SPC00449
Payments for the release of share options chargeable under Income and Corporation Taxes Act 1988, s. 135 – Application of PAYE Regulations – Whether obligation to deduct tax under existing law prior to its amendment by Finance Act 1998, s. 67 – Payments made after Budget announcement of change but prior to enactment of amending legislation – Whether obligation to deduct tax imposed retrospectively by s. 67 and SI 1998 No 1891 – Effect of budget resolution pending enactment of Finance Bill – Appeal allowed

THE SPECIAL COMMISSIONERS

	DEMON INTERNET LIMITED	Appellant

	- and -

              D YOUNG
	 (HM INSPECTOR OF TAXES)    	Respondent

				Special Commissioners:        Malcolm Gammie QC
Dr David Williams

Sitting in London on 29 and 30 September 2004 in public

Graham Aaronson QC and Paul Farmer of counsel instructed by McGrigors, solicitors, for the Appellant

Ingrid Simler of counsel, instructed by the Solicitor to the Inland Revenue for the Respondent

© CROWN COPYRIGHT 2004

DECISION

1	Demon Internet Ltd (Demon) is appealing against a determination issued under regulation 49 of the Income Tax (Employment) Regulations 1993, SI 1993 No 744 (the PAYE Regulations). The Respondent inspector determined on 31 March 2003 that Demon failed to operate those Regulations in relation to certain payments made to its employees (including where relevant former employees), and failed to account to the Inland Revenue for income tax of £981,623.75 due on those payments. The payments were sums paid by Demon to its directors and employees and/or former directors and employees (referred to only as “employees” below) in return for the release by those employees of share options held by them by reason of their employments with Demon. 

2	This bland statement conceals what Demon, in a case argued for it in the strongest terms by Graham Aaronson QC, regards as an overstretched series of assumptions, deeming provisions and attempts to make new legislation retrospective. On his analysis, to reach the position set out in the first paragraph involves assuming:
(a) that the payments were made by Demon when they were not;
(b) that the payments were made through the payroll when there is no evidence that this was so;
(c) that the payments were made at a date later than they were actually made; and
(d) that the relevant regulations were in force at the date of payment when they were not.
In the Appellant’s view, in so far as it made, or is deemed for current purposes to have made, the payments it was under no duty, and had no right, at the relevant time to make income tax deductions as demanded. In its view, the Inland Revenue is attempting to enforce intended law rather than actual law in making the Regulation 49 determination. 

The facts

3	The Appellant was an internet services provider. Its entire issued share capital was acquired by Scottish Power Telecommunications Ltd (Scottish Power) on 30 April 1998, as a result of a share purchase agreement signed and completed on that day. Following the acquisition, it has become a dormant company (although we do not know precisely from when this has become the case). 

4	Employees of Demon had been granted options by Demon under its Demon Internet Limited Executive Share Option Scheme (No 1). A grant of an option under the scheme entitled the employee to acquire shares for which no consideration was payable or paid. At the time of the acquisition 253 employees (that term including former employees and directors) held options. 

5	As part of the process leading to the acquisition, Demon agreed that cash payments totalling £2,826,659.60 would be paid to the 253 employees in consideration for the cancellation of options held by each of them and entitling them to acquire shares in Demon. Demon reached agreement individually with the option holders to cancel the options for agreed cash sums. The specimen “Agreement for release of options” that we saw was signed by the option holder (but not by Demon) and dated 1 April 1998.  The total sum to be paid to the employees in this way was provided by Scottish Power. The agreements with the option holders were made by Demon as agent for Scottish Power as undisclosed principal. 

6	On 30 April 1998 Scottish Power wrote to the then finance director of Demon. The letter instructed the finance director personally (and not as a director or employee of Demon) to pay the gross amount payable to each option holder to that option holder. The letter added:

“… please write to each of the option holders explaining clearly that he/she should reserve the appropriate sum to cover such Schedule E taxation on the full amount received.”

A copy of the letter was countersigned by the finance director in his own name (and not as director) against the statement “I accept your instructions as set out above.” 
We heard no evidence of the terms, if any, in which the finance director discharged these instructions, if he did.

7	On or about 30 April 1998 the sums were paid to the employees without deduction of tax. We were given no clear evidence of when, how or by whom the payments were made, and conclude only that the payments were made and that no return was made by the payer to the Inland Revenue in respect of any income tax deducted when the payments were made. Nor were we given evidence, beyond the most general, about when all or any of the 253 directors or employees ceased to be employees of Demon either by reason of the transfer of the undertaking or for any other reason. We therefore do no know if all or any of the employees remained employees of Demon, or of an associated person, on 31 July 1998 or any other relevant date. 

8	We record that we did not receive evidence from the finance director or any other involved individual about whether individual employees had or had not been warned to pay, or had paid, income tax, or had made returns indicating liability to income tax following receipt of these cash payments. None of the employees was a party to, or had been given notice of, this appeal. We therefore make no finding of fact or assumption about any specific income tax liability of any of them individually save for the purposes of this appeal.

The liability to tax on the payments

9	The Respondent contended, and the Appellant did not dispute, that the recipients of the payments were in principle liable to income tax under the former Schedule E by reason of section 135 of the Income and Corporation Taxes Act 1988 (the Taxes Act). As noted, none of the individuals said to be liable to income tax on these payments was a party to this appeal, and we accept the Respondent’s contention on that basis and for the purposes of this appeal only. As no income tax was deducted, we assume that there has to date been no formal occasion for an employee to object to the potential liability asserted by the Respondent.     
 
