is needed to avoid double counting.

The timing of the charge may also be an issue, with the company perhaps seeking to impose the whole charge in the year of grant. This is as much an accounting issue as it is a transfer pricing issue. One would generally expect an option premium to be paid at the date of grant, but then to be spread for accounting purposes over the vesting period. A similar approach seems reasonable for a pricing method based on the fair value of the options. If timing becomes an issue inspectors should consult an Large Business Service or Local Compliance accountant, as appropriate.

Buying shares in the market

Where shares are bought in the market the Special Commissioners found that the facility was not simply the making of a loan. Pricing the facility is not therefore simply a matter of pricing the loan. Rather the pricing of the loan is one ingredient in establishing the price of the facility. In the Waterloo case there was not an exact match between the exercise price of the option and the price of the shares acquired for hedging. Instead shares were purchased during the year at propitious times in anticipation of the grant of options later, so the price of the shares could be more or less than the exercise price of the option. Other groups may buy some shares before the grant of options and some after. Provided the parent company does not have an ulterior motive (such as supporting its share price) the actual purchase pattern of the parent is a good starting point for determining an appropriate strategy for the subsidiary.

Table 1 sets out how a group might calculate the charge to its affiliate for options granted to employees of that affiliate. For the sake of simplicity the example assumes that options are granted at the year end and the mid year point is when options are exercised and shares purchased in advance of the next tranche of options. The example also assumes that the costs of acquiring more shares than are required for hedging are costs of the parent company, and are not to be allocated to the subsidiary. Thus the allocation of costs to the subsidiary is determined by the ratio of subsidiary shares needed ‘C’ to total shares needed ‘D’ (and not subsidiary shares needed to shares held). In practice how the costs of ‘excess’ share purchases are allocated will depend on the precise circumstances. If the parent company routinely and persistently overpurchases it may be that it is doing so for its own purposes. If, on the other hand, it is sometimes over- and sometimes underpurchases, it may be that this is a valid hedging strategy for the share option awards so that all costs are allocable.

Table 1

Options		Year 1	Year 2	Year 3	Year 4	Year 5
Options b/f	.	0	1000	1100	850	850
Options granted		1000	600	0	0	150
Price granted		1.75	2.5	0	0	3
Options exercised		0	500	250		300
Options unexercised		1000	1100	850	850	700
Shares
Subsidiary Options		400	550	350	350	300
Exercise Rate		75%	75%	75%	75%	75%
Shares needed for subsidiary	(C)	300	413	263	263	225
Shares needed by trust	(D)	750	825	638	638	525
Shares held by trust		900	1100	850	700	600
Loans
Opening loan	(A)	0	1485	2010	1573	1348
Shares Acquired	.	900	700	0	0	200
Price		1.65	2	0		2.9
New Loan		1485	1400	0	0	580
Shares sold		0	500	250	150	300
Price	.	0	1.75	1.75	1.5	2.5
Loan repaid		0	875	438	225	750
Loan end of year	(B)	1485	2010	1573	1348	1178
Rate of interest		5%	5%	5%	5%	5%
Interest (A+B)/2		37	87	90	73	63
Less div income		5	5	5	5	5
Net cost	(E)	32	82	85	68	58
Subsidiary=	E x C/D	13	41	35	28	25

Expected rate of exercise - if, historically, only say 60% of options granted were actually exercised, one would expect a prudent business to purchase 60 shares for every 100 options granted. Expected rates of exercise may vary from group to group depending on such factors as staff turnover and performance conditions attaching to the options. For new schemes documentation about expected take up may have been produced internally or by remuneration consultants involved in setting up the scheme. Such documentation could form the basis of expected rates of exercise until more reliable data is available.

Rate of interest - as with any loan the arm’s length rate of interest depends upon the facts and circumstances of the case. Interest is calculated from the date the shares are purchased, not the date the options are granted.

