For corporate groups with cross border operations it is often necessary to consider how UK taxes will apply to the shares and securities of founders, managers and other employees who have a UK connection.
Such individuals would have a connection to the UK if at some point in time, they will be resident in the UK and/or they will carry out employment duties in the UK for the company or group in which they hold securities.
As a consequence, the UK’s Employment Related Securities regime (the ERS Rules) may apply. These rules can impose income tax (at a max. rate of 45 per cent) on the individual which can also give rise to a liability to social security contributions for the individual (at a rate of 3.25 per cent) and their employer (at a rate of 15.05 per cent). These charges are significant when compared to the current tax rate of 20 per cent (or even potentially 10 per cent) payable on capital gains.
The ERS Rules are complex and widely drawn. Understanding how they work means that tax charges can be anticipated and frequently mitigated. This memo explores some of the basic issues that should be considered.
Which securities fall within the ERS Rules?
The ERS rules apply to “securities” which are “employment-related”.
For this purpose:
“Securities” includes all types of listed or unlisted company shares and bonds, including ratchet and preference shares.
“Employment-related” means where the right or opportunity to acquire the securities is available by reason of an employment or by the employer.
“Employment” includes a former, current and future employment. Being a director or officer of a company is regarded as employment.
Shares issued by a company which is “connected with” the employer group will be employment-related.
Can the ERS Rules apply to securities which are held indirectly?
Yes. Employees may hold their shares in the employer group via a ManCo or in some cases through a personal investment company. The shares in these vehicles would usually be subject to the ERS Rules because they will be “associated with” the employee.
Can the ERS Rules apply to securities owned before the individual acquired a UK connection?
Yes. Under special rules for “internationally mobile employees”, individuals can be subject to UK tax on securities income that relates, broadly, to the period during which the person is resident in the UK, even if the shares were acquired whilst the person was non-UK resident and working outside the UK.
When will a tax charge arise?
Where the securities are “restricted” (see below) various events can cause a tax charge to arise. In addition to 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, the ERS regime does not apply but under general principles there will be an upfront income tax charge to the extent that the actual market value is not paid for the securities.
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 exactly is taxed?
The ERS Rules seek to tax the “untaxed value” of the securities. This is usually the amount by which the actual market value (AMV) of the securities exceeds the amount paid by the individual for the securities at the time they acquired them.
For restricted securities the “untaxed value” will be the difference between the unrestricted market value (UMV) and the amount paid for the securities. The UMV is the market value of the shares ignoring the effect of any of the restrictions and risk of forfeiture. Thus, the UMV will usually be higher than the AMV because the AMV will take into account the financial impact of any restrictions.
Where the charge is imposed at the time of disposal, the “untaxed value” is then applied as a percentage to the proceeds received on the sale of the securities, or to the market value at that time.
Who pays the tax, the individual or the employer?
If the restricted securities are readily convertible assets (RCAs) income tax arising must be collected by the employer and paid to the UK tax authority under the Pay As You Earn (PAYE) system. In essence, RCA’s are assets which can be easily converted into cash, however there are fact-specific rules on this point which must be considered at the time.
Only employers with a UK “presence” are obliged to operate the PAYE system of tax deduction. Again, this is a fact-specific issue which must be determined on a case-by-case basis.
Where the income tax is collected under PAYE, then social security payments (known as national insurance contributions (NICs) must also be paid. Where the income tax is not collected under PAYE, then NICs are not due and the individual will account for the income tax in their annual personal tax filing.
What can be done to mitigate the tax?
If the amount paid for restricted securities, whether in cash or by a contribution of other securities, is equal to the UMV (see above) of the securities then (normally) no income tax charge can arise. However, anti-avoidance provisions must also be checked (see below). Further, if foreign income tax has been applied to the UMV of the securities, credit for this tax will be given.
As an alternative, or in addition (as a protective measure) it is possible for the employee and employer to make a joint tax election, known as a “431 election”.
The 431 election has the effect of taking the restricted securities out of the ERS Rules with the result that although an immediate income tax charge may arise (by reference to the UMV), any subsequent increase in the value of the securities will only ever be subject to capital gains tax and not to income tax.
The 431 election must be made at the time the restricted shares are acquired and the shareholder must be UK resident at that time.
If neither of the solutions mentioned above are available, in some cases it may be possible to enter into another type of tax election (a “430 election”). This would trigger an immediate income tax liability but would prevent future income tax charges arising. Alternative solutions may be also available depending upon the precise circumstances.
In all cases, where UMV has been paid, a professional independent valuation of the relevant securities, is critical to ensuring certainty with respect to the shareholder’s UK tax liability.
What about share options?
Again, under the internationally mobile employee provisions part of the gain arising on the exercise of a share option can be subject to UK income tax based on the time spent in the UK or otherwise on a just and reasonable basis.
What else should be considered?
It is always necessary to check whether the anti-avoidance provisions of the ERS Rules may apply. For example, these provisions, amongst other things, seek to prevent an artificial inflation or reduction in the price paid for employment related securities.
There are a number of factors to be considered when assessing the liability to UK tax on employment-related securities, in particular where the ERS Rules apply. There are preventative measures that can be adopted and with careful planning, it is possible to limit income tax charges. A detailed analysis by a specialist UK tax professional is advised.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, May 2022