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Chilcott and grossing up notional payments

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Chilcott and others v HMRC [2010] EWCA Civ 1538, illustrates the consequences of the application of TA 1988 s 144A (now ITEPA 2003 s 222). Under s 144A an employee was regarded as having received additional income if an employer was required to account for PAYE on a notional payment of income and the employee did not make good the PAYE to their employer before the end of the period of 30 days (extended to 90 days for notional payments since 8 April 2003) from the date of the notional payment. No account was taken by s 144A of any subsequent reimbursement by the employee. There are equivalent provisions for employee's NICs.
Mr Chilcott had been granted share options which he exercised giving rise to a PAYE liability for Mr Chicott's employer (EGS). Mr Chilcott self assessed himself for the income tax but did not reimburse EGS for the PAYE liability within the 30 days following the imposition of this charge and therefore HMRC assessed Mr Chilcott in respect of the benefit he received (the PAYE liability paid by EGS). Mr Chilcott contested this assessment on the basis that section 144A should be construed purposively.
The Court of Appeal rejected this argument holding that the words of the statute were 'plain' and 'unambiguous' and that no proposed remedial or alternative construction had been put forward. In such circumstances there is little room for purposive construction.
Implications for employees and employers
The case demonstrates the need for employees to be advised of the risks of gross up liabilities under s 222 before the time of the notional payment. A right of recovery under an indemnity from an employee does not of itself 'make good' the liability so the employee should consider whether to deposit funds with the employer to prevent a gross up until any potential liability has been ascertained.
However, there will be situations where employees become aware of liability after the 90 day period has expired and are then unable to avoid the gross up. For example, HMRC may challenge a share valuation following the submission of a tax return. Where section 222 applies, the overall effective rate of taxation borne by the employee is bordering on penal and, following the introduction of the additional rate, can be up to 76.5% of the payment (see Box 1).
Chilcott reaffirmed the earlier Court of Appeal decision (McCarthy v McCarthy & Stone [2007] EWCA Civ 664) that an employer will generally have a restitutionary remedy for any PAYE liability or employee's NICs liability (referred to as 'employee taxation') which they are unable to or failed to deduct from payments to the employee provided that:
  • they were compelled by law to make the payment;
  • they did not officiously expose themselves to the liability; and
  • the payment of the employee taxation discharged a liability of the employee.

These conditions are likely to be satisfied in most situations where the employer has inadvertently failed to pay the employee taxation providing the employer a right of recovery even where it has not obtained any express indemnity from the employee. This is in addition to the circumstances where the employer is expressly prohibited by the PAYE regulations from effecting the recovery by utilising the deduction mechanism (because, for example, there are insufficient earnings).

Is it fair?

At first instance, the Special Commissioner had some sympathy for Mr Chilcott's predicament noting that under s 144A:

  • employees who reimburse their employers after the time limit fare worse than those that do not; and
  • if the fixed time limit for reimbursing the employer has passed, there is no incentive for the employee to reimburse promptly;and
  • suggested that HMRC should use their collection and management powers to vary the amount of the charge.

These arguments were rejected by the High Court. It noted that employers always had a right to recover the PAYE in restitution. But what would happen if the employer chose not to enforce that right or agreed in advance not to do so? On the timing point, it held that the provisions were "doubtless intended to encourage employees not merely to reimburse their employers but to reimburse them promptly". But does this work? In situations where the parties are unaware of the liability until after expiry of the time limit, this 'encouragement' is ineffective.

The judgments of the Court of Appeal accepted that the application of the section could be said to be potentially unfair and indiscriminate but largely avoided discussion of this issue. Given the introduction of the additional rate, the application of s 222 is now potentially even more expensive and HMRC should amend the provision. Tax law should be targeted in a proportionate manner at the perceived mischief. This could easily be rectified by cancelling the charge if the employee reimburses the employer for the PAYE liability at any time (which would be similar to the approach taken in s 223 in relation to payments made to directors without deduction of PAYE) or by taxing the benefit of the employer's payment of the PAYE as a notional loan granted to the employee. The PAYE system should operate as a collection mechanism and should not impose on employees tax liabilities for 'benefits' for which they have paid in full, otherwise it will be perceived as arbitrary and unfair.
Implications for statutory construction
Where legislation is tightly drafted and leaves no room for manoeuvre, the Courts are rightly reluctant to impose a differing 'purposive' construction and Chilcott follows a number of decisions to that effect. The High Court judgment in the anti-avoidance case of Mayes v HMRC [2009] EWHC 2443 was decided along the same lines on the basis that the prescriptive drafting of the legislation could not be interpreted in a purposive manner and it will be interesting to see whether this is upheld by the Court of Appeal in its decision which is expected shortly. Why should this principle of construction not also limit the ability of the courts to interpret legislation to counter tax avoidance cases?
Box 1
An employee (an additional rate taxpayer) acquires shares (which are readily convertible assets), pays the employer £1,000 and makes a section 431 election. At the time the unrestricted market value (UMV) of the shares is estimated to be £1,000 and the employee indemnifies their employer for any PAYE/employee's NICs. After 90 days following the share acquisition, HMRC dispute the valuation and the UMV of the shares is ultimately agreed to be £2,000 giving rise to PAYE/employee's NICS which are reimbursed by the employee at that time.
Employee 'Gain' on Acquisition                                                                                                                             £1,000
PAYE for Employer                                                                                                                                                      (£500)
Employee's NICs for Employer                                                                                                                                 (£10)
Section 222 for Employee (500 x 50%)
Employee's NICs for Employer (500 x 1%) (Regulation 22 of SI 2001/1004)
Total Income Tax/Employee's NICs
Effective Tax Rate
Nicholas Gardner, Senior Associate, Ashurst