Dividends - typically dividends are waived on shares held by share scheme trusts so those dividends payable to other shareholders are not diluted. A subsidiary acquiring shares from a hypothetical third party for its employees would not care about the interest of the other shareholders. The only concern would be with minimising the costs of its hedging strategy. So in calculating the price of an arm's length hedging strategy there would be no reason to waive the dividends.

Profits and losses on disposal of shares - the example at Table 1 does not include an explicit entry for profits or losses that might arise on the disposal of shares. Such profits and losses are, however, included implicitly in the calculation since disposal proceeds on the sale of shares affect the amount of debt left in the trust, which in turn determines the amount of interest to be allocated to the subsidiaries. Share option schemes tend to be enduring structures and one might expect profits and losses to balance out sufficiently over the life of the scheme so that all debt is repaid: shares purchased to hedge a tranche of options which lapse while the options are under the water become the hedge for a second tranche of options granted when the share price recovers. In a period of steep and prolonged decline in share prices, however, it may be that the group decides to sell surplus shares to prevent further losses arising. The losses incurred on selling surplus shares may be so great that part of the loan to the trust will never be repaid. In such circumstances it may be appropriate to include as an ingredient in the price of the facility an amount for loans permanently written off. Such an apportionment might not be straightforward. The objectives and actual pattern of disposal of surplus shares of the parent company (whose shares are held in the trust) may be different to the pattern of disposal that would have been chosen by a subsidiary whose only interest in the shares is as a hedge against its employee options.

In principle it seems appropriate that losses could be allocated to the parent: buying shares in the market to hedge is an arm’s length thing to do, but one of the downsides of this arm’s length strategy is exposure when share prices fall.

The starting point will be the actual losses made on sale of shares by the parent company, but this will not necessarily be definitive. The actions of the parent company may be motivated by reasons other than hedging against employee share options. The difficulty here will be trying to hypothesise what the subsidiary would do if it were a stand-alone entity - how quickly would it get rid of the shares once the options were 'under the water'? (For example, what would company X do if it had offered its employees options in, say, company Y; and had bought Y shares as a hedge?) Provided that what the parent company does seems sensible (judged solely by the criteria of hedging the options) then any losses may form part of the price of the facility.

As well as accepting buying shares in the market as a primary pricing method, Tax Bulletin TB63 also suggests using it as a proxy method even where the scheme is actually supported by issued shares. There were two objectives behind this suggestion:

Firstly, where the group is small (or where the group is large, but it does not use share options much) the compliance costs of commissioning a Black Scholes type report can be prohibitive. The market purchase method, however, is made up of ingredients that most tax managers (and indeed inspectors) are familiar with, interest rates etc
Secondly, inspectors may want to use this as a sanity check when confronted by Black Scholes models that have been produced purely for tax purposes.

There may be cases in which companies who have in fact supported the share option scheme by issuing new shares realise with the benefit of hindsight that if they had chosen a market purchase approach they would have been able to allocate large losses to the parent. Any attempt to employ a market purchase approach in such circumstances should be resisted. As indicated in Tax Bulletin TB63, the share purchase model can become complicated where loans need to be written off and could become very difficult to apply when there are no actual loans or share disposal patterns from which to work.

Set offs for overcharging and undercharging of options

The arm’s length price for share options results in a charge, which is spread over a number of years from the date of grant to the date of exercise (if a market purchase method is used) or from date of grant to the date options vest in the employee (if Black Scholes is used). A single charge made at the date the option is exercised will therefore tend to overstate the amount of the deduction for the year of exercise (and hence understate the subsidiary’s profits for that year) and understate the charge for the earlier years (and hence overstate the amount of subsidiary’s profits for those years).

Example A

Accounting method: recharge at exercise date

(a single tranche of options granted in year 1, ignoring further tranches granted in subsequent years, exercised in year 4).

	Yr 1	Yr 2	Yr 3	Yr 4	Total
Market value at date of grant	100
Market value at exercise				190
Spread Claimed	0	0	0	90	90
Arm's Length	10	10	10	0	30

The market value of the shares at 1 Jan year 1 is 100 (the strike price), option premium calculated using Black Scholes, say 30% of value of shares at grant date, spread over 3 years.

