Many enlightened owner-managed companies now provide shares to their managers and employees, despite the natural reluctance of the owner-manager(s) to concede part of their equity share capital. Many empirical studies have shown that providing managers and employees with valuable shares or share option rights can be a very powerful motivator, resulting in increased commitment and productivity.
However, Revenue & Customs is keen to ensure that any profit or reward element in the shares/share options is taxed as employment income. The law has become increasingly complex to counter attempts by tax advisers to side-step what many consider to be punitive tax charges.
Many owner-managed companies seek to use Revenue approved share plans, such as Enterprise Management Incentives (EMI) schemes, to obtain preferential tax treatment. (See Accountancy, April 2005, p114-116). However, EMI schemes are circumscribed by various qualifying rules and may not always be feasible to implement.
In many cases, directors and employees are simply offered shares or granted options over shares which do not fall within the ambit of a Revenue approved plan - these are often known as unapproved share/share option plans.Employment shares
The main employment income tax charge occurs when a director/employee receives free or cheap shares, whether from a direct share award or on the exercise of a share option. This tax charge is based on the 'benefit' received, which is broadly calculated by reference to the market value of the shares less any consideration paid by the employee.
Clearly the employment income tax charge only arises where the shares are acquired by reason of the directorship or employment (and the legislation extends this to cover a past or prospective office/employment). This will be deemed to be the case where shares are awarded or share options are granted to a director or employee. The main exception to this rule is where shares are transferred to a family member, since this would be a personal gift (s421B(3)).
Virtually all unapproved share arrangements for employees and/or directors must be reported to the Revenue (even where no tax charge is considered to arise) on the annual return Form 42. This must be filed by the 7 July following the end of the relevant tax year.
Following the Finance Act (FA) 2003 changes, it is now necessary to consider whether the shares are likely to fall within the 'restricted securities' regime. Where the employee pays an amount equivalent to the market value of the shares (reflecting any inherent restrictions in the rights attaching to the shares), there is no immediate tax charge. A typical restriction would be a requirement for the employee to sell the shares back to the company at less than their full value if they subsequently left.
It would also appear that even the simple restriction contained in Table A articles of association giving the directors the right to refuse to register a share transfer is a 'restriction' for this purpose.
Broadly speaking, if the shares would be worth more ignoring such restrictions, the shares are likely to be restricted securities (s423), which gives rise to a number of important issues.Dealing with restricted securities
Where the shares constitute restricted securities, there is a potential risk of incurring additional income tax and national insurance contributions (NICs) on a later sale of the shares (or some similar 'chargeable event'), unless a special 's431 election' is made (see below).
In practice, it may not always be easy to determine whether the restrictions attaching to certain shares are sufficiently substantive to render them 'restricted' within s422. One of the key requirements is that the relevant restrictions have the effect of reducing the value of the shares, which can often be a subjective matter.
Given that a failure to treat shares as 'restricted' could increase the employee's tax and NIC liability on a subsequent sale of the company, a prudent approach is often taken. Section 431 elections will often be made, even where the risk of the relevant shares being treated as 'restricted' is remote.
The Revenue treats restricted securities as if they had two values - an actual market value taking into account all the restrictions (the 'restricted value') and an 'unrestricted market value' (assuming all the restrictions and similar provisions were taken out). The difference between the unrestricted and restricted market value of the shares will drive their tax treatment.
The tax costs of exercising an unapproved share option to acquire restricted shares at an undervalue is best illustrated by way of a worked example (see Panel 1). As shown in the example, if no election is made, the employment income tax charge is based on the amount by which the restricted value of the shares exceeds the amount of any actual consideration paid for them.Management buy-outs
In management buy-out (MBO) situations, the shares acquired by the management team in the new acquiring company (frequently referred to as Newco) will be treated as acquired by virtue of their employment. The managers' shares in Newco invariably contain various restrictions that tend to have a depreciatory effect on the value of their shares. However, the Revenue has reached an understanding with the British Venture Capital Association which provides that the managers' shares will not be regarded as 'restricted' provided certain conditions relating to the MBO deal structure are satisfied (see The Memorandum of Understanding (MOU) issued on 25 July 2003). However, given the wide variety of MBO structures, it may not always be possible to meet the requirements of the MOU. Once again, it will often be prudent to treat the managers' Newco shares as restricted and make protective s431 elections.Charges on subsequent events
Probably the biggest disadvantage for shares being treated as 'restricted securities' is their vulnerability to (further) income tax (and NIC) charges on subsequent chargeable events. This would mean, for example, that part of any proceeds received on a sale of the shares would be subject to income tax and NIC. The calculation of the taxable amount on a subsequent chargeable event can be complex and is based on the legislative formula (contained in s428), as summarised in Panel 2.
