Underlying tax principles

Unless specific tax rules apply, any share-based benefit passing from an employer to an employee will normally be subject to income tax at the employee's highest rate.1 The benefit may also be subject to national insurance contributions ("NICs"). The purpose is to prevent the evasion of income tax and NICs by means of providing share based benefits to employees. Share benefits normally subject to income tax include the value of any shares gifted, any discount on shares acquired through a share purchase scheme, or any profit realised from exercising a share option.2

As previously noted, however, the UK government is keen to promote employee share participation. It therefore offers a number of statutory employee incentive schemes, namely the Share Incentive Plan, the Enterprise Management Incentive, the CSOP Scheme and the SAYE Option Scheme. These all offer certain tax advantages in exchange for certain restrictions and limitations designed to limit tax avoidance. The specific rules applicable to each of these schemes can be found under the relevant headings in the index.

This section deals with the underlying tax principles that apply to share based benefits that do not fall within one of the statutory schemes.

The tax planning industry has devoted considerable effort to designing schemes that can give employees the tax advantages of the statutory schemes without the associated limitations and restrictions. In the past, many such avoidance schemes relied on the manipulation of the value of private company shares. For example, employees might be awarded shares with heavily restricted rights. These "restricted shares" were arguably of little value, thus minimising the taxable value of the award. Later, the shares would gain value when the restrictions expired or were removed. In other cases, shares would be awarded at a low value for tax purposes but they would then convert into other securities of higher value: these are sometimes known as "flowering shares".

Many of these schemes were based on misunderstandings of the law rather than exploitation of genuine loopholes. However, new measures to deal with such schemes were introduced in the Income Tax (Earnings and Pensions) Act of 2003 ("ITEPA 2003") which offers a unified, if complex, taxation regime for dealing with all forms of restricted and convertible (flowering) shares. We deal with each situation in turn.

Restricted shares

Shares can be restricted in a variety of ways. For example:

the shares may have no rights, or restricted rights in respect of voting, dividends or the return of capital;
the shares may be non-transferable for a set period of time, or transferable only to certain parties and/or on restricted terms;
employee shareholders may be required to sell their shares on leaving employment;
the shares may be forfeit in whole or in part, or converted into worthless securities, if specified performance, loyalty or other conditions are not met.
UK tax law makes a distinction between the actual fair value of a share, taking account of all the restrictions attaching to it, and the unrestricted fair value of the share. Reflecting the algebra contained in the legislation, these concepts are often referred as "AMV" - actual market value; and "UMV" - unrestricted market value. In relation to unquoted shares, the term "market value" refers to the concept of fair value that would be agreed between prudent buyer and willing seller, assuming the buyer had the information he or she might reasonably expect.

A good starting point for describing the tax treatment of restricted shares is to consider what happens when an employer makes a straightforward gift of restricted shares to an employee.3 All else being equal, the value of the shares, taking account of any reduction in value due to the restrictions, will be subject to income tax. The amount subject to income tax is reduced to take account of any amount paid for the shares and any expenses incurred in acquiring them.

When shares are sold, restrictions often fall away and in this case the default treatment is that a further charge to income tax will arise. For example, if employees are allowed only to sell to purchasers approved by the company, but the whole company is then sold, the restriction will no longer apply to the shares. Restrictions might also be lifted in circumstances unrelated to a sale, for example if shares which previously had no dividend rights were made eligible for dividends.

If following the acquisition of a share, restrictions are lifted or fall away on sale, income tax will be payable on a proportion of the value at that point which is equal to the reduction of the original value due to the restrictions. Expressed another way, income tax is charged on the proportion of value that escaped tax at the outset, because of the restrictions, plus any subsequent gains that accrue to that proportion. The other gains are normally subject to capital gains tax, not income tax, since that part of the value of the shares was already fully taxed at the outset.4

For example, if shares worth £1 each are gifted to an employee with restrictions that reduce their value to 70p, then the employee will initially pay income tax on 70p. If the shares are subsequently sold for £2, in a situation where the restrictions no longer apply, the employee will pay further income tax on 60 pence, being 30 per cent. of the unrestricted sales proceeds. This is equal to 30 per cent. of the original untaxed value (£1) plus 30 per cent. of the gain (£1). He or she will also pay capital gains tax on the remaining 70 per cent. of the gain (70p), subject to available reliefs.

If however the shares are sold in circumstances where the restrictions continue to apply, such as where shares held by employees can be sold only to other employees, there will be no part of the sale proceeds attributable to the release of restrictions and therefore no charge to income tax.

Employee elections

An employee can escape the possibility of an income tax charge on share gains by electing to be treated for tax purposes as if the value of the shares at the time they are acquired is the full unrestricted value. Thus if an employee receives a straightforward gift of shares with a restricted value of 70p but an unrestricted value is £1, the employee will now pay income tax on £1. More income tax has been paid initially but there is now no "untaxed portion" in the original share value and accordingly only capital gains tax will be payable on any subsequent gains.