Market value at exercise 190, less strike price of 100 paid by employee, leaves spread of 90 paid by subsidiary to parent.

A strict application of both ICTA88/S770 and ICTA88/SCH28AA on an annual basis may therefore result in the company being denied any deduction: the 90 in year 4 would be disallowed because at arm’s length no charge would have been due in that year, and there would be no mechanism to give credit for the overstated profits in years 1-3 (unless, for example, the tax treatment in the parent company created an opportunity to claim a compensating adjustment).

ICTA88/S770 is a ‘one way street’ so that overcharging in one year cannot be offset by undercharging in another. Indeed overcharging on one transaction cannot be offset against undercharging on another transaction within the same year.

In certain circumstances ICTA88/SCH28AA does allow offsetting within the same year (see INTM432050). However one of the conditions to be met is that the offset must be intentional. For example, a company deliberately overpaid on options exercised in the year because it knew that it was being undercharged for options granted but not yet exercised within the year. To demonstrate the necessary intention there should be an explicit reference to the intentional set off in the transfer pricing documentation that existed at the time the return was made. It is extremely unlikely that such documentation will exist.

Where companies make a provision for the increase in share prices over the course of the option this may, depending on share price movements, result in profits being overstated in some years and understated in others.

Example B

Accounting method: difference between market value of underlying shares and option strike at year end

(again, a single tranche of options)

	Yr 1	Yr2	Yr 3	Yr 4	Yr 5	Total
Increase in share price	5	15	0	100	(45)	75
Arm's length price	10	10	10	0	0	30

As in example A, the market value of the shares at grant (1 Jan year 1) is 100; which gives option premium of 30, spread over 3 years. At the end of year 1 the share price has risen by 5 to 105, then by 15 to 120 at end of year 2. It remains at 120 at end of year 3 and then increases by 100 to 220 at end of year 4, falling by 45 to 175 at end of year 5.

There is a particular problem in periods, such as years 4 - 5, when prices of shares shoot up and then down again before the option is exercised. Not only would the 100 claimed in year 4 be disallowed, the 45 reversal in year 5 would still be taxed. For many groups 2001-2002 could be like years 4 - 5.

A pragmatic approach

Where, in the past, parent companies have charged their subsidiaries the spread on exercise or made provisions annually in respect of the increase in share prices on unexercised options, the sharp fall in share prices in 2002 should mean that most of the provisions in respect of unexercised options have been reversed out by the end of 2002. In other words in the periods prior to the new legislation coming into effect, what many companies will have effectively claimed deductions for will be options that have been exercised. Deductions for options unexercised at commencement of the new legislation will be given when the option is exercised under the new rules.

The pragmatic approach therefore is to ignore unexercised options and price only exercised options, and to allow in the year of exercise the amount that would have been allowed (in aggregate) at arm’s length. So, in example A above, HMRC would not disallow the full 90 in year 4 (year of exercise), but give credit for the arm’s length 30 of the 3 preceding years leaving a disallowance of 60 in year 4. The process can be repeated for options exercised in each in-date year. It may be that for a particular year (or a particular tranche of options) the aggregate arm’s length price exceeds the spread deduction in the year of exercise.

Example C

In practice, each year's options will be exercised with a variety of grant dates. So for example in the year 2000, 100 options are exercised, giving a spread deduction of £200. 60 of the options had been granted in 1996 with a fair value (option premium) of 75p. 40 had been granted in 1997 with a fair value of 100p. This would be treated as follows under the pragmatic approach:

For each year of review add back amounts claimed on exercise or in respect of increases in share prices since grant of option.
Where the parent company has produced fair value (which equates in price to an option premium) at date of grant calculations for accountancy disclosure purposes (i.e. not tax) then
For each year of review identify the number of options exercised by UK employees and the dates those options were granted

Multiply the options exercised by their respective fair values to give the allowable deduction for the year of exercise.

