The Taxpayer and Commissioner of Taxation
[2013] AATA 367
[2013] AATA 367
Division Taxation Appeals Division File Number
2012/1369
Re
The Taxpayer
APPLICANT
And
Commissioner of Taxation
RESPONDENT
DECISION
Tribunal Senior Member Bernard J McCabe
Date 31 May 2013 Place Brisbane The objection decision under review is affirmed.
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Senior Member Bernard J McCabe
CATCHWORDS
TAXATION – Income tax – Shares and rights – Employee share scheme – Commissioner's discretion to allow late election – Issue date of shares – Reasonable care by taxpayer – Remission of penalty – Decision under review affirmed
LEGISLATION
Income Tax Assessment Act 1936 Div 13A
Income Tax Assessment Act 1997 Div 83A
CASES
Archibald Dixon as Trustee for the Dixon Holdsworth Superannuation Fund v Commissioner of Taxation [2008] FCAFC 54
Isaacs v Commissioner of Taxation [2006] FCAFC 105
REASONS FOR DECISION
Senior Member Bernard J McCabe
This case deals with the way in which the value of discounted shares and other rights acquired under an employee share scheme should be taxed. The law says the discount on the shares or rights must be counted as part of the taxpayer’s assessable income. But at what point should that occur if the shares or rights are awarded in one year but do not vest until later? The issue is an important one in this case because the value of the shares in the employer’s company rose after the shares and options were awarded – creating a large paper profit – but then fell dramatically after the shares and options vested in the employee three years later.
THE FACTS
The taxpayer was at all material times a senior officer in the Australian subsidiary of a large multi-national company listed on the London Stock Exchange. He was one of a handful of executives who were eligible to participate in the parent company’s employee incentive share scheme (“the scheme”). He joined the scheme in 2004. A copy of the scheme documentation was tendered into evidence: see exhibit two at p. 483.
The scheme provided for the parent company to confer awards on participating employees each year. More precisely, the parent company’s Remuneration Committee (a board committee responsible for setting the remuneration of directors and senior employees) made an annual recommendation to the scheme’s trustee that Awards be granted to specified employees. There were four kinds of Award under the scheme, but only two are relevant here: Share Awards and Market Value Options. A Share Award was defined in the scheme’s rules as:
an Award made in the form of a contingent right to receive Shares or an allocation of Shares subject to Restrictions as the Remuneration Committee or the Trustee shall specify at the Date of Grant.
A Share is separately defined as a fully paid ordinary share in the parent company. When a participant received a share award, he or she became entitled to receive free shares subject to the company achieving certain performance milestones. The shares did not vest for at least three years from the date of grant.
A Market Value Option is defined in the scheme rules as:
an Option granted with an Exercise Price per Share equal to the Market Value of a Share at the Date of Grant.
An Option is defined to mean:
an Award made in the form of a right to acquire Shares granted or to be granted pursuant to Rules 2.1 or 2.6…
There are other kinds of options recognised in the rules, but I need only focus on Market Value Options for present purposes. The Date of Grant is the date on which the award is granted (or treated under the rules as being granted) to the employee. The Exercise Price is the amount (in US dollars):
…as determined by the Company which a Participant shall pay to acquire a Share on the exercise of …a Market Value Option…[which amount] is not less than the Market Value of a Share on the Date of Grant…
There is an important question over whether the awards are qualifying shares or qualifying rights for the purposes of Division 13A of the Income Tax Assessment Act 1936 (ITAA36). I will return to that issue in due course.
The taxpayer was granted 22,382 Market Value Options at an Exercise Price of £7.349 per option and 6715 Share Awards on 4 March 2004. The following year, on 11 March 2005, he received further awards under the scheme: 15,436 Market Value Options at an Exercise Price of £10.60 per share and 4631 Share Awards. The Award Certificates are reproduced in exhibit two at pp. 321, 322, 325, and 326.
The taxpayer said in his evidence at the hearing he was aware of some taxation advice that had been prepared by KPMG in London in connection with the scheme. The advice was of a general nature, and he said he did not discuss the scheme with the small number of his colleagues who might also have been participating in the scheme. He said he did not really think about the taxation implications of the scheme when he received the awards because they did not vest for three years. That is surprising, given the complexity of the scheme and the potential for large gains. He explained (transcript at p. 9):
So initially we thought, “Look, that’s way in the future.” It was only when they became real in 2007 that I guess I really looked at them for the first time, because it actually meant something to the – to my tax situation.
The taxpayer repeated the substance of those remarks in cross-examination (transcript at p. 32).
