UK: Finance Act 2003 Makes Significant Changes to Tax Treatment of Employee Share Acquisitions

Last Updated: 11 August 2003

The Finance Act 2003 received Royal Assent on 10 July and has made a number of significant changes to the tax treatment of employee share acquisitions.

The most important change is the introduction of the concept of "restricted securities" which replaces the old rules that potentially taxed both the receipt of shares and, in some circumstances, any increase in value of the shares acquired (the so-called "conditional shares" and Finance Act 1988 charges). Whereas it was usually possible to structure an acquisition so as to fall outside the old rules, the new rules raise a number of issues for employees acquiring shares (although they are likely to be of less significance for employees of most listed companies). The new rules also have implications for earn-outs, MBOs and private equity arrangements. The new provisions take effect in respect of shares acquired on or after 16 April 2003.

The new "restricted securities" regime – key changes

There are two key changes to the old regime. Under the old regime the whole of the gain relating to shares acquired by an employee could be subject to income tax. Under the new regime the "untaxed proportion" of the shares will now be taxed upon the occurrence of a "chargeable event" (generally, where restrictions are varied or removed or the shares are disposed of). For these purposes, the untaxed proportion is the difference between the market value of the shares (taking the restrictions into account), or what an employee pays (if higher), and the unrestricted market value of those shares. Any further gain is then subject only to capital gains tax (with the benefit of taper relief).

The other key change is that the employee and employer can now jointly elect to disapply the new provisions to avoid any post-acquisition income tax and, where applicable", NICs1 charge when the restrictions are lifted or on disposal of the shares. Instead, there will be an up-front income tax charge on the unrestricted value of the shares. In many cases, where it is expected that the share price will rise before the restrictions are varied or removed or the shares are disposed of, it will be beneficial to make an election so as to "cap" the income tax and any NICs liability.

What securities will be affected?

In order to fall within the new regime, it is necessary to consider whether the securities are "employment-related" and whether they are "restricted" (see below).

What are "employment-related securities"?

Securities will generally be regarded as "employment-related" if they are made available by a person’s employer or a person connected with his employer.

However, they will not be regarded as "employment-related" if the employer is an individual and the securities are made available in the normal course of family or personal relationships.

What are "restricted securities"?

In general terms, employment-related securities will be restricted securities if their market value is reduced by the effect of one or more defined restrictions attaching to the securities. Most shares acquired by employees of private companies will be restricted securities because the Articles of Association of private companies usually contain a restriction which requires employees who leave employment to sell their shares, often for less than market value ("bad leaver" provisions).

Shares acquired pursuant to a public offer will not be affected by the new rules.

Factors to consider in determining whether employment-related securities are "restricted"

The following factors will need to be considered in determining whether the securities are restricted securities:

  • restrictions on retention, transfer or disposal;
  • restrictions on rights conferred by the securities, for example voting or dividend rights;
  • provisions requiring transfer, reversion or forfeiture if certain circumstances arise; and
  • restrictions which disadvantage the employee, the holder or a connected person.

However, a requirement to sell or transfer the securities if the employee leaves employment due to "misconduct" would not of itself be a relevant factor.

Will a company’s employee share schemes be affected?

Shares acquired under an Inland Revenue approved SIP, CSOP or SAYE scheme will not be affected by the new provisions.

In addition, most employee share schemes under which shares are awarded at nil-cost to employees (for example LTIPs and deferred bonus plans) do not give employees rights to the shares until vesting/transfer (following which there will be no further restrictions). Any forfeiture provisions or restrictions do not apply to the shares but are terms of the award, contained in the plan rules. As a result, the new regime does not apply to these plans.

In some cases, however, employees will have acquired the shares or a beneficial interest in the shares at the date of the award (for example, in some restricted share plans or matching share plans, and, in particular, French "classic" and leveraged" plans). In such cases, care should be taken that, if appropriate, an election is made to disapply the new provisions or the taxation position is explained carefully to employees.

The charge to income tax

An up-front income tax liability will arise on the acquisition of restricted securities unless at least the restricted market value of the restricted securities is paid. An income tax charge may also arise on the occurrence of a later "chargeable event".

In the case of securities where the restriction is a forfeiture provision, no immediate income tax or NICs liability will arise as long as the securities will cease to be restricted securities within 5 years of acquisition. Instead, an income tax charge will arise when a "chargeable event" occurs.

Where securities subject to forfeiture will not cease to be so restricted within 5 years, an immediate income tax liability will arise unless at least the restricted market value is paid. An income tax charge may also arise on the occurrence of a later "chargeable event".

A "chargeable event" will occur whenever restrictions are varied or removed, or the securities are disposed of. A complex formula is set out in the legislation to determine the proportion of the value of the securities which is subject to income tax. This is based on the extent to which the restrictions which are varied or removed reduce the value of the securities by comparison to unrestricted securities.

Example

On 1 June 2003, a company offered shares subject to a 5-year no sale restriction. The market value of the shares taking into account the restrictions on the shares is £7.50. However, the market value of the shares without any restrictions is £10 per share. Assume that the employee pays £7.50 per share.

Assuming no election is made for an up-front tax charge to apply, the amount assessed to income tax on the occurrence of a chargeable event will be based on the restricted market value (£7.50). In this case, no up-front income tax charge applies as the employee has paid the restricted market value of the shares.

The uncharged proportion, that is, 25% of the unrestricted market value, will be taxed when the no-sale restriction ends. Therefore, if the unrestricted market value rises to £25, there will be a charge to income tax on 25% of £25 (i.e. £6.25). The remaining gain (i.e. £11.25) is subject to capital gains tax and may benefit from taper relief.