Add back £200
Allow (60 x .75) + (40 x 100p) = £85
Adjustment = £115 in 2000.

Example D

Arm's length price for particular tranche of options exceeds charge in accounts

In some circumstances, the arm's length price for a particular tranche of options may exceed the charge in the accounts.

	Yr 1	Yr 2	Yr 3	Yr 4	Total
Spread on exercise	0	0	0	20	20
Arm's length price	10	10	10	0	30

The extent to which the inspector judges they can reasonably allow this overcharging on one batch of exercised options against undercharging on another batch of exercised options will depend on the particular facts and circumstances of the case as a whole (including non-transfer pricing issues). Inspectors may also want to take into account the option recharge for the year immediately preceding the open years: if, for instance, the UK was grossly overcharged for that closed year they might consider that an appropriate response would be to withhold the credit of 10 in Example D.

In negotiating on a pragmatic basis, it is important to bear in mind that the whole approach represents a reasonable and practical solution to a potentially difficult issue. A legalistic approach may well leave the company in a much worse position. This approach also simplifies the transition into the new regime, and does away with the need to establish contemporaneous projections of the expected rate of exercise of options each year.

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Charges and provisions to UK subsidiaries for accounting periods starting on or after 1 January 2003

The new statutory deduction will be available to a company within the charge to corporation tax for accounting periods beginning on or after 1 January 2003, where an employee of that company acquires shares in that or another company whose shares meet the requirements for relief. The deduction will be equivalent to the difference between the market value of the shares at the time they are acquired and the amount payable by the recipient, or another, in respect of the shares. The interaction between this legislation and transfer pricing rules is discussed at INTM464150.

Where a statutory deduction is not available, for example, because the shares are not of a qualifying type, any corporation tax deduction must be based on arm's length principles. The new statutory deduction legislation has transitional rules to ensure that amounts claimed in respect of options or shares in accounting periods starting before 1 January 2003 are taken into account when calculating the statutory deduction. The statutory deduction in respect of particular employee acquisitions will be reduced to the extent that amounts have been claimed pre 2003 in respect of those acquisitions.

In applying transfer pricing legislation to the costs of providing share options, HMRC’s approach will be based on its interpretation of a recent Special Commissioners' decision concerning the application of the transfer pricing legislation to such share option schemes.

Transitional Rules

Where companies have claimed amounts in periods starting before 1 January 2003, based on the spread at the date of exercise the transitional rules are not relevant because the options no longer exist when the new legislation comes into force. On the other hand, companies may have made deductions in their accounts for period(s) beginning before 1 January 2003 where options are not exercised until after the new legislation takes effect. In such circumstances a deduction will be allowed for the arm's length price in the appropriate pre 1 January 2003 period, and, when the options are exercised (i.e. the shares acquired by the employees) a statutory deduction will be available, reduced by any element of the arm's length amount(s) allowed in earlier periods that relates to the cost of providing shares (see guidance on the interaction between this legislation and transfer pricing rules at INTM464150). This might reduce the new relief but does not create a charge to tax if the earlier amounts claimed exceed the statutory deduction.

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Practical issues

There are some practical issues that should be borne in mind in considering groups’ application of transfer pricing rules to group share option schemes.

Black Scholes

UK groups, unlike certain foreign groups, do not often, as yet, disclose the fair value of options (which equates to the option premium in price terms) in the accounts. Where a Black Scholes model is produced, therefore, it will probably have been produced in response to the transfer pricing enquiry. As such it may need to be investigated closely. The Tax Bulletin says that the typical option price is between 25-35% of the value of shares at date of grant. It may be that, depending on the facts of the case, not much will turn on whether the value is at 35% or 25%, and before getting into a detailed challenge of the fair value it makes sense to assess the impact of the valuation. It may also be the case that particular options over particular shares may fall outside that range, so such valuations are not necessarily non-arm's length.

Newly issued shares: capital or revenue receipt?

