Selling shares in your company: Understanding the income tax trap

When selling shares, particularly as part of a business exit, it’s natural to assume that what you receive will be taxed as a capital gain. This is not always true. In some cases an apparently simple share sale can become an employment tax problem. This can then lead to a much higher tax bill, national insurance liabilities and even potential penalties.

It is therefore important to plan when selling shares and structuring exits in advance alongside getting specialist advice. This can help ensure that you are not hit with painful unexpected tax charges.

Why might selling shares be taxed as employment income rather than as a capital gain?

The key idea is simple. If the value you realise is really part of your reward for working (or being a director or non-executive director), the tax system will try to treat it as employment income under the employment related securities (ERS) rules in Part 7 ITEPA 2003, rather than leaving it solely to be taxed under the capital gains tax provisions.

One of the main scenarios where this may be the case is where an employee or director sells shares for more than their market value. This ‘premium’ may be classed as employment income.

The recent tax case of CooperVision Lens Care Ltd v HMRC highlight this principle. If the deal terms given to management or employee shareholders give a better price than that being realised by other shareholders, it may suggest that those shareholders are being rewarded for more than just their shares. In such cases, HMRC may seek to argue that part of the proceeds should have been taxed as employment income, rather than as capital, significantly increasing the resulting tax liability.

Why the CooperVision case matters to shareholders

In the CooperVision case, several individuals, who were both shareholders and employees, received a higher price per share than other investors. HMRC argued – and the tribunal mostly agreed – that this uplift wasn’t simply about the value of the shares. Rather, it reflected something connected to their roles in the business.

As a result, HMRC can tax the uplift as earnings. This is subject to far higher income tax rates and not as a capital gain.

The tribunal didn’t just consider the legal documents – it considered the economic reality. That meant asking the key question of why did these particular individuals get more money?

The key issue when selling shares: reward for work or for shares?

The tribunal looked closely at why some people received more money per share than others. HMRC’s argument was:

The shares were employment related because the sellers were employees
The higher amount they received wasn’t just because of the shares themselves
Instead, the uplift looked like a reward linked to their position in the business

For most of the shares involved, the tribunal agreed.

The result: those amounts were treated as taxable employment income and liable to income tax and Class 1 NICs.

Not just an issue for the selling shareholders – PAYE implications

The tax implications of shares sale proceeds being recharacterised as employment income stretch beyond the selling shareholder. Another related tax case, that of Gray’s Timber Products Ltd v HMRC, acts as a cautionary tale on this point.

In Gray’s Timber, a managing director bought a relatively small percentage holding. However, a separate subscription / shareholders’ agreement meant that on a takeover he would receive a much larger share of the consideration than his pro–rata entitlement. On sale, the Supreme Court upheld HMRC’s view. The shareholder’s disproportionate slice of takeover proceeds was an amount that should be taxed as employment income under the “sold for more than market value” ERS rules.

Once an amount counts as employment income under that ERS charge, ITEPA s698 applies. This means that the PAYE rules apply. The employer needs to operate PAYE on the employment income element, withholding / paying over to HMRC the income tax and the NIC (both employee and employer) that was due. The Supreme Court made it clear that the primary liability for the income tax and NIC should be pursued against the employer as the PAYE/NIC collector.

The PAYE obligations may fall on the purchaser if they are operating the PAYE immediately after obtaining control. This issue is likely to be a hot focus during transaction due diligence. This increases the commercial costs of doing the deal.

High risk of enforced liabilities and penalty charges

If you don’t plan and get advice at an early stage, there is a significant risk of not realising that a proportion of the proceeds should have been treated as employment income until it is too late.

In the CooperVision case, HMRC issued a Regulation 80 PAYE determination. This is a formal assessment of the PAYE income tax that the employer should have deducted from employee’s pay but failed to operate correctly. HMRC charged the missing PAYE to the employer as if it had been properly deducted at the time – against the company for failing to operate PAYE on ERS sold for above market value. Although not technically a penalty, this functions like an assessment for under-deducted PAYE. The economic effect on the employer mimics a penalty because PAYE becomes irrecoverable from employees after the end of the tax year.

If PAYE is not paid by the due date, the employer may face late payment penalties. This escalates based on the number of defaults in a year, under Schedule 56 FA 2009.

Companies must notify HMRC of any liability to income tax and / or national insurance contributions. If the employer fails to notify a PAYE liability arising from ERS income, HMRC could charge penalties under Schedule 41 FA 2008

In ERS cases where the employer does not operate PAYE on chargeable amounts, HMRC could potentially apply penalties under Section 98A TMA 1970. In practice they are more likely to issue a Regulation 90 determination.

Further complications can arise if the employer pays an employee’s PAYE liability. If the employee does not make good the tax by 4 July after the tax year, a further PAYE charge under section 222 ITEPA 2003 may arise. This would require more PAYE to be paid.

Careless behaviour means extended time limits for HMRC

In the CooperVision case, the tribunal explicitly found that the employer had been careless. They had failed to account for PAYE and NIC on the ERS disposal. A finding of carelessness allows HMRC to assess up to six years after the end of the tax year instead of the normal four.

It is highly likely that HMRC would, in other similar circumstances, argue that a taxpayer had been careless.

What can be done to fix the problem

A tax charge often arises where an employer has promised an employee a specific value on exit. Often the shareholdings held by employees do not reflect the value which the employer intends for them to receive. When payments are made to the employees, the excess of the market value is often caught by an ERS tax charge. The sooner an employer considers this risk and takes steps to fix the problem, the better.

The solutions could include:

Awarding further shares or options to the employee
Considering share terms and rights
Offering a bonus arrangement to meet the expectations promised to the employee

What this means for people selling shares

If you’re a founder, manager, or employee selling shares in a business, this case highlights several practical points:

Don’t assume everything will be taxed as capital. Even if you’re selling shares in a standard exit process, HMRC may view part of the payment as linked to your employment
Different pricing for different shareholders is a warning sign. If you receive a higher price per share than other investors, a buyer’s due diligence team or HMRC may ask why. They may argue the difference is taxable as income
Employers can face consequences too. If HMRC believes employment income has been paid, they can pursue the company for PAYE and NIC. This can increase the cost of undertaking transactions, pressure during enquiries and create disputes years after the sale.

For advice, please get in touch with our shares scheme team below.