If, however, the unrestricted market value falls to £4, then there will be a charge to income tax on 25% of £4 (i.e. £1).

Making an election

There are four possible elections which can affect how much income tax and, where relevant, NICs are payable at any particular point in time:

  • a section 431(1) "full election" to ignore all restrictions on shares so that the securities are taxed on acquisition as if they were unrestricted. This is likely to be the most common election, especially where the employee has paid the full unrestricted market value of the shares or it is anticipated that there will be substantial future growth in the share price. This is very common in the US where a similar election procedure applies;
  • a section 431(2) "partial election" so that the income tax charge on acquisition will be based on a partially restricted value with further income tax arising on a chargeable event. Making a partial election ensures that a key part of the formula set out in the legislation (the initial unrestricted proportion (IUP)) is less than it would otherwise be (but query whether employees will prefer to make a full election);
  • a section 425(3) election to pay tax on the restricted value on acquisition where the risk of forfeiture of the shares does not last for more than 5 years. An income tax charge will still arise on a chargeable event occurring. If no election is made no tax would be due on acquisition. However, an employee may wish to make this election if he intends to stay with the company and anticipates share price growth (although the section 431(1) full election would have the advantage that no income tax will arise on any future chargeable event and may therefore be preferable); and
  • a section 430 election to treat securities as unrestricted where one or more restrictions are removed or varied but the securities remain restricted securities. An employee could make this election and pay income tax on the first chargeable event on a higher amount to avoid income tax on any subsequent chargeable event.

Example

To continue with the earlier example:

If a section 431(1) full election is made to ignore all restrictions, there will be a charge to income tax based on the discount to the unrestricted market value of £10 (i.e. £2.50). There will be no future income tax charge (or NICs) when the restriction is removed. Any further gains would be subject only to capital gains tax.

Therefore, if an election were made for an upfront tax charge based on the unrestricted market value of the securities, then, if the value of the securities increases, this would result in a lower overall income tax charge. However, if the value of the restricted securities subsequently falls, an upfront election will lead to a higher overall tax charge. This risk will need to be balanced against the benefit of fixing upfront the amount of the tax charge.

How do you make an election?

The election must be made jointly by the employer and employee. An election is irrevocable and must be made on the prescribed Inland Revenue forms. The election does not need to be sent to the Inland Revenue but must be retained by the employer as it may be requested if there is an enquiry into the employer’s records or the employee’s return.

What are the timing requirements for making an election? An election will generally need to be made within 14 days of the acquisition of the shares. However, where shares were received on or after 16 April 2003 and before a day appointed by Treasury (not expected to be before 1 September 2003), an election can be made during the 14 days following the appointed day.

How will the income tax and any NICs be collected?

This will depend on whether the securities are "readily convertible assets" ("RCAs"). If the securities are RCAs, the employer must operate PAYE to collect both the income tax and employee NICs which arise on the chargeable event, and must also account for employer NICs.

If PAYE does not apply, the employee must account for the income tax directly under the self-assessment rules. NICs will not be due in the event that the securities are not RCAs.

It is worth noting that as a result of the Finance Act 2003, in addition to all "tradable securities", all non-tradable securities are now treated as RCAs unless the employer is entitled to corporation tax relief in respect of the securities.

How will securities be valued for these purposes?

The restricted market value and unrestricted market value must be calculated by reference to the general statutory open market valuation rules prescribed by the Taxation of Chargeable Gains Act 1992.

The Inland Revenue has stated that it is not possible for Shares Valuation to agree a standard set of discounts to take into account certain common restrictions as the impact of any particular restriction will be affected by many other considerations, such as the volatility of the share price. It may, therefore, be necessary to agree a valuation with Shares Valuation.

What are the reporting requirements under the new restricted securities rules?

The Inland Revenue must be provided with written particulars of certain "reportable events" before 7 July in the year following the tax year in which the event occurred. These events are wide-ranging and include both the acquisition of securities and the occurrence of a chargeable event.

In most cases the employer will carry out this duty. If the employer does not carry out this duty, then it must be carried out by any host employer (broadly, one who has taken on the role of the employer for PAYE purposes at the time of the event), the person from whom the securities were acquired or the person who issued the securities.

When will corporation tax relief be available?

Where the statutory rules for obtaining corporation tax relief are met, such relief will be available to the employer when the employee is taxed on the restricted securities. The amount of the relief will be equal to the amount on which the employee is taxed.

Earn-Outs

The new rules can potentially catch shares issued to vendors on a sale of a company where there are earn-out arrangements. However, in accordance with guidelines that have been issued by the Inland Revenue, where it can be shown that the shares issued under the earn-out are further consideration for the sale rather than a reward for services or an inducement to continue working in the business, the new rules will not be applied.

MBO’s and Private Equity arrangements

The new rules also impact on shares given to management in MBO transactions and to the carried interests acquired by fund managers in limited partnership private equity fund structures.

In an attempt to ensure that only value obtained by reason of employment is taxed under the new rules but that capital growth is not, the Inland Revenue have released two Memoranda of Understanding as a result of discussions with the British Venture Capital Association (BVCA). Broadly speaking, interests received will not be taxed under the new rules where they conform to the arrangements set out in the Memoranda. For further details please see our separate private equity briefing dated July 2003.

Footnote

1 Wherever mention is made of an income tax charge arising, employers’ and employees’ NICs will also be payable if the shares are readily convertible assets.

By Colin Chamberlain and Paul Ellerman

© Herbert Smith 2003

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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