As indicated above in the discussion about the Special Commissioners' decision, where shares are bought in the market the facility is not the making of an interest free loan and any receipt by the UK parent would be payment for a business facility, not interest. Similarly, inclusion of fair value of the options at grant in the price of the facility does not mean that the provider of the facility has actually sold an option to the trust (or subsidiary) mirroring the terms of the options granted to employees. Rather the price of such an option is merely an ingredient in pricing the facility. Where the parent, as in Waterloo, supports the scheme by a combination of market purchased and newly issued shares any payment received cannot - in light of the Commissioners finding of what the facility was - be separated out into capital and revenue. The receipt is indivisibly on revenue account and taxable as income.

In the consultation process that led up to the publication of the Bulletin, HMRC’s attention was drawn to the structure often employed by small and medium-sized firms. Typically such firms support their share-based compensation schemes entirely by issuing new shares directly to the employees. HMRC was asked to consider whether Waterloo would apply in such circumstances. Tax Bulletin TB63 conceded that there will be no transfer pricing adjustment where a group supports all of its various share-based schemes entirely by issuing new shares directly to the employee and does not use a trust or secure a P&L deduction for the newly-issued shares. This is because the Commissioners’ analysis of ‘the total facility’ does not appear so appropriate in these circumstances: it is difficult to see how the receipt could be anything other than capital in this simplified structure. The parent company is still receiving payment for the provision of a business facility, but that transaction arguably collapses into a receipt for the issuing of shares.

Since publication of Tax Bulletin TB63, HMRC has been asked if the introduction of a trust into the above scenario would, on its own, be sufficient to convert the receipt from capital to revenue. HMRC has confirmed that the introduction of a trust would not alter the position. It appears that some advisors have taken this assurance as a signal that HMRC accepts the effectiveness of certain tax-planning opportunities based around using one trust for newly issued shares (capital transactions) and one trust for buying shares in the market (revenue transaction).

HMRC does not accept that such ‘allocation strategies’ are effective circumventions of the Waterloo decision. The Commissioners did not find that the business facility was the creation of a trust per se. In Waterloo itself there was more than one trust involved in the share option scheme (paragraph 23) but the Special Commissioners did not conclude from this that there was more than one facility. Rather there was a single facility - the total facility of providing incentives to employees of the subsidiaries - and the trusts were merely part of the machinery. It is not therefore permissible to fragment the facility by multiplying the number of trusts.

The total facility, moreover, is not simply the making of interest-free loans or undertaking to issue shares. The facility is that of making options available for the employees of the subsidiary. From the perspective of the employee and the employer subsidiary it does not matter whether the option is satisfied by newly issued shares or shares purchased in the market. From the perspective of the parent company the facility it has provided to its subsidiaries is the granting of options to the employees, and that it what it receives payment for. The parent company is then free to hedge its own exposure either by issuing new shares or buying shares in the market, but that is separate from the business facility itself. In many cases the parent company will want to retain the flexibility of choosing to satisfy options either by issuing new shares or buying them in the market. At the date options are granted, the fee received is neither interest on a loan nor an option premium. It may be that the issue of new shares subsequently satisfies the options, but that does not necessarily make the fee an option premium.

Some groups may seek to collapse the facility into a capital transaction by arranging for an actual option agreement to be drawn up between the parent company and the subsidiaries (perhaps via a trust) which mirrors the options granted to the employees, and arranging for an arm's length payment to be made. Such an approach creates a number of problems for groups, not the least of which are the capital gains implications. A formal option contract would give the subsidiary a right to exercise the option whenever it saw fit, and in particular even when it did not need the shares to satisfy options to employees. The tax administration dealing with the affairs of the subsidiary may in due course want to know why the subsidiary chooses not to exercise an in the money option.