In the vast majority of cases, the formula will simplify to UMV x IUP (Unrestricted Market Value x Initial Uncharged Proportion). Broadly speaking, this would represent the fractional part of the unrestricted market value that was not charged to income tax (on acquisition) multiplied by the market value of the shares at the time of the event (eg, sale proceeds on share sale). Consequently, the amount of sale proceeds etc, that would be subject to income tax would grow in line with any increase in the amount by which the initial unrestricted value of the shares exceeds their restricted value.
Panel 3 illustrates how the tax charge would be calculated on a later sale of the restricted shares in the Panel 1 example (assuming no election was made).Section 431 elections
It is important to recognise that the risk of incurring income tax/NIC on a later chargeable event can be entirely eliminated by making a s431 election. The election has the effect of basing the initial income tax charge on the unrestricted market value of the shares.
Clearly, the valuation of a minority shareholding in an unquoted company is a subjective matter, and it is not unusual for the employee/company and the Revenue to determine different valuations. The employee may therefore believe that they have paid the proper market price for the shares but the Revenue may subsequently succeed in arguing that a higher amount should have been paid. Provided a s431 election has been made, the employee's maximum income tax exposure would be limited to the unrestricted market value of the shares. Without an election, the employee could be exposed to a sizeable income tax liability if the shares have gone up in value significantly. The election therefore ensures that any further growth in the value of the shares will be taxed within the CGT regime (and would invariably benefit from substantial business asset taper relief).
There is a potential downside: if the relevant shares decrease in value, then an election could mean that employees end up paying more income tax than had they not made the election. Nevertheless, elections will generally be made (even on a protective basis) since most employees enter into share awards or share options in the belief that 'their' company will prosper and their shares may eventually be sold at a considerable gain.
Section 431 elections must be made between the employing company and the employee within 14 days of the share acquisition. Companies normally insist (especially where an 'exit' is envisaged, such as in MBO situations) that an election is made to avoid any risk of incurring PAYE and NIC liabilities on part of the employees' sale proceeds (see below). There is no need for the election to be submitted to the Revenue. However, the company should retain the election safely, as it is likely to be inspected on any later Revenue enquiry.
The worked example in Panel 4 shows the beneficial effect of making an election.Payment of tax, PAYE and NIC
Employment income tax charges arising on the provision of shares or exercise of share options can create cash flow difficulties. This is because the tax often tends to be incurred on 'unrealised' gains, which do not generate any cash to finance the tax liability. In the normal course of events, the income tax liability is dealt with through the self-assessment payment system, which means the tax will generally be paid on the 31 January following the end of the relevant tax year.
However, where the shares constitute readily convertible assets (RCAs), the tax would be collected under the PAYE system. In broad terms, the shares would constitute RCAs if:
• they are about to be sold; or
• where there is an arranged 'market' for them; or
• where they are held in a subsidiary of an unlisted company.
Employees must reimburse the PAYE tax within 90 days otherwise they will also be subject to a 'grossed-up' income tax charge on the PAYE amount under s222. Furthermore, where the shares are RCAs, national insurance also becomes payable on the benefit of shares and the exercise of options.
This would cost the company an additional 12.8% in employers' NIC and additional employees' NIC would also be due. It is possible for the employing company to pass its NIC liability to the employee.Corporate tax deduction
Companies can now obtain corporate tax relief on shares provided to employees (and on other chargeable events in respect of employee shares). The company's tax deduction is broadly based on the amount subject to income tax relief in their hands - so that it matches the amount and timing of the employee's income tax charge (Sch 23, FA 2003). Thus, where an employee exercises an unapproved share option, the company can claim tax relief on the amount by which the market value of the shares exceeds the option price paid by the employee (ie, their chargeable employment income). Special rules provide relief for EMI shares. An important exception where relief will not be available is where employees' shares are provided through a subsidiary of an unlisted company.
