Awarding Shares To Employees – The Restricted Securities Bear Traps

Over recent years it has become increasingly common for employers to give shares to key employees as part of their remuneration package. This makes a great deal of sense. Share awards are recognised as being an effective means of incentivising and retaining key members of staff and management and are also seen as an effective method of attracting new talent.

By far the most attractive arrangement is the Enterprise Management Incentive option scheme (EMI). It has a number of tax advantages. However, for some employees this does not go far enough because it only gives them the option to acquire shares at a point in the future whereas they may want a stake in the business straightaway.

An employer awarding actual shares to an employee instead of options will want to build in some protection either by way of a Shareholders Agreement or in the Articles of Association. Typically, there will be a restriction on the ability of the employee shareholder to sell the shares and it is also highly likely that there will be the risk of forfeiting the shares if the employee leaves the employment.

Tax implications of awarding shares to employees

From a tax point of view, such shares are known as “restricted securities” and they come with some nasty tax traps for the unwary. These revolve around the difference between the value of the shares including any restrictions (“actual market value” or AMV) and the value of the shares if all the restrictions are ignored (“unrestricted market value” or UMV).

When restricted securities are awarded to an employee, there will be an income tax charge under the “general earnings” provisions. Under those provisions any shortfall between the AMV of the shares at the time they are awarded, and the amount actually paid for the shares by the employee is treated as taxable income. Obviously, if the employee pays AMV or more than AMV, no tax charge arises.

The bear traps lie in wait for employee shareholders who have been awarded restricted shares when there is a future “chargeable event”. For these purposes, a “chargeable event” generally arises when there is a lifting of any restrictions which results in the value of the shares increasing or, more commonly, when the shares are disposed of.

On the disposal of restricted employee shares, the repercussions can be very nasty. Essentially, a proportion of the sale proceeds the employee shareholder receives will be treated and taxed as income rather than capital gain. This proportion is calculated as a percentage of the sale proceeds by reference to the difference between the AMV and the UMV of the restricted shares.

Example of chargeable event liable for Income Tax

It is easiest to illustrate this problem by way of an example. Let us assume that an employee shareholder is awarded restricted securities. At the time of the award the restricted value of the shares (AMV) is £15 per share and the unrestricted market value (UMV) is £20 per share. For the purposes of the illustration let us assume that the employee pays £15 per share. No tax charge under the general earnings principle arises at the time of the award. The employee has therefore paid 75% of the UMV.

When the shares are sold, however, the proportion of the sale proceeds which is subject to income tax rather than capital gains tax is 25% (the difference between AMV and UMV at the time the shares required). It is important to be aware that this percentage is applied to the sale proceeds, not the gain. When you consider that the top rate of income tax is currently 45% compared to the top rate of capital gains tax which is 20%, this could represent a significant tax disadvantage.

National Insurance and Employer’s Liability

As the tax charge arises on the disposal of the shares it is highly likely that HMRC will treat them as “readily convertible assets” which will mean that the deemed income is also liable to a National Insurance charge for both the employer and the employee. Under those circumstances the tax and National Insurance has to be paid over through the usual payroll. There can be further tax repercussions if the employee shareholder does not make good the tax and National Insurance paid over on his or her behalf by the employer within 90 days.

Utilising Section 431 Election to avoid the bear traps

Fortunately, all is not lost. Employees acquiring restricted shares do have a means of avoiding later income tax charges arising on chargeable events. They can make an election under Section 431 of the Income Tax (Earnings and Pensions) Act 2003.

What this election says is that the employee chooses to be treated as having received the restricted securities at their unrestricted market value at the date of acquisition. The employee will then pay tax at that point based on that UMV but, more importantly, any future growth in value of the shares will not give rise to an income tax charge on a subsequent disposal or other chargeable event.

This vital election has to be made by both the employer and the employee within 14 days of acquisition of the shares. Unusually, there is no requirement to submit the election to HM Revenue and Customs at that stage. It should merely be retained by the employer and the employee in order to be produced at a later stage.

Advice on Employment Related Securities

For detailed advice and guidance on Employment Related Securities or other company share plans including Enterprise Management Initiatives and other share option award arrangements, please David Gillies on 0121 633 2007 or contact him by email at david.gillies@friendllp.com