How do employee share plans and restricted securities work?

If you intend to reward you employees with shares, it is important to be aware of the ‘restricted securities’ tax legislation. Unfortunately, some employers award shares to employees without taking professional advice. When this happens, the restricted securities rules can be overlooked, resulting in unexpected employment tax charges when the shares are eventually sold.

The restricted securities legislation is complex. The purpose of this blog is to provide a high-level overview of the rules and explain how you can protect employee shareholders from an unintended tax bill.

What are restricted securities?

Broadly, a restricted security is a share (or security) that is subject to restrictions which depress its value.

Common examples of restricted securities include:

• Shares that can be forfeited (for example, compulsory transfer if certain events occur)
• Shares with restrictions on sale or transfer
• Shares with drag- along rights (i.e. rights that can force the shareholder to sell on a company sale)

Why do restricted securities matter?

If an employee acquires shares by reason of their employment, those shares will be employment related securities (ERS). If the shares are both ERS and restricted securities, the restricted securities tax rules apply.

When an employee acquires restricted shares for less than their “market value”, an income tax charge can arise. However, the legislation contains multiple definitions of market value, which is where problems often arise.

For restricted securities, there are two key values:

• Unrestricted market value (UMV) – the value of the shares ignoring the restrictions.
• Actual market value (AMV) – the value of the shares reflecting the impact of the restrictions.

The tax issue

On acquisition, unless further action is taken, employment income tax normally applies to:

• The AMV of the shares, less any amount paid by the employee.

As a result, the restricted element (i.e. the difference between AMV and UMV) is left untaxed at acquisition.

When the restrictions later fall away — commonly on a sale of the company — that previously untaxed value can give rise to a further employment income tax charge.

Unless the employee paid more than the AMV on acquisition, the amount taxed is broadly the difference between the UMV and the AMV at the time the restriction lifts (e.g. on the sale).

Example – no action is taken on acquisition

• Dave, a higher-rate taxpayer, acquired one share in his employer company, and pays £1 for the share.
• The Articles of Association contain restrictions on transfer of shares, which depress their value.
• At acquisition the share has a AMV of £9 and a UMV of £10.
• The amount subject to income tax on acquisition is £8 (£9, less the £1 paid).
• The company is later sold, and Dave sells the share for £1,000
• A restricted securities income tax charge arises on disposal equal to £1,000 x 10% (the proportion not previously subject to tax). The amount subject to the restricted securities tax charge is £100.
• Total of £108 is subject to income tax (£8 on acquisition and £100 on sale).

Had Dave been taxed up to the full UMV at acquisition, only £9 would have been subject to income tax.

Although amounts taxed as employment income ordinarily reduce the capital gain on the future sale of the shares, this outcome is often undesirable for higher‑rate taxpayers. Dave pays income tax at 40%, whereas the main rate of capital gains tax on shares is 24%.

With the benefit of advice at acquisition, Dave could have taken steps to mitigate the future restricted securities charge.

How can restricted securities charges be mitigated?

There are two ways to mitigate a restricted securities tax charge.

1. Make a joint section 431 election

An employee can enter into a joint section 431 election with the employer company.

This election treats the shares as unrestricted for income tax purposes on acquisition. As a result, the employee is taxed on the full UMV upfront, preventing a future restricted securities income tax charge.

Key points:

• More tax is payable at acquisition.
• If the shares increase in value, this usually leads to a better overall tax outcome.
• If the shares fall in value, the tax paid cannot be recovered.
• The election must be made within 14 days of acquisition.

2. Pay the unrestricted market value on acquisition

If the employee pays the full UMV for the shares on acquisition, no restricted securities tax charge should arise in the future.

In practice, this may not always be affordable. Employers may consider funding arrangements such as a loan or bonus (noting the associated tax implications).

Even where the UMV is paid, a section 431 election is still recommended as a “belt and braces” approach.  The s.431 election could be particularly helpful if the valuation of the shares is later challenged.

Example – section 431 election made

Revisiting Dave’s example, here is what the outcome would be if Dave entered into a s.431 election:

• Dave, a higher-rate taxpayer, acquired one share in his employer company and paid £1 for the share
• The Articles of Association contain restrictions on the transfer of shares, which depress their value
• At the time of acquisition, the share has a AMV of £9 and a UMV of £10
• Dave and his employer enter into a joint s.431 election within 14 days of acquisition, so the share is treated as if it were unrestricted for income tax purposes
• Dave is taxed up to the UMV on acquisition meaning £9 (£10 − £1 paid) is subject to an employment income tax charge
• The share is later sold for £1,000
• As a s.431 election was made, no restricted securities income tax charge arises on disposal
• Total amount subject to income tax: £9 (all on acquisition)

This would have been the preferable outcome for Dave.

Possible exclusions

There are limited carve outs from the restricted securities tax charge.  There most relevant for private companies is the ‘control exclusion’.

Broadly, the control exclusion will apply where:

• The restrictions apply to all shares of the same class
• The same event affects all shares of that class
• There are no tax-avoidance arrangements; and
• Immediately before the chargeable event, either:
• The company is ‘employee‑controlled’ by reference to shares of that class, or
• The majority of the shares of the class are not ‘employment‑related securities’ (‘I.e. shares acquired by reason of an employment or office)

Ordinarily, therefore, a company will be employee‑controlled where employees own most of the relevant class of shares and, through those shares, have control of the company.

This is only a high-level summary of complex rules, and the exclusions are narrow and fact specific. In practice, where employees acquire shares in a private company, it is usually safest to enter into a section 431 election on acquisition rather than relying on an exclusion.

Restricted securities: Key takeaways

• Shares awarded to employees and officeholders are nearly always ERS.
• If restrictions apply to those shares, the restricted securities taxing legislation should be considered. The restricted securities rules are complex and highly fact‑specific.
• If no action is taken when shares are acquired by an employee or officeholder, this could lead to a restricted securities employment income tax charges on a sale. This is often unexpected
• If a s.431 election is made within 14 days of acquisition, this will prevent a restricted securities tax charge.

This blog provides only a high‑level overview. If you are considering awarding shares to employees, we strongly recommend taking professional advice.

If you would like to discuss how we can help, please get in touch.