It is easy to overlook this type of tax relief in the corporate tax computation.
Procedures should therefore be put in place to ensure this deduction is picked up.
• In this article, all statutory references are to the Income Tax (Earnings and Pensions) Act 2003, unless stated otherwise
Peter Rayney is BDO Stoy Hayward's National Tax Technical Partner. He is author of Tax Planning For Family & Owner Managed Companies 2005-06, published by TottelsPANEL 1: Calculation of employment income tax charge on exercise of option to purchase 'restricted' shares (with no election)
On 1 June 2006, Patricia exercises an option to purchase 10,000 £1 B ordinary shares in her employer company, Caputo Ltd, at their par value of £1 each. The B ordinary shares were subject to various restrictions, and therefore it is prudent to treat them as restricted securities. The B shares are not considered to be readily convertible assets.
The value of each B share at 1 June 2006 was as follows:
Without an election, Patricia would have taxable income of £10,000, being the difference between the restricted market value and the amount actually paid by her:
|Restricted market value - (10,000 x £2)||20,000|
|Less: Amount paid - (10,000 x £1)||(10,000)|
|Taxable on exercise of option||10,000|
The amount taxed as employment income on a subsequent chargeable event is calculated as: UMV x (IUP - PCP - OP) - CE
UMV = Unrestricted Market Value at time of chargeable event.
IUP = Initial Uncharged Proportion, which is broadly the proportion of the unrestricted market value at the date of acquisition that was not charged to income tax (since no s431 election was made).
PCP = Previously Charged Proportion, being amounts that have been charged to income tax on a previous chargeable event or events.
OP = Outstanding Proportion, being
UMV less AMV/UMV
UMV is as above and AMV is Actual Market Value immediately after the chargeable event taking account of restrictions. CE = Consideration paid by the employee for varying rights, etc, and any other expenses.PANEL 3: Income tax charge and CGT on later sale of shares (no election)
Continuing the example in Panel 1 (with no s431 election having been made), Patricia would also suffer an income tax charge based on a third of the taxable amount on a future 'chargeable event'. Thus, the amounts subject to income tax and CGT on a subsequent sale of the shares in (say) December 2008 for £70,000 would be calculated as follows:(a) Amount taxed as employment income
Using the formula in s428 (see Panel 2) UMV x (IUP - PCP - OP) - CE
UMV = £ 50,000 (being the sale price)
IUP = £30,000 less £20,000/£30,000
PCP and OP and CE = 0
The amount charged to income tax is calculated as follows:
£70,000 x (0.333 - 0 - 0) - 0 = £23,310
Thus, assuming Patricia's marginal rate is 40%, her income tax liability collected under PAYE (since the shares are RCAs) would be £9,324. She would also incur additional NIC of £233 (marginal employees' NIC rate of 1% x £23,310)(b) CGT liability
To prevent 'double taxation', the amount charged as employment income is treated as additional expenditure on the shares for CGT purposes (s119A TCGA 1992).
The CGT liability on the sale of the shares would therefore be computed as follows:
|Less: Cost (June 2006)||(10,000)|
|Amount taxed as income - June 2006||(10,000) -|
|Less: Business taper relief (75%)||(20,018)|
|Taxable gain - assumed covered by annual exemption (for 2008/09)||6,672|
Patricia can jointly elect with Caputo Ltd (her employer) under s431 to be taxed on the unrestricted value of the shares when she acquires them on the exercise of her option, as follows:
|Unrestricted market value - (10,000 x £3)||30,000|
|Less: Amount paid - (10,000 x £1)||(10,000)|
|Amount taxed as employment income||20,000|
By making the election, any further growth in value of the shares falls completely within the CGT regime. Thus, if the shares were sold for £70,000 in (say) December 2008, her taxable gain would be £10,000:
|Less: Cost (June 2006)||(10,000)|
|Amount taxed as income - June 2006||(20,000)||(30,000)|
|Less: Business taper relief (75%)||(30,000)|
|Taxable gain (before annual exemption)||10,000|