Consistent with that approach, the taxpayer’s tax agent (whom the taxpayer described as “a small suburban accountant”) completed and filed income tax returns for the 2004 and 2005 years of income that did not address issues that might arise under the shares. Alarm bells began to sound when the tax agent was completing returns for the 2007 year of income, after the awards had begun to vest. The company’s share price had risen significantly and the taxpayer was showing substantial paper profits.
The taxpayer and his agent sought specialist advice from PriceWaterhouseCoopers, another firm of accountants. That advice confirmed the taxpayer should have made an election under s 139E of ITAA36 in the 2004 and 2005 years of income. To remedy the oversight, the taxpayer asked the Commissioner on 6 March 2007 to exercise the discretion to allow a late election under s 139E in respect of the Awards made in 2004 and 2005. If the Commissioner had done so, the taxpayer would have been able to lodge amended returns in respect of the 2004 and 2005 years of income which took account of the awards. He would have had to pay some extra tax in respect of those two years, but he would still have been better off than if the value of the discount relative to the much higher share price prevailing in 2007 and 2008 were taxed in those years. The Commissioner refused the request on 2 May 2007.
The taxpayer exercised options and grants on 3 July 2007 in respect of 25,005 shares. He immediately sold about half of the shares and received $514,799.26 into his account (exhibit two at p. 346). In March 2009, he lodged amended returns in respect of income for the years ending 30 June 2004-2007. He argued the Share Awards were not qualifying shares for the purpose of Div 13A and repeated his request to allow a late election under s 139E of ITAA36 in respect of the Market Value Options he had been awarded under the scheme. The Commissioner responded with an audit of the taxpayer’s affairs. An amended assessment was subsequently issued in respect of the 2007 year and a notice of assessment was issued in respect of the 2008 year of income. In each case, the Commissioner insisted the amount of the discount relative to the much higher share price that was then prevailing had to be included in the taxpayer’s income for those years rather than in the 2004 and 2005 years of income. For good measure, the Commissioner added an administrative penalty calculated at the rate of 50% of the tax shortfall on the basis the taxpayer had been reckless. On objection, the rate of the penalty was revised to 25% but the objection was otherwise affirmed.
I note the value of the shares fell substantially in the second half of 2008. The price of the shares has not recovered significantly.
THE OPERATION OF DIVISION 13A
Division 13A has now been repealed, but it was still in operation during the relevant years of income (Employee share schemes are now dealt with under Division 83A of the Income Tax Assessment Act 1997). The old Div 13A dealt with the taxation of shares and rights acquired pursuant to employee share schemes. Section 139B(1) stated the basic proposition: where a taxpayer receives a share or right at a discount under an employee share scheme, the amount of the discount should be included in his assessable income. Section 139B(2) goes on to say the discount should be included in the assessable income of the taxpayer in the year the discount was received, although that sub-section acknowledges there are exceptions to the general rule as to timing. One of the exceptions – and the only one that applies here – is referred to in sub (3), which deals with a share or right that is a qualifying share or right. In such a case, the amount of the discount is included in the taxpayer’s income at the cessation time unless an election is made under s 139E. The expression cessation time is defined in relation to shares in s 139CA, and in relation to rights in s 139CB. The calculation of the discount amount is dealt with in s 139CC.
Put simply, the amount of this taxpayer’s discount would be assessed in the 2007 and 2008 years of income when the shares and rights vested if they satisfied the definition of qualifying shares or qualifying rights. In those circumstances, the amount of the discount would be calculated with reference to the higher share price that prevailed at that time. The only way around this outcome was to make an election under s 139E to assess the discount in the 2004 and 2005 years of income – but that was not done.
The election under s 139E should be made in the same year in which the shares or rights were acquired. The Commissioner may allow the taxpayer to make a late election. He refused to do so in this case. Unfortunately for the taxpayer, the Commissioner’s decision cannot be reviewed by the Tribunal. That much is clear from the decision of the Full Federal Court in Isaacs v Commissioner of Taxation [2006] FCAFC 105 at [40]-[42] per Emmett, Siopis and Rares JJ. It follows the taxpayer’s gains will be assessed as part of his 2007 and 2008 years of income – unless his Awards did not confer qualifying shares or qualifying rights within the meaning of Div 13A. If they did not, the discounts will be included in the earlier years of income when the Awards were conferred pursuant to s 139B(2).