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Some other issues

Set offs against non-share option transactions

Some subsidiaries - distributors for example - may be rewarded with a guaranteed net margin on sales. In such circumstances, provided the net margin is acceptable, companies may claim that any overpricing on the option recharge has been offset by a reduction in (say) the purchase price of goods, to give the subsidiary sufficient gross profit to meet all its expenses (including the option recharge) and leave a reasonable profit. As already mentioned ICTA88/S770 does not allow such set offs and ICTA88/SCH28AA only allows them if it is intentional. If the company continues to make its set margin irrespective of fluctuating option charges in the year then the company would have a good case for saying the set off is intentional. The counter party to both transactions would still need to be the same (i.e. goods would need to be purchased from the same company that issues the shares).

In short, the strict legal position is that HMRC could seek an adjustment for ICTA88/S770 periods and also for ICTA88/SCH28AA if the purchase of goods is not from the same company that issues the shares. The question that would remain for pre CTSA years is: is a distributor which is making an acceptable margin really the most offensive case around, particularly if the company can show that the purchase price of goods was intentionally reduced to take account of option charges and the purchase of goods and options is from the same counterparty?

Cost-plus and cost-sharing arrangements

Pricing share options by reference to the gain made by the employee will not give the same result as applying general transfer pricing rules. It follows transfer pricing methods which incorporate or rely upon profit made by the employee will not result in an arm’s length price. Where, for example, a company is remunerated by affiliates on a cost-plus basis, and those costs include a charge for share options based on the employee profit, the mark up has been applied to a non-arm’s length cost base. Similarly, where companies enter into cost-sharing arrangements, and the costs include a charge for share options based on the employees’ profit, the resulting sharing of costs will not be on an arm’s length basis because a non-arm’s length cost was included in the pool. Cost-plus and cost-sharing arrangements must instead be based on an arm’s length cost calculated according to one of the acceptable methods explained above. This will remain the case from 1 January 2003.

Treasury shares

Later in 2003, UK companies will be allowed to hold shares in treasury for the first time. The transfer pricing analysis is exactly as it would be for a market purchase strategy using a trust. The parent company will have incurred interest costs on buying the shares in, and the loan will not be repaid until the employees exercise their options. At arm's length, the parent company would not have incurred those costs on its own. Treasury shares used to support share option schemes will not qualify as ‘newly issued shares’.

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Objections to Tax Bulletin approach

General background

In drafting Tax Bulletin TB63, HMRC consulted the 'Big 4' accountants, the Share Schemes Lawyers Group and the CBI. They raised a number of objections to the approach HMRC were taking. Inspectors are likely to face the same objections, so the guidance includes a list of the main objections together with an appropriate response.

Objection: The Bulletin adopts a prescriptive ‘one size fits all’ approach which is at odds with OECD Guidelines

Response:

The Bulletin offers two approaches, both of which will give a highly individualised answer depending on the precise facts and circumstances of the particular group
Black Scholes' fair value of particular options is derived from the volatility of each particular company’s shares; the dividend policy of each individual company; the interest rate for that particular company; the performance conditions of the particular option scheme; the duration of the particular options, the staff turnover of the particular subsidiary, etc.
The buying shares in the market method will start with what the group has actually done and will only depart from that to the extent the actions of the parent company appear to be motivated by considerations other than hedging the liabilities created by granting share options.
The only prescriptive aspect of the bulletin is that it does not accept the spread method when the group as a whole has adopted a hedging strategy of some sort. The bulletin explains why this is so and is fully in accordance with OECD.

Objection: The Bulletin is premature. There is an OECD working party currently working on transfer pricing of share options. HMRC should postpone publication till OECD decides, otherwise there will be double taxation, as other tax administrations will not give corresponding relief for UK adjustments.

Response:

The Special Commissioners' decision clarified for the first time the approach to establishing the arm’s length price of providing share options for group members. This cannot simply be ignored.
In negotiating the price in the Waterloo case itself and in producing Tax Bulletin TB63, HMRC was, as always, guided by the OECD Guidelines. Accordingly HMRC believes that the TB63 conclusions are consistent with OECD.
Where Competent Authority proceedings are in point HMRC is confident that it can defend adjustments as being on an arm's length basis.

Objection: The Bulletin is late so the decision should not be applied to periods before 2001.

