Key points

• The employment-related securities legislation can be found in ITEPA 2003, Part 7.
• There are four main elections available within the legislation – the most common is the s 431(1) election.
• A s 431(1) election is not always necessary or even possible in the case of some share transactions.
• Where the shares held by an employee are restricted securities, a chargeable event may occur (s 427(3)).
• In the event of a disposal of shares, despite this being a capital disposal, a proportion of the gain may be charged to income tax.
• A s 431(1) election can provide significant tax savings in the long run despite a potentially higher upfront cost on acquisition.

At its core, the employment-related securities (ERS) regime is a set of anti-avoidance provisions designed to ensure that employees (past, present or future) are subject to income tax on the issue of securities or changes in value.

The legislation can be found in ITEPA 2003, Part 7.

Section 431(1) elections are a staple of the ERS regime, and every due diligence questionnaire I have ever encountered seeks confirmation of whether these elections have been entered into at various events during a company’s lifecycle. Despite this, there seems to be a lack of understanding of what they are, when they are required, and their impact.

It is true that a s 431(1) election can be invaluable in minimising a shareholder’s tax exposure. However, a s 431(1) election is not always necessary or even possible in the case of some share transactions. Therefore, this article seeks to debunk some of the myths and clarify what it means to enter into such an election and the situations where an election is advisable.

All references are to ITEPA 2003 unless otherwise stated.

The basics
To understand when a s 431(1) election is required, we first need to understand the ERS regime, including when shares fall within it and how they’re taxed.

Employment-related securities
Section 421B explains when the ERS regime applies, specifically where ‘securities, or an interest in securities, [are] acquired by a person where the right or opportunity to acquire the securities or interest is available by reason of an employment of that person or any other person.’

The key terms of this definition are ‘securities’ and ‘right or opportunity… available by reason of employment.’

Section 420 defines the term ‘security’, the most obvious security being shares in a limited company. However, notable others include debentures and loan stock, bonds, warrants, options and futures.

The term ‘employment’ applies whether the individual is a former, current or prospective employee (s 421B(2)(b)) and applies to directors as well as employees. We must also consider securities issued to ‘other persons ‘if it is by reason of an employee’s employment as being within the regime. This ensures we cannot circumvent the ERS rules simply by issuing the shares to an individual who is not an employee, eg issuing shares to an employee’s spouse. For further reading, see HMRC v Vermilion Holdings Ltd as a recent Supreme Court decision on this topic.

There is a specific exemption from the regime where the right or opportunity to acquire the securities is made available by an individual, and it is made available in the normal course of the domestic, family or personal relationships of that person (s 421B(3)(b)).

If this condition is met, we needn’t continue the analysis to consider whether the securities are restricted and in need of any election.

HMRC has always taken a stringent view of this rule. Family members are most likely to be eligible for this exemption. Even then, where family members receive shares on the same terms and at the same time as other employees, HMRC may still take the view that the opportunity is a result of their employment and not their personal relationship.

Restricted securities
Now that we understand employment-related securities, we must understand what ‘restricted securities’ are.

Restrictions are common on shares held by employees and directors as they protect the company and other shareholders in certain events, eg an employee leaving the company.

Very broadly, securities are ‘restricted securities’ where they have restrictions attached to them that depress the market value. These restrictions may include the following:

• Forfeiture (s 423(2)): Shares must be transferred (typically back to the company) upon certain events, eg, an employee leaving the company.
• Restrictions (s 423(3)): shares with restrictions of when or to whom they may be sold.

These restrictions may be found in ‘any contract, agreement, arrangement or condition’ (s 423(1)(a)), meaning documents such as the company’s articles, shareholders’ agreements, and contracts of employment are all documents requiring scrutiny in assessing whether employment-related securities are restricted.

Where the shares held by an employee are restricted securities, a chargeable event may occur in any of the following circumstances (s 427(3)):

• The lifting of the restrictions.
• The variation of the restrictions.
• The disposal of the securities.

Section 429 provides an exception to the chargeable event rules, but only where:

• all shares of that particular class are subject to the same restriction;
• the same event triggers the same lifting of restrictions;
• the company is employee-controlled by virtue of holdings of shares of that class, or the majority of the shares of that class are not employment-related securities; and
• there is no tax avoidance motive.