I have already referred to the rules of the scheme which defined the different kinds of Awards that might be made. There appears to be little doubt that the Market Value Options referred to in the rules are rights. As the Commissioner pointed out in his submissions, an option cannot possibly be a share unless and until it is exercised. An option is, by definition, a right to acquire a share at a future time, or on the happening of a specified event. Since five of the six conditions referred to in s 139CD(1)(b) and set out in subs (2), (3), (4), (6) and (7) are satisfied in relation to these instruments, there is no doubt the Market Value Options are qualifying rights for the purposes of the legislation.
What of the Share Awards? Are they shares, or are they also rights? I note the rules refer (at exhibit two p. 494) to the Share Awards as a “…contingent right to receive Shares or an allocation of Shares subject to Restrictions…”.
The letter dated 31 March 2004 informing the taxpayer of the allocation of the Awards is at p. 309 of exhibit two. The Award Certificate relating to the 6715 shares awarded on 4 March 2004 that was included in that letter is reproduced at p. 321. A similar letter dated 11 March 2005 in respect of the following year is reproduced at p. 301. It includes a share award certificate referring to 4631 shares that were allocated on that same day: p. 325. Both of the letters point out the “Award Certificate…sets out the terms of your Share Award...”. Neither letter of offer specifies whether the Share Awards in question were “a contingent right to receive Shares” or were regarded as “an allocation of Shares subject to restrictions...”. I infer it must have been a contingent right to receive shares because of the definition of “restrictions” in the rules of the scheme. That definition assumes the shares which are subject to the restriction have been allocated to the employee and are legally owned by him, albeit that he accepted a restriction on his ability to deal with the shares. That is not what happened here, and I will proceed on that basis.
The text of both Share Award certificates is almost identical. Each of them identifies the taxpayer as having been granted an award by the trustee that entitled him to acquire the shares. In each case, the Award is expressed to be subject to the rules and notes the Share Award “will vest in accordance with the terms of Plan”. The body of each certificate then states the number of shares subject to the award and the “Vesting Date” (being the third anniversary of the grant) and the “Lapse Date”.
The taxpayer argued he was awarded shares on the date of grant, rather than rights. But he said they were not qualifying shares within the meaning of s 139CD because the scheme did not meet all of the applicable conditions in s 139CD that must be satisfied – specifically, the scheme did not satisfy the fourth condition (set out in s 139CD(5)) that at least 75% of the employees of the company or group were entitled to participate in the scheme. If the taxpayer is correct, the amount of the discount would need to be included in his assessable income on the date of grant, in accordance with the default rule in s 139B(2). In the alternative, he argued he acquired a beneficial interest in the shares on the date of grant even though they were not released until the vesting date, and subject to achievement of the performance conditions. The Commissioner says the taxpayer acquired a right – a qualifying right, at that – on the date of grant, and that it should be taxed on that basis.
The Award documents do not expressly require that the shares be issued on the date of the grant. The rules of the scheme do not require that the shares be in existence at any particular point before the vesting date. While the shares may come into existence and be held by the trustee within the three year period (and there is provision for dividends to be paid and votes cast where they do exist: see cl 2.9), the rules are vague on the question of precisely when the shares will be issued. It is likely that ambiguity is intentional: it maximises the flexibility of the trustee and the parent company in the operation of the scheme. At any rate, it is difficult to understand how a beneficial interest could arise in shares that have not yet been issued.
It is unclear whether the shares in this case did come into existence at the date of grant. It is possible this information is not available. But even if I assume the shares had been issued on the date of the grant and were being held by the trustee, I think the Share Awards should still be characterised as rights. The question of whether (and how many of) the shares would vest depended on achievement of the “performance conditions” referred to in the correspondence accompanying the Award certificates in 2004 and 2005. As the letter of grant dated 11 March 2005 explains:
Your Award will vest on the third anniversary of the Date of Grant to the extent that the performance condition is met (any unvested part of your Award will then lapse). The Trustee (or the Plan Committee of the Company) will inform you on or shortly after this date whether the performance condition has been met and the extent to which your Award has vested.
The letter of grant dated 31 March 2004 is in almost identical terms. I would add the text of the letters of grant clearly note the taxpayer would be taxed having regard to the market value of the shares on the vesting date (albeit that the letter of 11 March 2005 adds that an election might be made to pay income tax on the date of grant).
It seems clear the true effect of the scheme is to confer a right on the participant on the grant date that entitles him to receive shares on the vesting date in certain conditions. He does not have a share until the vesting date: he merely has a right that is contingent on the achievement of certain targets. That is consistent with the language used in the definition of Share Award in the rules, which speaks of the Award as a “contingent right”. That approach to the question is also consistent with the understanding of the taxpayer, who explained in his evidence that he did not expect to receive all of the shares he had been awarded. Under cross-examination (see transcript at p. 32), he spoke of an expectation the parent company would find an “excuse” that resulted in a smaller number of shares vesting than had been awarded. I also note PriceWaterhouseCoopers took this view when it asked the Commissioner to allow the taxpayer to make an election under s 139E: see letter dated 6 March 2007, reproduced at S1, exhibit two p. 211.
