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Section 431 elections often crop up in an investment scenario, MBO or when a company wishes to incentivise its employees (for example through shares or share options). For employees who will be acquiring such shares (and indeed for their employers) it pays to understand the tax implications of this – a section 431 election can be a very useful tax mitigation tool for both parties.
We commonly advise on transactions where employees or directors are to be acquiring securities in their employer or a related company (whether from existing shareholders or newly issued shares). A section 431 election in these circumstances is almost always relevant and well-advised employers and employees can minimise both income tax and national insurance by entering into the joint election appropriately. (The focus of this article is on the acquisition of securities which are shares, rather than share options, though the election is often applicable in respect to options in a similar way).
Background to the election: what are the employment-related securities rules?
Shares acquired by employees by reason of employment fall under a specific set of tax rules called the employment-related securities rules. The rules have been in place historically to prevent employees being given value for their services in the form of shares which would not be liable to income tax and national insurance in the same way as, for example, a cash bonus. Shares in private companies will typically be subject to restrictions. A common tax avoidance technique in the past was to issue shares to employees with relatively low value given their restrictions (for example on the ability to transfer the shares for a period of time). Once the restrictions fell away or were withdrawn then the shares would be worth a lot more and the employee could sell them for a larger amount and pay CGT on their gain. The employment-related securities rules prevent such passing of value to employees.
The ERS rules can apply in connection with a current, former or prospective employment and also apply to non-executive directors and officers (and the family / connected persons of such a person), so the remit is extremely wide. As shares in private companies are pretty much always restricted in some form (for example in the articles or a shareholders’ agreement), these shares are therefore a type of employment-related security which is a restricted security.
Valuation matters:
Employment-related securities have two different values for tax purposes. One the one hand, there is the actual market value of the share (AMV) which takes account of the restrictions. On the other hand, there is the unrestricted market value (UMV) which is the share’s value if you ignored the restrictions, which is always the same as the AMV or higher.
Broadly speaking, the tax implications when the employee acquires and disposes of the shares are as follows:
- If the employee does not pay at least the AMV, there is an immediate income tax charge on acquisition to the extent that this value not paid;
- If the employee does not pay at least the UMV, part of the gain in value of the shares will be chargeable to income tax on disposal (the proportion of the share price between the UMV and the AMV).
By way of example: suppose that an employee subscribes for shares in their employer. The UMV (ignoring the restrictions), is £100. Due to the restrictions in the articles, the AMV is only £80. If the employee pays £80 for the shares, there is no income tax charge on acquisition, but 20% of the gain in value will be chargeable to income tax on disposal. Where shares have risen in value greatly (and given that the rate of income tax of up to 45% is significantly higher than the minimum CGT rate of 10% for certain disposals), this can be a significant tax cost.
In addition, the circumstances around when the shares are acquired can also have a significant impact on the tax position. If the shares are readily convertible assets (broadly meaning that they could be readily exchanged for cash, such as if there is an impending sale of the company in the offing), then the employer must operate PAYE to collect the income tax instead of it being paid under self-assessment by the employee. Employee and employer national insurance must also be levied and accounted for by the employer, further increasing the tax cost.
How does the election help?
To minimise the tax cost, the section 431 election effectively takes the shares outside the scope of the restricted securities rules by ignoring some or all of the restrictions on the shares. The effect is that the employee is treated as paying the UMV at acquisition and the entire gain in value will be subject to CGT and not income tax (or national insurance). Returning to our example above, the employee pays £80 but enters into a section 431 election with the employer. So while income on £20 arises at the point of acquisition as the employee is taxed on £100 less £80, the entire gain in value is subject to CGT. The election therefore provides for a longer-term tax benefit in exchange for a slightly higher short-term income tax charge.
Should an election always be signed?
In many cases, entering into the election with your employer is advisable as it can be effective in ensuring that the gain in value of a share can be taxed as capital rather than income – this is particularly notable where shares are expected to rise in value. Indeed an election when shares are worth very little (perhaps even as low as nominal value) has virtually no down-side as the additional up-front income tax is negligible.
However, if a share’s value may decrease then it may be prudent not to make an election. An employee could end up in the undesirable position of having elected to pay income tax on a certain portion of value of the share at acquisition and a loss arises on disposal of the share. It is not possible to recover any overpaid income tax.
In the vast majority of cases, however, the election is beneficial and has become a standard tax planning tool. Neither the employer nor the employee needs to actually file the signed election anywhere or send it to HMRC, rather it should be kept as a record in case HMRC ever queried the tax position. The election must be made within 14 days of the acquisition by the employee of the shares.
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