By Tom Daltry, Keystone Law
There are circumstances where it can be argued that an individual is acquiring shares in an entrepreneurial capacity or as a founder shareholder, rather than the opportunity to acquire the shares being offered in an employment capacity. In this case there is the potential for a charge under the Employment Related Securities (ERS) legislation. Some of the charging provisions most commonly encountered can be read about below.
Less than Full Market Value Paid
These provisions can apply where:
- the purchase price payable to acquire the shares is less than the full market value of the shares, but the tax charge under general principles does not arise (because the opportunity to acquire the shares did not in fact arise from employment but is deemed to do so under the blunt instrument provisions of ERS legislation; or
- there is a full market value purchase price, but payment is deferred (e.g. until the shares are sold — to avoid the employee having to fund payment).
- In any such case the undervalue or deferred amount is treated as an interest free loan, such that:
- an annual tax liability on the notional interest free benefit may arise; and
- in a case where the value of the shares at the date of acquisition exceeded the purchase price and no charge under general principles arises, the difference is treated as a earnings when the shares are sold, subject to income tax and national insurance contributions; and
- in a case where a full market value purchase price was calculated but was deferred, but the company is not successful and the shares are sold for less than the purchase price or the company is liquidated and the employer company agrees to waive all or part of the outstanding purchase price, the amount waived is treated as taxable earnings.
An employee shareholding will typically be subject to various restrictions; e.g. provisions which require shares to be transferred if the employee leaves employment and provisions which regulate the circumstances in which the shares can be transferred. This will usually mean that the ERS legislation treats the shares as “restricted shares”.
Complicated provisions can then apply to treat part of any proceeds realised on a sale of the shares as earnings subject to income tax and NICs. The usual way of avoiding this problem is for a specific form of election to be made by the employee at the time the shares are acquired. This election should eliminate a tax charge on sale of the shares under this part of the legislation. However, this election will lead to a tax charge on acquisition if the price payable to acquire the shares is less than the market value of the shares, ignoring, for valuation purposes, the existence of the restrictions (which might otherwise depress the value of the shares).
So, in summary, tax problems under the restricted shares provisions can be avoided if:
- the appropriate election is signed at acquisition, electing to treat the shares as if they were “unrestricted” for tax purposes; and
- the price paid to acquire the shares is at least equal to the unrestricted market value of the shares (i.e. their value calculated as if the restrictions did not exist).
Other Heads of Charge
Some of the other provisions under which the ERS legislation can result in income tax liabilities and NICs are as follows:
- If the employee/director is granted a share option under which he/she can acquire the shares at a future date (e.g. when the company is sold) - in such a case income tax and NICs will typically be payable on exercise of the option to the extent that the then value of the shares exceeds the price payable by the employee/director to acquire the shares. There are particular types of tax favoured options which do not always result in such liabilities (see further in “Practical Tips” below).
- If a special type of share is created which has restricted rights at the outset (e.g. to keep the initial value of the share low) but the share can be converted at a later date into a full ordinary share — in such a case the act of conversion can give rise to income tax liabilities and potentially NICs in relation to the enhanced value which is crsytallised on conversion.
- Anti-avoidance rules exist to attack situations in which an employee shareholder receives benefits by virtue of the ownership of the shares. For example, bonus shares (if their value exceeds any loss in value of the original shareholding) could result in a tax charge; or if additional rights are created for the existing shares (e.g. by the employer making changes to the share rights in the Articles of Association) the enhancement in value could be taxed.
Application of PAYE and Reporting Requirements
Whenever income tax and national insurance liabilities arise the employer company must consider whether it is obliged to account for the liabilities under the PAYE system. Very broadly this will be the case where there are arrangements under which the shares can be sold (either at the relevant time or at a future date).
This obligation can arise even in circumstances where insufficient cash payments are being made by the employer company to the relevant employee from which it can make the PAYE deductions. It is therefore necessary to ensure that the position of the employer company is protected by ensuring that the employee shareholder is obliged to indemnify the company and to allow practical arrangements to be made to collect the tax.
Whenever shares are acquired in circumstances where the ERS legislation is applicable (whether or not tax liabilities arise) the company is obliged to make a return of that fact (before 7 July in the tax year following the year in which the acquisition took place).
This article is based on the law in force on 1 February 2012 and refers to tax rates applicable in the tax year 2011/12.
We have written these materials to help you, but no article can address all the issues. The benefit of using an experienced lawyer is that they ask the right questions and build the solution around you. Please therefore note that these materials only provide you with general information and should not be regarded as a substitute for taking legal advice.
Tom Daltry has more than 28 years of experience as a tax lawyer and was Head of Tax at Eversheds before becoming a Consultant Lawyer. He has acted for a broad range of clients, ranging from entrepreneurs and management teams to private equity houses, large PLCs/multi-nationals and financial institutions. You can contact him
on 020 7152 6550 or by email at email@example.com
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