In the case of a growing company, shares (or options) are generally acquired with the intention that they will be sold at a later date for more than the acquisition cost. Otherwise, why bother? This leads us to the issue at hand, the tax charges on restricted employment-related securities.

Tax charge on restricted securities
The basic principle is that shares awarded to employees are likely to be taxable under ITEPA 2003 s.62 as general earnings because they constitute ‘money’s worth’.

Furthermore, there are numerous situations in which tax charges may arise under the ERS regime, as seen in ITEPA 2003, Part 7 which are outside the scope of this article. However, the general premise is that restricted securities have two values: 1) the restricted (or actual) market value (AMV); and 2) the value, assuming there were no restrictions attached to the shares, the unrestricted market value (UMV).

In the absence of any elections, the employee would be taxable to income tax (and possibly NIC) on the excess of AMV over the price paid on the acquisition of the securities.

Any of the above chargeable events would then attract a further tax charge. At that point, the amount subject to income tax (and possibly NIC) is calculated using the formula in s 428.

So, in the event of a disposal of shares, despite this being a capital disposal, a proportion of the gain may be charged to income tax instead. The amount subject to income tax will be the difference between the UMV and AMV as a proportion of the UMV. The balance of the gain will then be subject to CGT as normal – see example 1.

Example 1
As a reward for his services, Steve is issued 50 shares in MCG Ltd, sufficient to make him eligible for business asset disposal relief (BADR), provided he holds the share for two years or more. The AMV of the shares is £35,000, and there are various restrictions, including a bad leaver clause, such that the UMV is £40,000.

Steve has paid nothing for these shares, so he is subject to income tax (as the gift constitutes ‘earnings’ under s 62) on the £ 35,000 value gifted. The entire value falls within Steve’s higher rate band, and he pays income tax of £14,000.

Ten years later, a competitor offers to acquire the company’s entire share capital, and Steve’s share of the proceeds will be £500,000.

Steve is therefore making a profit of £465,000 (£500,000 - £35,000). However, at acquisition, 12.5% (£40,000 - £35,000/£40,000) was related to the uncharged difference between AMV and UMV. Therefore, 12.5% of the profit is now subject to income tax at 45%, being £58,125, while the balance of £406,875 is subject to CGT at 10%.

Steve’s total tax charge on disposal is, therefore, £66,844.

Restricted securities elections
There are four main elections available within the legislation. However, by far, the most common is the s 431(1) election, which allows the individual to ignore the impact of all restrictions applying to the securities. This election protects the employee from any subsequent income tax charges. It also protects the employer, who may be required to operate PAYE and NIC in some circumstances.

A s 431(1) election must be completed within 14 days of acquiring the securities, and it is an irrevocable election between an employee and an employer.

For the sake of completion, the other elections are:

• s 431(2) allows the individual to elect that only certain restrictions are ignored;
• s 425(3) disapplies the forfeiture restrictions on acquisition;
• s 430(1) disapplies the effect of remaining restrictions after a chargeable event.

The impact of the s 431(1) election in ignoring the restrictions for tax purposes is that the individual will be subject to tax on the UMV. If they have paid AMV or less for the securities, this results in a higher income tax charge on acquisition.

Furthermore, if the shares fall in value there is no opportunity to obtain a refund for the tax paid on the higher value.

In practice, the difference between AMV and UMV may be very little, and making a s 431(1) election makes little difference to any income tax liability. However, this is entirely dependent on the restrictions in place, and it is therefore advisable for the employer and/or employee to obtain a formal valuation to fully understand their tax exposures when making the election.

Those are the downsides, and personal cash flow may dictate whether the employee can afford to enter into the election. However, the overall tax cost of not making the election will almost certainly be higher for a growing company – see example 2.

It is also worth considering the standard valuation methodology in minority interest shares. Typically, discounts of up to 80% may be justified where the shareholding issued is of a sufficient minority. In the event of a company sale where the buyer acquires 100% of the share capital, no such discount will be applied on exit, meaning the tax benefits of making the election will be significantly greater.

Example 2
Let’s assume that, in example 1 Steve makes a s 431(1) election on acquisition of the shares.