Response:

What companies see as the retrospective nature of the decision is probably the sorest bone of contention. The strict legal position is that HMRC can go back for all open years to 1989.
Prior to the Commissioners’ decision there was no generally prevailing practice in establishing the arm’s length price of providing cross-border options to employees of affiliates. Therefore HMRC is entitled to go back for all open years.
What actually happened before the Waterloo decision was that some groups exploited the absence of clarity to choose a pricing method that gave the best tax result: foreign-owned groups would charge the spread, UK-owned groups would charge nothing or very little. There were cases where arrangements were made for deductions in more than one country. Some groups and their advisors systematically took advantage of the situation. HMRC is merely applying the Commissioners’ decision even-handedly to both inward and outward transactions for all years that it can.
In the event HMRC are making considerable concessions, both in the number of years to be looked at and in considering set-offs between one year and the next.

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Appendix A: Basic information needed for each case

Total number of options/ shares awarded annually for each scheme
Total number of options/shares exercised annually for each scheme
Total/subsidiary split of option/share awards
Companies whose employees receive share options are required to make returns to Share Schemes Unit, Capital and Savings, 2ⁿ ^d floor, New Wing, Somerset House. These returns contain information about which employees receive options, the exercise price and the date of exercise
How the schemes are supported - purchase of shares in the market or issue of new shares. If in the market, when where the shares acquired.
Whether trusts are involved
Amount of any deductions (receipts) in respect of global plans, and basis of the calculation
For CTSA periods, documentation supporting the arm's length nature of the deduction/receipt
Conditions and time period for exercise of options
Procedures by which it is decided who gets what number of options/shares.
Rate of exercise of options. This can depend on a number of factors e.g. staff turnover or performance conditions attaching to the options. It can also depend on the length of time the employee has to stay with the company. Where options need to be held for a period of 3 years, whenever an employee leaves he abandons 3 years' worth of options. If the options, on the other hand, only need to be held for 3 months the employee is less likely to abandon any options.
Black Scholes evaluation models. The Bulletin accepts option-pricing models such as Black Scholes as representing an arm’s length price for the option. Inspectors are not qualified to challenge such models without expert advice (i.e. advice from an economist or banker). Many non-UK groups (US for example) however already disclose a fair valuation for the options in their consolidated accounts using Black Scholes models. The motivation for these disclosures has nothing to do with tax. Accordingly where a group discloses in its accounts that a Black Scholes model has been used to establish fair value of options, that value can safely be taken as the basis of an arm’s length recharge to a subsidiary.
Details of US accounts are readily available on the Internet and many Large Business Service inspectors are already aware of this source of information. See INTM461230 for information on Internet sources.
The value of ‘innocently’ produced valuations (i.e. where tax is not a driver) goes beyond assisting the settlement of an individual case. Valuations obtained should be reviewed to see if certain patterns emerge, for example the nature and extent of adjustments made to account for the long maturity dates on the typical employees option, and the valuations together with any conclusions shared across the LBO. That way, when a group produces a Black Scholes model purely for transfer pricing purposes, inspectors may be in a position to ask intelligent questions if the answer produced is significantly out of line with valuations of similar companies at the same time. It is also worth comparing reports prepared for justifying a charge out of the UK with reports prepared to justify a charge into the UK. In the final analysis, however, if it came to litigation HMRC would need to get in its own expert witness.
Inspectors may also usefully monitor the debate over IASB (International Accountancy Standards Board) and FASB proposals on the treatment of share options. These recommend that options should be priced on a fair value method at the date of grant using Black Scholes or similar models. Many multinational enterprises strongly object to the expensing of options and make submissions to the accounting bodies saying so. Inspectors may find that a group which charges its subsidiary companies on a spread basis makes a cogent argument to IASB or FASB as to why such a charge is incorrect. Equally, inspectors may find a group making a cogent argument for expensing, whilst failing to charge subsidiaries. The website address of the IASB is www.iasb.co.uk, and that of the FSSB is www.fasb.org.

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