Typical cash settlement provisions in share plan rules hitherto produced a "loophole" enabling UK employees moving abroad to escape UK income tax on options. HMRC (HM Revenue & Customs) have U-turned on an interpretation designed to block the loophole.
Most well drafted share plans give the establishing company the ability to settle in cash. This is rarely done in practice but it is sometimes necessary to avoid difficult securities law issues in some jurisdictions.
The cash settlement provisions can be structured in one of two ways:
A right to receive shares, but the person granting the right also has a right to substitute cash; or
A right to receive shares, but the person granting the right is entitled to pay "compensation" in cash instead.
Oddly, the subtle difference in drafting affects the tax treatment of UK participants. If the grantor has a right to substitute cash, the cash or shares received on exercise are taxed as "general earnings" rather than under the options rules. What this meant is that if a UK participant moved abroad before exercise, they escaped UK income tax under the earnings rules rather than those applicable to rights to acquire shares.
HMRC were concerned that companies were exploiting this "loophole" by structuring their cash settlement provisions to secure earnings treatment. This "loophole" has now been blocked by the Finance Act 2006 by allowing HMRC tax rights to acquire shares as securities if they are used for tax avoidance purposes.
Previously HMRC tried to prevent the abuse by arguing that all such rights were also securities, but said they would only tax them as such where there was abuse. This interpretation vastly complicated the tax treatment (albeit that it was not imposed) and was dropped on legal advice.
There is no evidence there was abuse as it required UK participants to move abroad to take advantage of the loophole. The change in interpretation is welcome all the same.
In any event the settlement in cash of rights to acquire shares may be undesirable (unless securities laws require it) as the accounting costs are higher under new international accounting principles (IFRS 2) than settlement in real shares.
The ability to cash settle should not be confused with "cashless exercise" (which involves settlement in shares and immediate sale of the shares) or "stock appreciation rights" (which involve settlement in shares equal to the value of the profit on exercise - used to minimise the number of shares which count towards dilution limits in plan rules).
Well drafted plan rules may include all these settlement facilities.