The Most Important Facts About Employment Related Securities

Employment Related Securities

A recent project undertaken by Harbour Key gives a warning of the tax risks that arise when advice is not taken in respect of shares, due to the wide-reaching anti-avoidance rules, commonly referred to as Employment Related Securities (“ERS”).

It is very easy to fall-foul of the rules due to their complicated nature, and how actions can be taken, such as transferring shares, without any thought to their tax implications. This area is now becoming a significant issue in pre-sale due diligence, with large accountancy firms have specialists who only advise on this one area.

ERS are securities that are acquired in connection with an employment. 

The term securities is broad and includes shares, debentures, loan stock and financial instruments such as options, futures and other contracts. 

Employment is also defined very widely, with limited exemptions (for example family relationship, but don’t take this as a given), covering pre, during and post-employment.  For example, an individual may subscribe for shares as part of an investment round who has no previous connection with the Company, and thereafter is appointed as a non-exec director purely for the purpose of monitoring the investment, this is an ERS, whether any tax implications arise, depends on the value (see below), the amount paid and any restrictions attached to the ERS. In this example, most view the share issue as being in their capacity as an investor, however the director role means ERS needs to be considered, and some belt and braces measures should be undertaken.

What is the issue?

When employees acquire shares or securities without paying market value there is an exposure to an income tax (and possibly NIC) charge based upon the market value of the shares or securities received.

In practical terms, this means that anyone who establishes a company and becomes a director of it will be treated as having acquired ERS. 

ERS can arise in many situations, and when considering any dealings in shares/options (which are the main areas of securities Harbour Key come across), you must consider the rules. 

It is not all bad news, as shares/options are a good way to incentivize employees, it is case of working out the best way to do it, and then implement correctly.  ERS schemes can either be tax-advantaged which are HMRC approved schemes or non-tax advantaged.

The following ERS schemes are classed as tax advantaged as approved by HMRC:

  • Enterprise Management Incentive (EMI);
  • Share Incentive Plans (SIP);
  • Save as You Earn (SAYE);
  • Company Share Option Plans (CSOP).

It is not the purpose of this article to look at approved schemes any further, and further information on the above can be provided on request.

Non-Tax Advantaged - when will a tax charge arise?

When securities are “restricted” (see below) various events can cause a tax charge to arise. In addition, on the acquisition or sale of the security, tax can be triggered at the time restrictions on the shares expire or are lifted or varied.

If the securities are not restricted (which is not common for SMEs, as most Articles have some level of restriction), then the restricted securities section of the ERS regime does not apply, however there will be an income tax charge if market value is not paid for the shares by the employee (acquisition for less than market value).

What are restricted securities?

Restricted securities are securities which are subject to limitations that can reduce their value. Examples of restrictions are:

  • Leaver provisions - in particular “bad leaver” provisions which require the shares to be sold when the individual ceases employment (often at less than market value);
  • Drag along rights;
  • Constraints on the shareholder’s ability to transfer the securities.

What is taxed?

The rules seek to apply tax to what is the untaxed value received, which is:

  • For unrestricted securities, the difference between market value of the securities and the amount paid by the individual. If no payment is made, the full market value is taxed;
  • For restricted securities the “untaxed value” will be the difference between the restricted market value (market value of the shares including the effect of any of the restrictions) and the amount paid for the securities.

For restricted securities only, a further charge can be imposed at the time any restrictions are lifted, or on disposal of the securities. The amount taxed at this point is a proportion of market value of the securities at that time, based on the difference between restricted and unrestricted market values on acquisition.

For example, if a restriction on acquisition reduces the value of the securities by 20%, the subsequent lifting of those restrictions in the future would result in 20% of the value of the securities at tax point being subject to income tax.

Who pays the tax, the individual or the employer?

If the ERS are readily convertible assets (RCAs) income tax arising must be collected by the employer and paid under PAYE. RCA’s are assets which can be easily converted into cash, for example:

  • shares being sold as part of a sale of the business, and 
  • shares issued in a subsidiary are always RCAs, as the parent company could acquire the shares, so easy to convert;

If the securities are not defined as RCAs, then the individual pays personal income tax (no NIC), which is reported and collected via self-assessment.

What can be done to mitigate the tax?