10	Section 135 of the Taxes Act, so far as relevant to this appeal, provides:

(1) … where a person realises a gain by the … the assignment or release of a right to acquire shares in a body corporate obtained by that person as a director or employee of that … body corporate, he shall be chargeable to tax under Schedule E on an amount equal to the amount of his gain, as computed in accordance with this section.

(3) … (b) the gain realised by the assignment or release of any such right shall be taken to be the difference between the amount or value of the consideration for the assignment or release and the amount or value of the consideration given for the grant of the right… 

(4) For the purposes of subsection (3) above, neither the consideration given for the grant of the right nor any such entire consideration as is mentioned in that subsection shall be taken to include the performance of any duties in or in connection with the office or employment by reason of which the right was granted …

(5) where such a right as is mentioned in subsection (1) above is obtained as mentioned therein and is capable of being exercised later than ten years after it is obtained, and the receipt of the right is chargeable to tax under any other provision of the Tax Acts, then –

(a) the amount so charged shall be deducted from any amount which is chargeable under subsection (1) above by reference to the gain realised by the exercise, assignment or release of that right …

11	The Respondent contends that these provisions presented Demon, as employer, with no problems and that as a result Demon should have deducted income tax on making the payments to the employees. This was because Demon was, at least at the beginning of the day in question, the employer of the employees; the share scheme was one under which the employees acquired their options for no consideration; and the scheme was one under which the options were acquired less than 10 years before disposal. Accordingly, there were no deductions to be made against the gross payments for the release of the options, so the operation of the tax charge presented no difficulties or uncertainties. All the payments were fully subject to the charge to tax under section 135 and should have been subject to deduction of tax under the PAYE scheme.

The liability to deduct tax

12	On the basis that the payments were fully liable to be subject to income tax, the Respondent asserted that Demon, as employer, was liable to account to the Inland Revenue for the income tax on those payments for successive reasons:

(a) the plain terms of section 203 of the Taxes Act applied, together with regulations 6, 14, 40 and 49 of the Income Tax (Employments) Regulations 1993 (SI 1993 No 994) (the PAYE Regulations); or, if this was not so
(b) the amendments made to the Taxes Act by section 67 of the Finance Act 1998, as enacted, together with regulation 80ZA of the PAYE Regulations, had retrospective effect to the relevant time and applied to the payments; or, if this was not so 
(c) the provisions of clause 67 of the Finance (No 2) Bill 1998 (first print) applied, as put into effect by budget resolution 40 passed by the House of Commons in respect of that year’s budget under the terms of the Provisional Collection of Taxes Act 1968 (and the appellant should have known about this because of contemporary formal announcements); or, if this was not so
(d) Demon as employer should have foreseen from that publicity that the new liability was about to be imposed and should have withheld the income tax in any event to await imposition of the liability.
 
13	As this series of alternatives reveals, the Respondent was seeking to collect tax under provisions in the process of legislative change. The reason for the changes of law being relevant is that the agreements were made on or about 1 April 1998 and the payments were made on or about 30 April 1988. But, the Respondent argues in the alternative, they were deemed to be made in the income tax month ending on 5 August 1998 by reason of the legislative changes. The announcements of legislative change both in the budget speech and the budget press releases were made on 17 March 1998. The 1998 budget resolutions were passed on 23 March 1998. The Finance Bill was published on 8 April 1998. The relevant legislative changes came into effect retrospectively from 6 April 1998 upon enactment on 31 July 1998 of the Finance Act 1998. The relevant amendments to the PAYE Regulations took effect on 4 August 1998. So all those steps were, in the Respondent’s view, in place before the payments were, by reason of the amendments set out below, made or deemed to be made by Demon. 

14	The Appellant submits that there was no underlying liability flowing from the terms of the law before amendment. Indeed, that was precisely why it was being amended. But the amendments had not come into effect at the relevant time for this appeal either directly (by means of retrospection) or indirectly (by means of the budget resolution). And there was neither duty nor power for Demon to deduct potential tax payments for which there was no lawful authority. Consequently, whatever the position of the employees and former employees, there was no basis on which Demon should or could have deducted income tax when the payments were made even if it did make the payments or is deemed to have done so.  

15	Miss Simler put the arguments of liability to deduct resulting from the unamended form of section 135 and the PAYE Regulations before us as the Respondent’s primary argument. We note, however, that it had previously been subsidiary to the argument under the new provisions.  Our view is that, for the reasons below, the Appellant is clearly right in asserting that it was under no liability to deduct income tax from the payments before the legislative changes in 1998 took effect, and that that view is confirmed in part by those amendments themselves and in part by the actions of the Revenue itself. Consequently, unless the Respondent can establish a liability to deduct and account under the changed (or changing) legislation then the appeal succeeds. We therefore deal with the arguments based on the new legislation before turning to the underlying law.  

