We provide a guide to some key employment related security tax points that business owners should be aware of in advance of an exit.
A hidden gem often overlooked is that options will create a corporation tax deduction for the seller on sale.
If you are preparing to exit and sell your company or you are at the stage of negotiating with a purchaser, tax is likely to be one of your key concerns. Principally you want to ensure that you receive capital gains tax treatment on the sale of your shares, including on any earn out or other deferred consideration. But, there is some very tricky legislation, known as the employment related securities. The effect is if you fall foul the legislation means that what you think is capital is treated as income for tax purposes resulting in much higher tax. We do see clients get caught out. Set out for you is a guide to some key employment related security tax points you need to know when planning your exit.
Corporation tax (CT) relief on the exercise of options
UK Corporation tax relief should normally be available on the exercise of options. With corporation tax rising to 25% in April 2023, corporation tax relief on options this represents an increasingly valuable relief for companies to claim. However, not all sellers realise this to their cost.
For example – unapproved options:
- 10 employees and directors are granted 100 unapproved options each.
- On exit the shares are worth £500 each.
- There is no cash outlay required from the employees or directors.
On the exit sale of the company the employees and directors will have to pay income tax and NI on the value of the shares – i.e. 100 x 500 = 50,000 individually or £500,000 for the 10 employees and directors combined.
The seller is eligible to claim CT relief of £500,000 because option holders will be exercising options on completion of the share sale. The seller is unaware that CT relief can be claimed following the exercise of options, and so did not seek to increase the sale price by any amount for it.
For sellers it is a case of ‘use it or lose it’ where CT relief and share options are concerned. It is too often the case that a seller will miss this valuable relief in negotiations with a buyer. On other occasions, sellers may only become aware of it too late in the exit process, and so lose out over the benefit of CT relief in pricing or by some other means.
(Also, option exercise prices can be significant in amount, and sellers should ensure that they are reflected ‘pound for pound’ in the purchase price paid by a seller especially if the total exercise prices are large in amount.)
Restricted shares and section 431 elections
Many directors or employees will acquire shares in their employer company (or another company in the group) subject to restrictions. The effect of these restrictions will be to reduce the up-front value of the shares in an individual’s hands on acquisition. This will also mean that a proportion of a director’s or employee’s future share sale proceeds will be subject to PAYE/NIC, unless they have taken certain steps.
- Say the unrestricted market value of a share is £12, but due to restrictions on the sale and transfer of shares, the value of the shares is £9 on acquisition.
- The employee paid £9 per share.
- The result based on the above scenario is the impact of the employment related securities legislation is that on sale of shares some years later, when the value per share had increased to £40, one quarter of the sale proceeds (£10 per share) is taxed to PAYE/NIC. The balance of the sale proceeds would receive capital treatment as expected.
- However there is a choice. If the employee had entered into a tax election with his employer to dis-apply the restrictions at the time of receiving shares the employee would have either paid an additional £3 on acquisition or been subject to income tax on £3. By making the election, his profit on sale would have been taxed as capital at the much lower rate of tax.
This tax election must be made within 14 days of acquiring by the employee jointly with his employer company (which may not be the issuer of the shares).
If an election has not been made within 14 days, depending on the facts, the parties could agree to the ‘lifting’ of a share restriction and electing for all outstanding restrictions to be ignored and make a new tax election. With careful planning it may be possible to lift a restriction in this way without incurring tax at that point. This would mean that the employee should not be subject to PAYE/NIC on an exit under the restricted securities legislation.
Share or option arrangements?
Companies may implement share or option arrangements for their employees. These could be tax advantaged arrangements, that allow employees to benefit from tax exemptions, including on exercise of options under Enterprise Management Incentive (EMI) or Company Share Option Plans (CSOP).
Failure to operate the arrangements correctly could mean significant PAYE/NIC exposures arising on an exit if there is non-compliance. For example, failure to report the grant of EMI options to HM Revenue & Customs (HMRC) on the online ERS service, within 92 days of grant, will mean that the options are not qualified, and won’t benefit from tax exemption on exercise. This is unless HMRC accept the company had a reasonable excuse, which excludes a failure or delay by the company’s advisors.
Replacement EMI options can be granted following a reorganisation (for example a reorganisation effected long before an exit). Even if the replacement EMI options qualify for EMI tax relief if the replacement EMI options are not notified to HMRC within 92 the EMI tax relief is lost entirely.
Other examples of non-compliance include the requirements to report share acquisitions and certain other reportable events to HMRC by 6th July after the end of the tax year in which share acquisitions/reportable event have occurred. Failure to report on a timely basis will result in penalties. There are also penalties if companies file incorrect returns.
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