In those circumstances, the share awards should be treated as qualifying rights. That means they will be assessed in 2007 and 2008 given there was no election under s 139E. It follows there has been a tax shortfall, and I affirm the objection decision in this respect.
PENALTY
I turn now to the question of penalty. I have already noted the administrative penalty was assessed at 25% on the basis the taxpayer failed to take reasonable care. (It was originally assessed at 50% on the basis the taxpayer was reckless, but that rate was reduced on objection.)
The taxpayer did not take reasonable care with respect to his tax affairs. That much was obvious from his evidence recorded in the transcript. He did not seek proper advice in relation to the scheme when he joined it even though he must have been aware there were taxation implications (I note each of the letters of grant referred to taxation implications, although it should have been obvious in any event that there might be issues). He agreed he put the documents in a drawer and decided, in effect, that he would deal with them when the shares vested and the options were exercisable. A reasonable taxpayer – let alone one with this taxpayer's experience of dealing with financial and other matters – would not have taken such an insouciant approach to his tax affairs. He did not seek proper advice until it was too late. But things did not improve once he did seek advice. After he briefed his tax agent, amended tax returns were filed on the basis that the share awards were not qualifying shares. I have already explained that approach is wrong, and was inconsistent with the approach taken by his own professional advisers when they asked for the Commissioner's permission to make a late election. I think the objection decision must be affirmed in this respect.
REMISSION OF PENALTY
That leaves the question of whether to remit the penalty (either wholly or in part). I must have regard to the particular circumstances of the taxpayer and decide whether the imposition of the penalty was harsh: see Archibald Dixon as Trustee for the Dixon Holdsworth Superannuation Fund v Commissioner of Taxation [2008] FCAFC 54 at [26] per Spender, Ryan and Emmett JJ.
The taxpayer explained in his evidence that he is in a very difficult financial position. He was left with a huge tax bill when the value of the shares was assessed having regard to the share price in 2007 and 2008 – but the share price subsequently fell dramatically. He sold some shares soon after they vested, but he held on to the balance. They have now declined significantly in value. In effect, he said the movements in the share price have left him with a largely paper gain that yielded an all-too-real tax bill and no means of satisfying the debt without liquidating other assets. The imposition of a significant penalty on top of this burden just makes things worse. I accept he is experiencing significant financial hardship as a result of what occurred.
The Commissioner points out the taxpayer's difficulty arose because he held onto the balance of the shares when he could have sold them all to manage his tax debts. Those debts were larger than they needed to be as a result of a misjudgement. The taxpayer's error in deciding to hold onto shares that subsequently declined in value compounded the earlier mistakes with respect to his taxation affairs. The taxpayer was unable to explain why he did not sell his shares before the share price began to fall in the latter part of 2008 as the “global financial crisis” began to unfold. He did not expect the decline in value, obviously; he also said in his evidence (transcript at p. 49) that he was busy with the commercial challenges he faced at work. But those challenges were presumably occurring after the onset of the crisis, rather than in the early part of 2008. In any event, his shares (and those of many other investors) declined in value and he was left owing money (albeit the money was owed to the Commissioner, rather than to financiers). His difficulties in this regard are not a consequence of the operation of the tax laws. They are a consequence of the operation of the market. He took a risk that the shares would maintain or increase their value, and he was wrong.
While the taxpayer has been placed in an unfortunate position as a result of these errors and miscalculations, I am not satisfied he has established the imposition of the penalty at 25% is harsh having regard to his circumstances. I acknowledge the quantum of the penalty is large, but that is a consequence of the operation of the law which provides for the imposition of a percentage penalty. If the tax shortfall is large, as in this case, the penalty can also be expected to be large. There is nothing intrinsically harsh or even unexpected about that.
CONCLUSION
The objection decision under review is affirmed.
I certify that the preceding 34 (thirty -four) paragraphs are a true copy of the reasons for the decision herein of Senior Member Bernard J McCabe ...............................[Sgd].........................................
Associate
Dated 31 May 2013
Dates of hearing 27 November 2012 and 17 January 2013 Advocate for the Applicant Pranesh Lal Counsel for the Respondent Shane Monks Solicitors for the Respondent Australian Taxation Office
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