The 1998 amendments

16	There are two new measures on which the Respondent bases the charge to tax, section 67 of the Finance Act 1998 and regulation 80ZA of the PAYE Regulations. Regulation 80ZA was introduced as follows. The Income Tax (Employments) (Notional Payments) (Amendment) Regulations 1998 (SI 1998 No 1891) were made and laid on 3 August 1998 and came into force on 4 August. They were made entirely under the powers in section 203 of the Taxes Act 1988 (as amended by, among other provisions, section 67 of the Finance Act 1998). They amended the main Income Tax (Employments) (Notional Payments) Regulations 1994 (SI 1994 No 1212). Regulation 8 of the Amendment Regulations adds a new regulation 12A to the 1994 Regulations. The new regulation 12A itself amends the PAYE Regulations to insert the new regulation 80ZA into the PAYE Regulations.

17	Section 67(1) of the Finance Act 1998 (gains from share options etc) introduced a new section 203FB (PAYE: gains from share options etc) to the Taxes Act. Section 203FB provides, so far as relevant:

	(1) This section applies where an event occurs by virtue of which an amount is assessable on any person (“the relevant person”) by virtue of section 135 …

	(3) If that event is the assignment or release of a right to acquire shares, sections 203 to 203F shall have effect … –

	(a) in so far as the consideration for the assignment or release takes the form of a payment, as if so much of that payment as does not exceed the amount assessable by virtue of section 135 were a payment of assessable income of the relevant person …
	
18	This is given retrospective effect under the following subsections of section 67:

	(2)	The preceding provisions of this section have effect in relation to events occurring on or after 6th April 1998 and shall be deemed, in accordance with subsection (3) below, to have come into force on that date. 
	
	(3) 	This section shall not be taken to have changed –

(a) the amounts which were deductible by any person under section 203 of the Taxes Act 1988 at any time on or before the day on which this Act is passed; or
	
(b) the amounts which should have been accounted for to the Board under section 203J(3) of that Act at any time on or before the fifth of the month following that in which this Act is passed;

	but the amounts which (but for this subsection) would have been deductible, or would have been amounts for which any person should have accounted, shall be deducted or accounted for in accordance with any such provision as may be made by regulations under section 203 of the Taxes Act 1988.

19	Section 67 relies in part on section 203J(3) (introduced into the Act in 1994).  Section 203J deals with accounting for tax under s 203B to s 203I. It was not argued that it was relevant to the charge on Demon. 

20	Assuming section 67 applies to these events, then section 203 (Pay as You Earn) is in the view of the Respondent to be applied to the payments in the form modified by section 203FB(3)(a). Section 203(1) provides:

On the making of any payment of, or on account of, any income assessable to income tax under Schedule E, income tax shall, subject to and in accordance with regulations made by the Board under this section, be deducted or repaid by the person making the payment, notwithstanding that when payment is made no assessment has been made in respect of the income and notwithstanding that the income is in whole or in part income for some year of assessment other than the year during which the payment is made. 

21	Section 203(2) provides the regulation-making powers to operate the PAYE system. The powers potentially relevant here are:

	(a)	for requiring any person making any payment of, or on account of, any such income, when he makes the payment, to make a deduction or repayment 
of income tax calculated by reference to tax tables prepared by the Board, and for rendering persons who are required to make any such deduction or repayment accountable to, or, as the case may be, entitled to repayment from, the Board; …

(c) for the collection and recovery, whether by deduction from any such income paid in any later year or otherwise, of income tax in respect of any such income which has not been deducted or otherwise recovered during the year; … 

22	 The 1998 Regulations that introduced regulation 80ZA recited as the relevant statutory enabling power only section 203. Miss Simler submitted that the Revenue’s power to make regulation 80ZA was section 203(2)(c). It was accepted that the power in section 203(2)(a) – the usual power in the case of ongoing payments – did not apply as the payments had been made when the Revenue made the regulation. 

23	The new regulation 80ZA provides:

	Payment for assignment or release of a right to acquire shares

	80ZA	- (1) This regulation applies where –

(a) the consideration for the assignment or release of a right to acquire shares takes the form of a payment,

(b) the payment is made in the period beginning on 6th April 1998 and ending on 31st July 1998,

(c) so much of that payment (“the relevant amount”) as does not exceed the amount assessable by virtue of section 135 of the Taxes Act is treated, in accordance with section 203FB (3)(a) of that Act, as a payment of assessable income of the relevant person, and

(d) the employer would, but for section 67(3) of the Finance Act 1998, have accordingly been liable to deduct an amount of income tax in accordance with these Regulations in respect of the relevant amount.

(2) Regulation 40 shall have effect as if the relevant amount was an amount of emoluments paid by the employer in the income tax month ending on 5th August 1998.   

24	Mr Aaronson drew our attention to the numbering and location of regulation 80ZA in the PAYE Regulations. It confirmed, in his view, the limited attention actually given to the drafting of the regulation and its proper insertion into the main PAYE Regulations. Its location is at the end of Part VI (Special Provisions), Chapter IV (other cases) although its effect as stated in regulation 80ZA(2) is to apply regulation 40, which is in Part V of the Regulations. No assistance is given in the interpretation of regulation 80ZA from its location and context in the Regulations.

Do section 67 and regulation 80ZA apply to these payments?

25	Miss Simler contended that section 67 and regulation 80ZA impose a duty on Demon to collect income tax in respect of the payments made on or about 30 April 1998 to the then employees. This is because the section and regulation engage the obligations on Demon under section 203 and the PAYE Regulations. In the Respondent’s view this applies to Demon regardless of whether all – or any – of the then employees remain employees of the company as at 31 July or 5 August 1998, regardless of who actually made the payment, regardless of how the payments were made, and regardless of whether Demon was still an active company at those later dates.  

