NCL - Court of Appeal upholds tribunal decisions and confirms that a company was entitled to deductions representing IFRS 2 debits

In HMRC v NCL Investments Ltd and Smith & Williamson Corporate Services Ltd [2020] EWCA Civ 663, the Court of Appeal has confirmed that accounting debits relating to the grant of share options to employees were a deductible expense for corporation tax purposes notwithstanding that no monies were actually expended.

Background 

NCL Investments Ltd (NCL) was a member of a corporate group of companies whose ultimate parent was Smith & Williamson Holdings Ltd (Holdings). The group provided tax and accountancy and wealth management services. 

NCL employed staff and made those staff available to other group companies in return for a fee. By deed, dated 6 March 2003, NCL established an employee benefit trust (the EBT) which gave employees a contractual right to acquire shares in Holdings for a specified price. 

Whenever the EBT granted an employee a share option, NCL agreed to pay Holdings an amount equal to the fair value of the option.  

That obligation was reflected in an inter-company balance owed by NCL to Holdings and was settled each month. For the accounting periods ending 30 April 2010-2012, inclusive, NCL prepared its accounts in accordance with generally accepted accounting practice.

For accounting purposes, the grant of the options was governed by International Financial Reporting Standard 2 (IFRS 2).

Under IFRS 2, on the grant of an employee share option, the employer company must debit the fair value of the option in its accounts.  It is the employer company that must account, even if the shares which are subject to the option are shares in another group company.  

On this basis, NCL debited its accounts when the share options were granted to employees by the EBT, in accordance with IFRS 2. HMRC refused the claimed corporation tax deduction on the grounds that:

1. the expenses were not incurred "wholly and exclusively" for trading purposes, as required by section 54(1)(a), Corporation Tax Act 2009 (CTA);

2. the expenses were capital rather than revenue in nature, for the purposes of section 53(1), CTA; and

3. section 1290, CTA (which disallows deductions for 'employee benefit contributions'), prevented a corporation tax deduction.  

NCL successfully appealed to the First-tier Tribunal (FTT) against closure notices issued by HMRC which disallowed the deductions. 

HMRC appealed to the Upper Tribunal (UT), but its appeal was dismissed. HMRC then appealed to the Court of Appeal.

Court of Appeal judgment 

The appeal was dismissed. 

With regard to the first issue, HMRC argued that the debits had not been 'incurred' for the purposes of section 54, CTA, as they did not represent a real expense and represented consideration for the services of employees.  The Court rejected this argument. It agreed with both the FTT and UT that the word incurred has no special meaning in this context and it was clear from sections 46 and 48, CTA, that it is sufficient that the debit was properly chargeable in the accounts. 

In relation to the second issue, the Court again agreed with the FTT and the UT and rejected HMRC's argument that the debits were merely a contra entry to the capital contribution made by Holdings and were therefore capital. The debits reflected the consumption of the services provided by the employees in earning profits and were not 'one off' items. 

With regard to the third issue and section 1290, the Court noted that term 'employee benefit contributions' was not defined. HMRC's position was that section 1290 applied because the grant of the options was for the benefit of employees and the share incentive schemes were 'employee benefit schemes' as defined in section 1291(2). Although it was expressly contemplated by section 1290(2) that a contribution resulting in property being held or used under an employee benefit scheme suggested a payment or transfer from which benefits would be provided to employees, the UT had held, correctly in the view of the Court, that the benefit received by the employees was the option to acquire shares at a price that might be less than their market value and that the grant of an option was a contractual right to acquire shares, not 'property' within the meaning of section 1291(1)(a). The acquisition of shares on exercise of the option was not the benefit received by the employee, but the fulfilment of an existing contractual entitlement. It  followed, therefore, that section 1290 did not apply to disallow the debits.

Comment 

This decision is helpful in understanding the limits of deductions for employee incentives and will be of interest to employers who have claimed corporation tax deductions in earlier accounting periods, in particular, in relation to accounting periods ending prior to 20 March 2013 (as Part 12, CTA, was amended by Finance Act 2013), in respect of 'underwater' share options that were not exercised where those claims have been challenged by HMRC.

The judgment can be viewed  here.