He is, therefore, subject to income tax on acquisition on the UMV of £40,000 at 40%; his total tax charge on acquisition is thus £16,000. However, the effect of the election is such that the shares are effectively now treated as being outside of the restricted securities regime.

When Steve sells his shares for £500,000, he is subject only to capital gains tax on the gain of £460,000 (£500,000 - £40,000) at 10%.

Steve’s tax liability on disposal is, therefore, £46,000.
By making the s 431(1) election, Steve has reduced his total tax liability (tax on acquisition plus tax on disposal) from £80,844 in example 1 to £46,000 in example 2, a saving of £34,844.

Summary
We now know the value of making a s 431(1) election and how it can provide significant tax savings in the long run despite a potentially higher upfront cost on acquisition. Indeed, this clearly shows why they are so important and must always be included in advice to clients. But other than the potential affordability of the higher upfront cost, what other aspects must we be aware of?

Restrictions on shares
While all shares and securities issued to past, present or future employees and directors are within the ERS regime (unless an exemption identified above applies), they are not all necessarily subject to any restrictions.

If they are not subject to restriction, then a s 431(1) election to treat the securities as unrestricted will have no effect, meaning no election is required.

There have certainly been cases where a due diligence exercise on a company sale has identified securities being issued in the past where no election has been made. In these instances, working on behalf of the seller, a perfectly valid response to the buy side due diligence team may be, to ask them what restrictions they are concerned about. That is because, even if restrictions can be identified, they may have little or no impact on the securities’ value; therefore, the AMV and UMV may have been the same, or not materially different, on acquisition.

Of course, it is not helpful here that ‘any contract, agreement, arrangement or condition’ may create a restriction. For example, bad leaver clauses are likely to be in place in most cases.

In the case of founder shares, HMRC’s position is that these are within the ERS regime (see ERSM20240). Furthermore, it is entirely plausible that there may be restrictions attached to those shares, meaning they are also restricted securities. However, when a company is incorporated with, say, 100 £1 shares. It holds nothing but the £100 subscription cash. This means that the difference between AMV and UMV will likely be nil. If an individual pays UMV for the restricted shares, then there should be no income tax (or NIC) charge on a future chargeable event, such as disposal.

This may also be a valid argument where shares are acquired later in the company’s lifecycle. If the employee pays UMV for the shares, the fact that a s 431(1) election was not entered into should not result in an income tax charge on disposal.

The problem is that if this is being scrutinised in a due diligence exercise, the buy-side team is unlikely to settle for that. As a minimum, a warranty is likely to be required so that if HMRC did make a case for a higher UMV on the original acquisition, the seller would be liable for the additional tax consequences. It may, however, reduce the risk to an acceptable level to enable the sale to proceed.

Company reorganisations
In the case of company reorganisations, we may be able to rely on s 430A to ensure there is no exposure to income tax on a reorganisation and also prevent us from entering into a new s 431(1) election.

Section 430A(5) explicitly states that if the consideration on a reorganisation consists wholly of new restricted securities, then:

• the disposal of the old securities and acquisition of the new securities will not give rise to any income tax liability;
• the disposal is not a chargeable event; and
• the restricted securities provisions apply to the new securities as they applied to the old securities.

So, in the case of simple share exchanges where the shareholdings in the new holding company mirror those of the original company or on a demerger, s 430A is likely to be in point.

This means no income tax exposure applies at the time of the transaction, even if a s 431(1) election was not made originally. However, the downside is that a s 431(1) election cannot now be made in relation to the ‘new’ securities (s 430A(6)), so we can’t use this as an opportunity to have a valid s 431(1) election in place where there was not one originally.

This is one instance where a s 430 election may be considered relevant on the next chargeable event if there is one before disposal.

If a valid s 431(1) election was made in relation to the original securities, the individual is not required to enter into a new election for the ‘new’ securities by virtue of s 430A(7).

However, in the case of an MBO where a shareholder may well receive a combination of other securities and cash, s 430A is not in point and a new s 431(1) election must be entered into if the intention is for the new securities to be treated as unrestricted.

In all cases, the provisions within s 430A are sufficiently complex that careful scrutiny will be required to ensure the requirements are met.

Tax-advantaged share options
In practice, a common clause of option agreements requires the employee to enter into a s 431(1) election upon exercising the options.