26	Miss Simler went on to contend that full provisional effect was given to these provisions under the Provisional Collection of Taxes Act 1968, so they applied under the relevant budget resolution. If, as the Appellant contends, the new legislative provisions could not be applied after the Act and regulation came into force because there was nothing from which to make the payment, then the Respondent contends that this was a problem for Demon, not the Respondent, as Demon should have taken steps to keep back the tax at an earlier date.

27	Mr Aaronson argued strongly against these contentions. There was in his view a serious question to be addressed about whether regulation 80ZA was within the powers available to the Revenue to impose payments in the way the Respondent contended. Even if it were within the Revenue’s powers, it did not apply to a payment that had already been made when the Regulation came into force. And it was not clear that the drafting of the Regulation worked as intended in any event. 

28	There is another point. By section 67(2) of the 1998 Act, section 203FB has effect in relation to events occurring on or after 6th April 1998. “Events” takes its colour from subsection (1) as something by reason of which an amount is assessable on any person by virtue of section 135 or other sections not relevant here. In this case the “events” are the assignments or releases of the share options. The specimen agreement for release of options put in evidence was a form of agreement for release signed by one party only and dated 1 April 1998. The wording of that draft – to which neither party drew attention – is that:

“The option holder hereby agrees to release the options … forthwith upon payment by Demon of the sum of [£ …] in consideration for such release. This sum will be paid … and upon payment Demon will be released from any liability in respect of these options.

Should the sum specified above not be paid by Demon on or before 30th April 1998 this release will no longer be effective …” 

The Respondent referred to this as a conditional agreement for the release of the options and no doubt it was effectively conditional on final agreement between Demon and Scottish Power as it was that step that would enable the stated sum to be paid.  This is not, however, explicit in the wording of the release.  In the light of the release, when was the “event” to which section 67 applies? Was it the making of the agreements or the payment of the consideration? The meaning of “event” in the section is not clear. It may be that the event is the agreement that gave rise to the right to the payment, albeit payment at a later date. If the events were the agreements for release, then section 67 fails to apply simply because the events occurred before 6 April 1998 (the operative date of the section under subsection (2)). But argument proceeded before us on the implicit assumption that the events were the payments and that these were after 6 April 1998. We do not rest our decision on this point but consider the case on the assumed basis. 

29	This issue arises in a second guise, again not argued before us. Section 203A(1) of the Taxes Act (PAYE: meaning of payment) provides that for the purposes of section 203  a payment “shall be made at the time found in accordance with the following rules (taking the earlier or earliest time in a case where more than one rule applies)”. One of those rules is the time when a person becomes entitled to a payment. Under the draft set out above and on the assumed facts, did each option holder became entitled to (as against receive) the payments before or after 6 April 1998? If entitlement arose when the agreements were made, then the payment would appear to have been deemed as made before 6 April 1998. If we are wrong in the conclusions we come to below, then these matters may have to be revisited as it is for the Respondent to establish that the events and time of payment were after 6 April 1998.   

The PAYE obligations on Demon

30	Section 67 does not directly impose any liability to collect tax on anyone. It does so by the indirect means of empowering new provisions in the PAYE Regulations and then providing for the transitional period while those Regulations take effect. It is common ground that under those Regulations, regulation 2 defines “employer” as meaning any person paying emoluments. “Emoluments” means the full amount of any income to be taken into account in assessing liability under Schedule E after deduction of allowable superannuation contributions and any sums withheld under section 202. The definition is also supplemented by section 203B where the payment is by an intermediary. For these purposes, our view is that Demon was the employer if it paid the option payments to the employees or some intermediary paid for it. In this respect the agreements for release while (perhaps unhelpfully from the Respondent’s perspective) dated 1 April 1998 do contemplate payments by Demon or presumably someone on its behalf.

31	Regulation 6 imposes the general duty on all employers to deduct or repay tax to employees under the PAYE system if a code has been issued. Regulation 14 provides for the calculation and making of deductions in accordance with regulation 6.  Beyond that, we were not clear from the argument presented to us how the PAYE Regulations were expected to apply to these payments. This is in part because the facts were unclear. For example, if the employees did not remain employees of Demon on or after the acquisition (or on or after 31 July 1998) then we assume that regulation 24 (emoluments paid after employment ceased) must be applied to require deduction of income tax at the basic rate from the sums paid rather than regulation 14. Regulation 14 is then expressly disapplied.  But regulation 24 was not part of the argument put to us. As nothing turns on the terms of regulation 49, which was part of the argument put to us, we do not need to consider it. 

32	Regulation 40 provides for payment of the tax monthly to the Revenue  by employers: 
40.-(1) Subject to regulations 41 and 48(11), the employer shall pay the amount specified in paragraph (2) to the collector within 14 days of the end of every income tax month. 

