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August 18, 2016

Bonuses Awarded as Loan Notes Taxable as Cash

In the recent case of Cyclops Electronics Ltd & Graceland Fixing Ltd v HMRC, the First-Tier Tribunal considered whether a 12 month survival clause was enough for loan notes to be considered restricted securities for tax purposes.

The appeals by Cyclops Electronics and Graceland Fixing were heard together because they gave rise to similar questions of fact and law. Furthermore, it was noted that there are several hundred appeals that also raised similar issues that had an interest in the decision.


  • The companies undertook a series of transactions which resulted in senior employees receiving loan notes from a third party.
  • The loan notes included a forfeiture provision triggered by the death of the employee. Where the employee did not survive 12 months, the loan notes would revert back to the ownership of the relevant company.
  • Both companies believed the loan notes were ‘restricted securities’ because of the forfeiture clause and were therefore not subject to income tax or National Insurance Contributions (NICs) on receipt according to ITEPA 2003 Section 425.
  • HMRC disagreed with this analysis and argued that the survival clause was inefficient for the purposes of the restricted securities legislation because the clause did not have a business or commercial purpose.
  • On this basis, HMRC made a determination that that the loan notes were not restricted securities and that the employees should be treated for PAYE and NIC purposes in the same way as a payment of cash equal to the value of the loan notes.

The Case

Previous Case Law

Both parties looked to the decision in UBS AG v HMRC and Deutsche Bank Group Services (UK) Ltd v HMRC in order to support their arguments.

The forfeiture provisions in Deutsche and UBS were (a) that the holder did not cease employment within 6 weeks; and (b) related to the performance of the FTSE 100 over a 3 week period, respectively.

The Supreme Court held that shares subject to a short-term contingency which was unlikely to occur were not restricted securities. The Court took a purposive approach and held that the contingency provisions should have been provided with a genuine business or commercial purpose, not for commercially irrelevant or arbitrary conditions whose only purpose is the avoidance of tax.

HMRC Submissions

HMRC noted that forfeiture clauses are included in the provision of securities in order to retain or incentivise employees; securities are forfeited if performance conditions are not met.

On this basis, HMRC held that the forfeiture provision included in the loan notes must have a business or commercial purpose in order for them to be restricted securities. As a survival provision is irrelevant for business purposes, the loan notes were not restricted securities.

Taxpayer Submissions

The companies distinguished their circumstances from the UBS and Deutsche case by arguing that the loan notes were forfeitable on an event not within their control and lasted a reasonable length of time (rather than the short timescale in the UBS and Deutsche appeals).

They contended that the loan notes were ‘real’ and at a genuine risk of forfeiture, therefore the survival clauses were sufficient to make the loan notes restricted securities.

The Decision

The First-Tier Tribunal applied the Supreme Court’s judgement in the UBS and Deutsche case along with the Ramsay Principle to defeat the tax arrangement.

The Court dismissed the companies’ submissions that the restriction had to be ‘real’. The question was whether those restrictions were inserted for a business or commercial purpose.

It was held that there was no independent business or commercial purpose for including the forfeiture provisions and they were included only to secure the benefit of the income tax and NICs exemption. On this basis, the loan notes were not restricted securities and PAYE should have been applied.

In view of the decision, employers planning on awarding securities to employees must ensure that the forfeiture provision is included with a genuine business purpose.

In light of the number of relevant cases reliant on this decision, it is likely that an appeal will be sought.

Contact us today to discuss your tax requirements.
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