By Stephen Betts, tax lawyer for Winslows
In this article Stephen Betts, tax lawyer for Winslows discusses the tax implications of the Employment-Related Security legislation and importance of 431 elections.
When shares are being transferred or issued to employees or company directors, it is common practice, as part of the tax planning process, for the individuals involved to be advised to sign a section 431 election. This is because such shares are likely to be employment-related securities and special tax rules apply. This note explains the reasons why this is the case, the risks of not entering into the election and what can be done if no such elections have been made.
What is an Employment-Related Security?
A share is an employment-related security, where it is subject to certain restrictions and consequently, the market value of the shares is lower than it would have been without such restriction. Usually, these restrictions are set out in the Articles of Association and/or any Shareholders Agreement.
It’s important to appreciate that specific tax rules apply to the issue or acquisition of employment-related securities, which affects all employees and/or directors who subscribe for or acquire shares in either their direct employer company or in a member of the same corporate group. It is important to note that the employment-related securities legislation can also impact investors who are subsequently appointed as company directors or employees.
Reason for the Employment-Related Securities Legislation
The employment-related securities legislation exists to ensure that any income arising from shares is not taxed as capital when it should properly be taxed as income and thus be chargeable to tax at higher rates. The reason for this is to combat what HM Revenue & Customs see as unacceptable tax planning, by giving employees or directors shares, which had restrictions on their rights, thereby reducing their value at the time that they were issued. The restrictions would then either fall away or be removed, leaving the employee with a more valuable asset than they had originally purchased. When sold, they would be liable for tax on a capital gain, at lower tax rates than the rates of income tax to which it was felt that the employee should have been properly been liable for.
The problem is that most shares in private companies have restrictions attached to them, the most common being the requirement for a director/employee to sell their shares back to the company or the existing shareholders, should they leave the employment of the company. This means that most shares in private companies fall within the employment-related securities legislation.
How does a Section 431 election help?
To avoid the income tax treatment of restricted shares on disposal, the parties can enter into an election under section 431 of the Income Tax (Earnings and Pensions) Act 2003, whereby the employee elects to pay income tax on the acquisition of the shares as though they were not restricted. This can increase the tax charge on acquisition but all further gains in the value of the shares should be subject to capital gains tax.
A section 431 election must be entered into no later than 14 days after the acquisition of the shares, although it is possible for such election to be made in advance of the acquisition of shares. If a section 431 election has been signed in respect of all restrictions (and/or unrestricted market value was paid at acquisition), there should be no income tax on the sale of shares. There should be a charge to capital gains tax on the difference between the sale proceeds and the unrestricted market value of the shares on acquisition.
Are there risks to clients and law firms?
At its most extreme, the income tax liability from an income tax charge arising under the employment-related securities legislation is 45% against capital gains tax liability (at the lowest possible tax rates) of 10%. This extra tax charge can be unexpected to a seller and can, in some cases, put the viability of a corporate sale in doubt. Whilst the tax risk to the client is clear, the law firm faces a risk as to whether, at the time of the acquisition of the shares, they should they have considered and advised in respect of entering into a section 431 election.
If during a transaction it transpires that no section 431 elections have been entered into, then the tax implications of this will need to be managed, to minimise any tax cost to the client, by using both tax advisers and share valuation specialists. Of course, minimising such tax costs reduces the risk to any law firm.
How can we help?
As experienced tax lawyers, Winslows are well versed in the legislation, rules and practice surrounding the employment-related securities legislation and can assist in advising on whether it is appropriate to enter into a section 431 election at the time the shares are acquired and also, on a company disposal, advise on the employment-related securities implications, particularly when it transpires that no section 431 election has been entered into.
For further information please contact info@winslows.co.uk