(2) The amount specified in this paragraph shall be determined by the formula-

where-
A is all amounts of tax which the employer was liable under these Regulations to deduct from emoluments paid by him in that income tax month; 
B is all amounts of tax by which deductions in that income tax month were reduced in accordance with regulation 36(3)(b), being amounts calculated under regulation 36(2) as due to be repaid in an earlier income tax month but whose repayment was precluded during that income tax month by regulation 36(3); 
C is any amounts calculated as due to be repaid in that income tax month, but whose repayment was precluded during that income tax month by regulation 36(3); and 
D is any amounts which he was liable to repay in that income tax month (excepting any amounts for which a reduction was claimed in any previous income tax month, or which are being recovered from the Board under regulation 42(6)).

It can be seen that regulation 40 does not itself impose an obligation to deduct. That must be imposed by some other regulation to which regulation 40 then attaches an obligation to account. But it is regulation 40 that regulation 80ZA is said to modify, not those other regulations. 

33	The Respondent’s argument is that the effect of section 67 of the 1998 Act and regulation 80ZA on regulation 40 is sufficient to activate a duty on Demon to account for tax to the Revenue in the tax month ending on 5 August 1998. We see a number of problems with this argument. 

34	Section 67(3) of the 1998 Act expressly disapplies section 203 and the PAYE Regulations “at any time on or before the day on which this Act is passed.” So the disapplication lasts until 1 August 1998. Subject to that disapplication, the subsection states that any amounts that would have been deductible but for that disapplication shall be deducted “in accordance with any such provision as may be made by regulations under section 203.” The duty in section 67(3) is a duty to comply with the PAYE Regulations that are extant at any particular time. Accordingly, the first question that the proviso to section 67(3) poses is:  what amounts would Demon have had to have deducted in accordance with the new section 203FB on the basis specified in section 67(2) that section 203FB applied to events on or after 6 April 1998?  Even if we assume that this was the amount that the Respondent says ought to have been deducted, the proviso to section 67(3) then requires that that amount “shall be deducted  in accordance with any such provision as may be made by regulations”.  Thus the effect of the section is to empower the making of new regulations that may impose a further duty to deduct, subject to the disapplication provision. The new regulations can be applied to any “event” on or after 6 April 1998. As we have noted above, that may mean the agreement providing for payment or it may mean (as we assume) the payment itself. 

35	Subsection (3) is not an easy provision to interpret, not least because it appears to contemplate that there would have been an obligation to deduct tax prior to 1 August 1998 (but for subsection (3)) and regulations can impose a further obligation to deduct after 31 July 1998, notwithstanding that payment (and with it the opportunity for deduction) has already occurred.  (The references in subsection (3) to “accounting for tax” rather than deducting tax refer to the obligation to account under section 203J(3), which is not said to apply in this case.)  It may be that with  continuing employments the regulations might have imposed an obligation to deduct the amounts that would have been deductible before 1 August 1998 from future emoluments.  It is unnecessary for us to speculate on this as this is not the basis of the Respondent’s argument.  

36	As events turned out there was no obligation imposed by further regulations before 4 August 1998 and, on the assumption that section 203FB was designed to close a gap by imposing an obligation to deduct where previously none existed, there was no duty to deduct prior to that date. It follows that this was not a case of payments being made subject to a duty to deduct extant at that time but disapplied only by subsection (3). On the contrary, they were made at a time when there was no duty to deduct. The amounts sought by the respondent are not “amounts which (but for this subsection) would have been deductible” unless subsection (2) can be said to be effective to impose that obligation subject only to the disapplication of subsection (3). 

37	Should the section be read to have retrospective effect either in the effect of the regulations it authorised to be made or by imposing the provisions of regulations not yet made? We were referred to various authorities about the approach to be taken to retrospective tax provisions, but in our view the issue does not need that support. We do not consider that the wording of the section imposes any obligation on an employer to deduct tax from a payment made before 1 August 1998. We bear in mind that we are considering provisions that are asserted to impose a liability to collect, and therefore to pay, income tax retrospectively. This needs, in our view, clear language. We see no language either in section 203 or in section 67 such as to make the operation of the PAYE Regulations retrospective by reference to a regulation that had not been made until after that date.  What we think is clear is that anyone paying sums for the release of options on 30 April 1998 (assuming that is the correct event) had no legal authority to withhold any part of the amount paid in respect of tax.  On any reading of section 67 there  was no obligation (or right vis-à-vis the payee) to withhold any amount at that date. We read both section 67 and regulation 80ZA as capable of applying only after the regulation was made and came into effect on 4 August. It therefore does not apply to these payments, irrespective of whether it is, might be or could have been effective in relation to some other payments made on or after it came into effect. 

38	This point can also be answered in a different way, based on the drafting of regulation 80ZA itself. If regulation 80ZA cannot operate until 4 August, then it must be considered whether it operates on the payments to which it purports to apply. Regulation 80ZA(1)(b) specifically states that the regulation applies where “the payment is made in the period beginning on 6th April 1998 and ending on 31st July 1998”. It cannot do that under the terms of the regulation itself. That must be derived from section 203 before or after amendment. Mr Aaronson strongly contended that this entire period is before regulation 80ZA came into effect. In other words there is no common period of time between the period that the regulation purports to cover and the period which by reason of section 67 it actually covers.  If that is so, it follows that for that reason also the section and regulation fail to apply to these payments. 

