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Business Tax  •  Entrepreneur's Relief  •  Personal tax  •  Share Schemes  •  Tax Planning  •  Tax Relief

What is a Section 431 election and why am I being asked to sign one?

By RJP LLP on 23 October, 2017

When shares are being transferred or issued to employees or company directors, it is common practice for the individuals involved to be advised to sign a section 431 election. This is part of the forward tax planning process and this article explains the reasons for making an election and the potential benefits.

 

Understanding the ‘employment related securities’ rules

Firstly, it’s relevant to appreciate that special tax rules apply to the issue of employment-related securities. This affects all employees and directors (whether they are executive or non-executive and are current or former employees); who either subscribe for or acquire shares in either: the company they work for directly, or a company that forms part of a group of companies for which they work.

The employment related securities rules can also impact investors who are subsequently appointed as company directors or employees. They exist to ensure that any income arising from shares is not taxed as capital when it should properly be taxed as income and thus be chargeable to tax at higher rates.

One of the unacceptable ways HMRC identified was being used to ‘convert’ income into capital (thus ensuring it was taxable at lower tax rates) was the practice of giving employees or directors restricted shares whose value, at the time they were issued, was suppressed by virtue of the restrictions attached to them. The restrictions would typically be documented in articles of association or shareholder / investor agreements and then either fall away or be removed, leaving the employee with a much more valuable asset than they had originally purchased, and therefore a large capital growth.

The employment related securities legislation provides that in such cases, a percentage of the capital growth is charged to income tax rather than capital gains tax.

The problem is that, even inadvertently, on more occasions than not employment related securities will have restrictions attached to them; the most common being the requirement for a director/ employee to sell their shares back to the company or the existing shareholders, should they leave the employment of the company.

This means that the shares automatically fall within the employment related securities legislation, and on a disposal, the gain will, in part, be subject to income tax at a potential rate of 45%, rather than capital gains tax at a potential rate of 10%.

The price originally paid for shares, taken together with a valid s431 election, can ensure this is not the case.

 

How are employment related securities valued?

When employment related securities are issued they have two different values:

  1. The Actual Market Value (AMV) – this is what the shares are actually worth with restrictions attached; and
  2. The Unrestricted Market Value (UMV) - what the shares would be worth without any restrictions attached – this will always be higher than the AMV.

Provided the director/ employee pays the full UMV for their shares as at the time of their acquisition and makes an election within 14 days to say they have done so (the s431 election), they will not be required to pay an income tax charge on the future growth in the value of the shares when they are eventually sold.

The broad purpose of the election is therefore to confirm that the shares have been acquired for their unrestricted market value, and not at a discount because of the restrictions attached.

 

Example: The employment related securities income tax charge

Greener Grass Ltd wishes to issue shares to Samantha, a new company director, as part of their total remuneration offering. These shares can only be sold if at a future point in time the company is sold to a third-party investor, at a date as yet unknown. At the time these shares are awarded to Samantha, their AMV is £1.50 and their UMV is £2.00.

Samantha pays £1.50 per share, however, the UMV of the shares is documented as £2.00, so when the shares are finally sold as part of a third-party purchase, Samantha will pay capital gains tax on ¾ of the gain, and income tax on ¼ of the gain.

 

Benefits of an s431 election

If Samantha pays £2.00 per share, and makes a s431 election to confirm that she has paid UMV for the shares, none of the future growth will be chargeable to income tax. Alternatively, she can pay £1.50 per share (or less), and pay income tax now on the difference between £2.00 per share and the amount per share that she pays, and provided she makes a s431 election, this will have the same effect.

If you have any questions regarding employment related securities, share transfers, s431 elections or establishing employee share schemes, please contact Lesley Stalker by emailing las@rjp.co.uk.

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