However, s 431A deems an election to have been made where shares are acquired under any of the following schemes, and no income tax liability arises on the acquisition of the shares:

• share incentive plan;
• save as you earn option scheme;
• company share option plan;
• enterprise management incentive scheme.

If we take EMI options as an example, given that this is the type of share option most of us will be most familiar with, an income tax liability typically arises when the options are offered at a discount at the date they are granted.

Other examples of an income tax charge arising on the exercise of EMI options include when they are exercised outside of the ten-year period, or when a disqualifying event occurs, and the options are not exercised within 90 days.

For this reason, to ensure the options are as tax-efficient as possible, the normal process is to agree on the AMV and UMV with HMRC and the employee will be entitled to exercise the options for the AMV.

If this is the case, strictly, no election is required as there is no income tax charge on exercise, because s 431A deems an election to have been made. Furthermore, the effect of the EMI regime is the employee paying AMV for the shares in accordance with the option agreement but being credited as paying UMV for tax purposes by virtue of s 431A. In other words, the deemed election does not mean there is an income tax charge on the difference between AMV and UMV, despite the fact they have only paid AMV.

Example 3
Andersons Ltd is a successful manufacturing business owned solely by James with 10,000 ordinary shares.

Stuart has been with the business since the beginning, and James wishes to recognise his contribution by offering him an EMI option over 2,000 ordinary shares vesting in five years.

HMRC has agreed to the valuation, after minority discounts, at £300 per share AMV and £320 UMV.

Five years later, Stuart’s options vest, and he decides to exercise them immediately as there is a proposed sale of the business for £50m.

Stuart pays £600,000 for the shares, and a s 431(1) election is deemed to have been made by virtue of s 431A. Therefore, he is credited as having paid £640,000 despite not being subject to income tax on the additional £40,000.

When the company is sold, Stuart receives £8,333,333 proceeds, the entire gain being subject to capital gains tax.

Conclusion
Given that an election must be made within 14 days of the acquisition of securities (although they are not required to be submitted to HMRC, only available on inspection at HMRC’s request), early advice is necessary to allow the taxpayer to understand the impact.

We must first consider whether the securities are within the ERS regime, most notably whether the personal relationship exemption may apply. Then, we must consider whether any restrictions apply and whether the employee has paid less than UMV for the securities.

Given that there are usually some restrictions, bad leaver clauses being a typical example or restrictions on who the shares may be sold to, the restricted securities regime is likely to be in point in most cases.

While there is a potential for additional tax charges on acquisition, given that the individual will be taxable on UMV instead of AMV, a s 431(1) election will almost certainly be beneficial in the long run in the case of a company whose share price increases.

Given the discounts that often apply on acquisition of minority interests, which may not be relevant on disposal, a s 431(1) election will become even more valuable because the proportionate difference is exacerbated on the higher, undiscounted, amount.

Although even founder shares may be restricted, the nominal value paid for those shares will likely represent both AMV and UMV, so a s 431(1) election will have no effect.

However, in most other instances, there is at least a theoretical risk that any restrictions will suppress the market value, making a s 431(1) election advisable, if only as a protective measure.

Where a reorganisation occurs, the impact of s 430A may be such that a new s 431(1) election is not necessary (where an election was made on the original securities) or not possible (where an election was not made on the original securities).

However, where consideration includes assets other than new securities, eg cash on an MBO, s 430A will not apply and a new s 431(1) election must be made if the new securities are to be treated as unrestricted for tax purposes.

Where tax-advantaged share option schemes are involved, s 431A deems a s 431(1) election to have been made, provided there is no income tax charge on the acquisition of the shares. This means a separate election is not required, and the employee is credited as having paid the UMV.

If an income tax charge does arise on the acquisition of tax-advantaged share scheme shares, s 431A does not apply, and the employee and employer would have to enter into the s 431(1) election to treat the shares as outside the restricted securities regime.

Of course, in situations where it is unclear whether any restrictions apply to the shares, making a s 431(1) election is likely to provide the most comfort for the taxpayer in the event HMRC makes an argument that there are. As advisers, this also reduces the risk of a future due diligence exercise creating unnecessary and unwarranted scrutiny.