39	Mr Aaronson’s argument about retrospection was also put on another basis. If and in so far as regulation 80ZA operated or purported to operate retrospectively, it was ultra vires as beyond the power of the enabling provision (section 203). There is nothing in section 203, before or after its supplementation by section 203FB and by section 67 of the 1998 Act, that enables the Inland Revenue to make retrospective regulations imposing a liability to collect tax from payments already made before any of the PAYE Regulations come into effect.  In particular, section 67 does not provide such authority.  

40	Miss Simler’s skeleton argument indicated that, in addition to resisting Mr Aaronson’s argument on its merits, she would also challenge the power of the Special Commissioners to deal with issues of vires. We indicated to the parties at the start of the hearing that in our view we were empowered to consider the issue of vires by the decision of the House of Lords in Chief Adjudication Officer v Foster [1993] AC 754. That decision applied to Social Security Commissioners (an office held by one of us) but in our view applied equally to the role of Special Commissioners for the reasons made clear in the opinion of Lord Bridge (with whom their Lordships agreed). Miss Simler did not seek to argue against that view, while reserving the right to challenge it elsewhere. We did not ask Mr Aaronson to address us on the point.  Had we taken the view that the regulation necessarily had retrospective effect, we would have considered this argument further. In the result, on our interpretation it does not apply and we do not need to decide on its validity. 

41	Separately again from those issues, there is another difficulty with the wording of regulation 80ZA and the way in which it is stated to affect regulation 40 (and no other provision in the PAYE Regulations). Regulation 80ZA(1) can be read as a statement of the circumstances in which regulation 80ZA(2) applies.  Thus, in this case it can be said that there was a payment in the period beginning on 6th April 1998 and ending on 31 July 1998 and it might also be said that there could have been an obligation to deduct tax but for section 67(3). When one turns to regulation 80ZA(2), however, we find it impossible to see how this imposes an obligation consistent with the proviso to section 67(3) to deduct any amount when there is no further payment and all that regulation 80ZA(2) does is to treat the relevant amount as an amount of emoluments for the purposes of regulation 40.  Paragraph (2) of regulation 80ZA provides that regulation 40 is to have effect as if the “relevant amount” was an amount of emoluments paid in the income tax month ending on 5 August 1998. “Relevant amount” is defined by regulation 80ZA(1)(c) as the taxable amount of the payment by reason of section 135 and to which section 203FB(3)(a) applies. Regulation 40 refers to amounts of tax rather than amounts of emoluments. The effect of regulation 80ZA must then be to add the “amount of emoluments” to the sums to which “A” applies in regulation 40(2). If regulation 80ZA operates in this way, it adds those amounts to “emoluments paid by him (the employer) in that income tax month”. But “A” is specifically not the amount of the emoluments but the amounts of tax “which the employer was liable under these regulations to deduct from” those emoluments. 

42	As noted above, regulation 40 contains no obligation to deduct. That must exist elsewhere in the regulations. In which regulation? Regulation 80ZA does not impose any new obligation. Section 67 of the 1998 Act does so in so far only as it introduces section 203FB. But section 203FB merely expands the enabling power of section 203. And the only use of that power was in making regulation 80ZA. Quite apart from the wording of the Regulations, we would be reluctant to conclude that regulation 80ZA(2) could be effective to impose an obligation to deduct tax on a post-3 August 1998 notional payment when no earlier obligation to deduct existed.  To so conclude would effectively be to penalise someone who had previously made a payment  gross by requiring them to hand over tax that they had no obligation or right to deduct.

43	These arguments lead us, by a series of different routes, to the same conclusion. If the intention of section 67 was to impose income tax on, and empower collection of income tax from, the payments made to the Demon employees on 30 April 1998, then it manifestly fails to do so because it at no time provides an effective obligation to deduct and account that was coterminous with the making of the agreements or the payment of the consideration under those agreements.    

The budget resolutions

44	The failure in the machinery of section 67 and regulation 80ZA as the means to achieve what the Respondent wishes to achieve is a timing failure. Had the facts in this case all taken place after 5 August 1998 then the machinery would have worked (albeit without assistance from regulation 80ZA).  Of course, if the key events were before 6 April 1998 (as they may have been) then the machinery did not purport to operate in any event. The period in between was the period of time it took from the start of the tax year to Royal Assent of the Finance Act and the subsequent amendment of the PAYE Regulations. During that period different machinery can be called in aid to impose obligations while Parliament considers them. This is the well known machinery of the Provisional Collection of Taxes Act 1968 and the relevant budget resolutions. We do not need to recite that Act at length. Its provisions are well known and clear. Under section 1(2) if the House of Commons passes an appropriate budget resolution, then the resolution has the same effect as if it were primary legislation provided, of course, that the measure is later enacted. The later enactment has occurred in this case. 

45	The relevant budget resolution was resolution 40, passed by the House of Commons on 23 March 1998. The official record of the resolution in Hansard for that day is:
Paye (non-cash benefits etc.) 
Resolved, 

That provision may be made-- 

(a) extending the circumstances in which a person is to be treated for the purposes of PAYE regulations as having made a payment; and 
(b) amending section 144A of the Income and Corporation Taxes Act 1988. 

As is common with such resolutions, it was adopted without debate. But if it was intended to provide the authority to operate what became section 67 and regulation 80ZA from 6 April 1998, then it signally fails to achieve that. It has nothing in it that can be regarded as being directly effective in imposing a liability to pay income tax or an obligation to deduct it or to account for it on anyone. It authorises only that provision may be made. It does not state what that provision is. The resolution cannot therefore rescue the Respondent from the difficulty created by the failure of the legislation in its application to the payments. 