Ensure that the amount paid for restricted securities is equal to the unrestricted market value. A valuation report to support the unrestricted market value should be prepared, and agreed by the board of directors, to evidence and defend any future HMRC challenge. A flag here is that valuations are subjective, and different methodologies can be applied, using different sources of information, but having something is better than nothing.

In addition (or we would always say as a protective measure) the employee and employer should enter a joint tax election, known as a “section 431” election.  This election doesn’t prevent any income tax charge on the acquisition of the securities if less than unrestricted market value is paid, but any subsequent increase in its value will only be subject to Capital Gains Tax.

The section 431 election must be made at the time the restricted securities are acquired and the shareholder must be UK resident at that time.

HMRC Reporting?

The 431 election does not have to filed with HMRC, however the employer (or an employing company within a group, which as a registered payroll), has to file an ERS return following the end of the self-assessment tax year (6th April) in which the security has been issued/granted or rights changed, and before 6th July. 

The return has to report to HMRC the type of security, the market value and if a section 431 has been completed, along with other details.

Failure to file a return results in late filing penalties.

What are Harbour Key seeing?

  1. HMRC – Where HMRC have opened an enquiry/compliance check in to a securities disposal, say on a business exit, they will check the capital gains tax calculation is correct, and if business asset disposal relief is claimed, if it is a correct claim. However, we now see HMRC asking more questions re: how the shares were acquired.  We have one client currently under enquiry, where HMRC have unsuccessfully challenged the disposal, but are now looking at how the individual got the shares, which were issued as part of an employee non-HMRC approved incentive package. A valuation was prepared 12 months before the share issue (which was delayed due to covid), by a big 4 accountancy firm, and HMRC are now reviewing the valuation to see if in their view the value is at market value or not.  Unfortunately, Harbour Key did not know the client at the time, no s431 election was completed, so a successful challenge to the valuation by HMRC could result in an income tax charge at the date of issue on the difference between the value paid and HMRC determined market value; 
  1. Pre-Sale Due Diligence – ERS has in our view become the biggest area, and the greatest risk in pre-sale due tax diligence, replacing employment status (is an individual self-employed but should really be an employee). 

We were recently referred a client in the middle of a transaction, and going through due diligence, where the buyer had identified ERS risks. The Company had issued shares to employed managers as part of an incentive scheme to grow the business, advising on a sale they would be able to sell their shares, receiving a share of the proceeds, subject to capital gains tax (at the 10% rate) as business asset disposal relief would be available. 

On looking at the situation, the shares, which had been issued to a number of employees over a period of time, had a number of tax implications: 

  1. A PAYE charge (income tax and NIC) arose on the issue of the shares, as the shares were in a subsidiary, therefore RCAs, and the employees paid nothing for the shares. The client therefore had a PAYE failure, and the buyer was advising this failure had to be disclosed to HMRC, with the outstanding tax paid, together with interest and penalties. (Generally, where employees have been issued shares, there is an agreement, that where a tax liability may arise charged to the employer, it can be recovered from the employee. In this case no agreement was in place);
  1. No ERS returns had been filed, the buyer wanting all reporting brought up to date, resulting in late filing penalties over a number of years;
  1. On the sale, the shares would be classed as RCAs, with a value determined by the sale consideration. Therefore, another PAYE charge, resulting in the employees, who would all be additional rate taxpayers, paying 47% tax, so practically only receiving 50% of the sale proceeds. In this transaction, these employed managers were key to the handover and success of the business post sale! 

Harbour Key Tips:

  1. Where any action is taken in respect of shares (any action of any kind! – issuing shares, buying shares back, changing shares), think ERS! Don’t rely on solicitors, as some will think or warn about ERS, others will not, on the basis it is tax, not their area, but if your accountant isn’t aware of the position until post event (generally on completing the annual accounts), nothing can be done;
  1. Before issuing/giving shares to employees, consider is there another way to incentivize employees (where relevant)? Can one of the HMRC approved share schemes be used, which can prevent other issues around bad leavers, and recovery of shares in the future, by using share options;
  1. If shares are to be issued, get a contemporary valuation undertaken by the Company accountant, to support the valuation being utilized to calculate tax charges;
  1. Whatever the position, complete a section 431 election;
  1. Make sure that annual returns are filed with HMRC. 

There are a number of factors to be considered when assessing the liability to tax under ERS rules. There are preventative measures that can be adopted; however, these need to be considered before any shares/securities are issued. 

Taking advice is key, to prevent a tax nasty arising in the future!