An obligation to collect the tax ahead of the legislation?

46	We deal even more briefly with the argument that Demon should have deducted income tax from the payments, either of its own initiative or in agreement with the employees, because it was made aware as a result of the budget speech, press releases, and professional information of what was intended to be the law. We thought those arguments had been brought to an end if not by the Bill of Rights then by Bowles v Bank of England [1913] 1 Ch 57, the case which forced the passage of the original Provisional Collection of Taxes Act. Nowadays taxpayers can pray in aid also the decision of the House of Lords in Woolwich Equitable Building Society v Inland Revenue [1993] AC 70, to which we were referred for other purposes, and possibly also their Convention rights. Unless there was legal authority for the sums to be deducted as income tax, how else could they be withheld? We entirely reject the suggestion, which we were surprised to hear, that this should have been done voluntarily ahead of the legislation becoming effective if, as we find, the legislation and the budget resolution both failed to impose any obligation at the date of payment. 

An underlying obligation

47	We conclude that the Respondent fails to persuade us that any of the arguments based on the 1998 Budget and Finance Act establish the authority to impose an obligation on Demon to collect tax from the employees or (whether or not it collected it) to pay the tax that should have been deducted to the Revenue under the regulation 49 determination. We therefore turn to what was presented as the Respondent’s principal argument. The argument is that the obligation was in place under sections 135 and 203 of the Taxes Act regardless of the 1998 amendments. Miss Simler based this contention on the interpretation given to the underlying legislation by the decision of the House of Lords in CIR v Herd conveniently reported at all levels of appeal in (1992) 66 Tax Cases 29. 

48	Before we turn to that case, we note three comments on the state of the existing law before the 1998 amendments that were put to us by Mr Aaronson. The first is the explanatory note to clause 67 of the Finance Bill, the measure that became section 67 of the 1998 Act. In the background note to the clause the House of Commons was told:

19. Employers are not presently obliged to operate PAYE in respect of payments to employees for assigning or releasing share options. Paying for an employee to give up rights of this sort could enable an employer to put case into the hands of an employee without operating PAYE. This Clause closes that loophole and puts beyond doubt that PAYE must be operated where readily convertible assets are provided in return for employees giving up share options.

The language of that paragraph of the note contains none of the doubts expressed elsewhere in the note when explaining the parallel new provision dealing with the exercise of a share option. It unambiguously expresses the official opinion that there was no current duty to deduct income tax from assignments and releases. We agree with Mr Aaronson that, although we do not expressly rely on it as a formal guide to interpretation, it confirms the approach that the reason for clause (and section) 67 was because the underlying law failed to apply to sums for the release of a share option.

49	Mr Aaronson also asked us to note the view of the Inland Revenue in a letter written to the Share Scheme Lawyers Group on 23 May 1995 about the application of the PAYE Regulations to payments for cancelling share options. The letter read:

“I can now confirm that following consideration of the decision of CIR v Herd PAYE does not apply to these payments.

That will be so regardless of whether any payment has been made for the grant of the option, and whether or not the cancellation payment is made by the employer or by a third party.

We would of course raise no objection to the operation of PAYE where that was acceptable both to the employer and employee and our agreement was sought.

…

I hope this minor clarification will be helpful.”

50	Mr Aaronson also drew our attention to the inconsistencies between the arguments put to the Special Commissioner and the courts in Herd and the arguments Miss Simler was putting to us.

51	It is true, of course, that the Revenue’s arguments as put to the Commissioner in Herd were not fully endorsed by the Court of Session or the House of Lords. Miss Simler is also correct in her response that the Respondent is not bound by any of these views, and that a different view of the law can be taken. But we trust we may be forgiven for some scepticism at her argument given the views previously expressed by the Inland Revenue in Herd, to Parliament, and to the most relevant group of specialist lawyers concerned with these provisions.

52	We set out the relevant provisions in section 135 of the Taxes Act in paragraph 10 of this decision. The operation of the PAYE Regulations on payments of the kind caught by section 135 was considered in Herd. The case concerned the taxation of a sum received by Mr Herd on the sale back to an employer of shares sold to him by the employer under an agreement including a right to sell the shares back. Mr Herd challenged an assessment on him for income tax on the gain realised on the sale with two arguments. First, the sum should be assessed, if at all, as a capital gain. Second, if it was income then the employer should have deducted the tax in making the payment to him. It is that second argument that is in point here. 

53	Before the Special Commissioner, Mr O’Brien, the Inland Revenue argued that Parliament could not have intended the PAYE Regulations to apply to either of the charging provisions relevant to that payment, namely section 67 of the Finance Act 1976 and section 79 of the Finance Act 1972 “because of their inappropriateness”. This was because section 79 could apply both to transactions involving payments and those not involving payments, and it would follow that PAYE would apply in some of these cases but not others. With regard to section 67 of the 1976 Act, there could be doubt about the scope of the provision. The Special Commissioner recorded those arguments briefly and accepted them without further analysis.

54	The Crown appealed to the Extra Division of the Inner House of the Court of Session. The main argument for the Inland Revenue at that stage was that the sums in question were capital and therefore could not be subject to the PAYE Regulations. After close argument, and with an express indication by Lord McClusky that he found the issue to be one of real difficulty, a majority of their Lordships found in favour of the taxpayer on the deduction issue, Lord McClusky accepting the reasons given by Lord Coulsfield. His view was that the question turned ultimately on the proper interpretation of the definition of the word “emoluments”, a point not in dispute in this case. Lord Sutherland found the question “passing strange” and took the view that the sums were capital and therefore not emoluments and so not subject to deduction of tax.

55	The Crown again appealed, but only on the application of the PAYE Regulations. The case was heard by the House of Lords with Lord Mackay of Clashfern LC presiding. The others of their Lordships agreed with his opinion. 
Lord Mackay set out the relevant charging and collection provisions and then declined to decide the case on the wider ground of the scope of those provisions. He rested his opinion instead on a narrower ground:

In both of the statutory provisions relied upon as creating liability, the liability to tax under Schedule E is not attracted by the amount paid but as in this case to part only of the amount paid. The charging mechanism is not one which treats the whole payment made in this case as an emolument and then preserves a right to claim a deduction by way of allowance. Indeed in this case each payment is subject to two different sections which provide the basis for two different charges under schedule E on sums which in total are less than the total of the payments. … the ascertainment of its amount involving as it does questions of the market value of shares which are not publicly quoted could involve considerable calculation and perhaps even more important substantial judgments on matters of opinion. Neither the empowering provisions of the Act of 1970 nor the deduction regulations themselves include an obligation on the payer to deduct tax from a payment only part of which is assessable to income tax under Schedule E. 

	…

Although I found the arguments for the taxpayer attractive and cogently argued, I have reached the conclusion ultimately that to give effect to it would be to extend the scope of the provisions for deduction of tax under Schedule E to situations for which they were not intended and in respect of which here is no machinery for determining in respect of a single payment at the time the payment is made the amount of it which is to be subject to the deduction arrangements. 
   
Lord Mackay concluded:

The reasons which I have given differ considerably from the reasons given by Lord Sutherland in the Court of Session for reaching the same view and I would not be prepared to affirm his analysis of the transaction into a capital transaction completed at the time of payment followed by a statutory treatment of certain parts of the payment as income for tax purposes. The reasoning of the majority only takes one the distance of saying that part of the payment was to be treated as emoluments under Schedule E but for the reasons I have given this does not appear to me to be sufficient to sustain the taxpayer’s argument and to have obliged the employers to deduct income tax under the 1973 regulations on making the payment which even on the majority’s view was in part only so assessable.

56	Both Mr Aaronson and Miss Simler considered this case to support their respective arguments. We take some comfort from this as it is, with respect, a difficult case from which to draw any wide conclusions. The single opinion on behalf of their Lordships confines itself expressly to a narrow issue. It disagrees with Lord Sutherland’s reasons for reaching the same conclusion while both finding little help in the majority decisions of the court below and also resisting a wide argument on behalf of the taxpayer. While Lord Mackay did not rest his decision on the income/capital issue (not an issue in this case), he did rest it on potential complexities of deducting tax from payments made for share options that Mr Aaronson contends are equally present in this case.  

57	We agree with Mr Aaronson that there are similar complexities of application under section 135 as under the sections at issue in Herd. There are a number of complexities that might arise in the operation of section 135 as a whole, and they are such as to invite the same approach as that adopted by Lord Mackay in Herd. Miss Simler argued that there was no such complexity in this case. Here there was no consideration for the grant of the option. So no deduction was necessary under section 135(3)(b) for that reason. There was a payment in cash and no other benefit. So there was no need to consider the provisions in section 135 dealing with payments in kind. And the payment was less than ten years after the grant, so no complication arose from section 135(5). 

58	However, that is to argue from the coincidental specific facts of this case to the general rule. In this case there were no complications, but we follow the opinion of the House of Lords in Herd that the PAYE Regulations cannot be applied on the basis that they should be operated where there are no problems but ignored where there are complications. This would suggest that there is a requirement in these circumstances for employers to consider the terms of the section and determine whether the amount paid is taxable in its entirety or only in part, with the result that PAYE may apply in some cases but not others. Those were among the reasons put forward by the Inland Revenue to the Special Commissioner in Herd and accepted by him. We agree with those arguments. The PAYE Regulations must either apply to all cases falling within section 135 or to none.  We do not think that it can depend upon how easy it is to calculate the gain under that section and whether the deduction to be made in calculating that gain is £1 or nothing.  In our view the PAYE Regulations did not apply to these payments in the absence of specific statutory provision and, as we have previously found, the changes that were being made to deal with this did not operate at the time the payments were made to the Demon employees.  

59	We conclude that the Respondent has failed to make good any of the arguments presented to justify the regulation 49 determination. We allow the appeal in full and the determination must be set aside. We reach that decision without having to decide whether Demon did make the payments, or was properly to be deemed to have done so; or when the events occurred  to which section 67 applied or did not apply; or whether regulation 80ZA was within the vires of section 203 of the Taxes Act. And we repeat that we express no view about whether the employees or any of them have any liability to pay tax on these payments. 

MALCOLM GAMMIE QC

DR DAVID WILLIAMS

SPECIAL COMMISSIONERS

Release Date: 7 December 2004

SC 3041/04