This election to be taxed initially on unrestricted market value is made under section 431(1) ITEPA 2003.5 The election is signed by both employee and employer.6 If the shares seem likely to rise substantially in value then it may be worth paying more income tax initially in order to ensure that all subsequent gains are subject to the lower capital gains tax rate. It is common for section 431(1) elections to be signed even when the value of restrictions on the shares is thought to be small or non-existent; this is because there can be uncertainty about the value that HMRC will ascribe to such restrictions.7

A special rule applies if shares are restricted by a risk of forfeiture. For example, an employee may be given shares on the basis that they must be handed back to the company (forfeited) if he or she fails to complete a minimum period of service. In this case the tax treatment is that if the risk of forfeiture will cease within five years of their being acquired, no tax is payable on acquisition but instead tax will be payable, as and when the risk of forfeiture ceases, on their value at that time. This rule does not apply if the risk of forfeiture can continue for more than five years.

It is important to note that a share is deemed "subject to forfeiture" not only if it is given up for no consideration, but also if the holder can be obliged to transfer the share for any amount less than would have been received if the shares had been disposed of freely.

An election can be made under section 425(3) ITEPA 2003 to disapply the deferral of income tax for shares subject to the risk of forfeiture within five years. As in the case of a section 431(1) election, the advantage is that subsequent gains should be taxed as capital gains not income.

Elections under sections 425(3) and 431(1) ITEPA 2003 must be made within 14 days of the transaction.8 This short time-scale is designed to prevent taxpayers waiting to see how the value of the shares is moving before deciding whether to make an election. The elections are not submitted to HM Revenue & Customs but retained by the taxpayer for possible inspection at a later date.

Signing a 431(1) or 425(3) election also carries risks. If the shares are subsequently disposed of at a loss, or written off, there will be no tax to pay but any additional tax paid as a result of the election cannot be recovered. However, if the shares were subscribed for in an "eligible trading company" (and not merely acquired from an existing shareholder) then it may be possible to set the loss against either other taxable income or other taxable gains. However this is subject to detailed rules (see footnote ).

Convertible securities

A security is regarded as convertible if it can or will be exchanged for another security of a different type. This is the case whether the conversion is voluntary or obligatory. If, by contrast, the security has rights which may increase in value over time, such as those resulting from the operation of an equity ratchet in a management buy-out, then it will not be subject to the convertible securities regime.

In general, when a convertible security is acquired, income tax is paid on its value, less any amount paid for it, without taking account of the value that may arise on conversion. "Security" in this context can include convertible loan stock. Income tax is then paid again when the security converts,9 and is charged on the gain - that is, the fair value of the securities acquired through conversion less the fair value of the original securities at the conversion date, ignoring the value of their conversion rights. Any increase in the value of the original shares up to the date of conversion, ignoring the value of conversion rights, is subject to capital gains tax. Credit is available for any amount paid for the conversion.

For example, if convertible shares are acquired for £1 each, being their fair value ignoring conversion rights, and later convert into a different class of shares worth £2 each at a time when the original shares were worth £1.60, ignoring the value of conversion rights, then capital gains tax is payable on 60 pence and income tax on 40 pence.

The legislation dealing with restricted and convertible shares relies heavily on algebra. In some circumstances, the expressions can produce surprising results and professional advice should be sought.

New ventures

HM Revenue & Customs normally accepts that, when a company is first formed, shares acquired either directly or through a company formation agent are not acquired at an undervalue if all the following are true:

all the shares are issued at nominal value;
no other type of security in the company is acquired;
the shares are not acquired in connection with employment with another company; and
the shares are acquired by a director or prospective director of the company, or a person with a family relationship with the director who receives them as a result of that relationship.

The same treatment will apply to subsequent issues of shares by the company if it has not commenced trading, no assets have been transferred to it and the shares are acquired at nominal value by a director or prospective directors and not in connection with any other employment.

Problems can arise if an individual acquires shares in a company that already has value, even if it does not yet trade. For example, the company might have valuable rights or established know-how, which could be said to give it a market value. Individuals may themselves supply value in the form of expertise or a client base and in return receive a "carried interest" in the form of free or low cost shares. They may be participating in a management buy-out or buy-in where they have acquired equity relatively cheaply but at high risk. In these cases a tax charge could arise if the individual is able to obtain shares at less than the hypothetical "fair value" between unconnected willing buyer and willing seller.

In an attempt to clarify the position the British Venture Capital Association and HM Revenue & Customs have entered into two memoranda of understanding. These deal, respectively, with co-investments by managers and venture capital backers, and situations where members of a limited liability partnership are also employees. The memoranda set out certain principles which, if adhered to, will normally represent a "safe haven" from possible attack by HM Revenue & Customs.

With regard to venture capital co-investments, the conditions are that:

the price paid by the managers for the equity of that class is not less than the price paid by any venture capital backers, and the shares are acquired at the same time;10
the price paid for any preference shares or other securities by venture backers is on commercial terms - this is to prevent cross-subsidy of the equity price in favour of management;
there are no favourable conditions attaching to the managers' shares and the managers are fully compensated for their services by means of employment contracts.

The memoranda also set out a "safe haven" for ratchet arrangements. Initially it was agreed that, to avoid a potential income tax charge when the ratchet delivered value, managers would have to agree to be taxed at the outset on the maximum economic benefit - that is, assuming all performance targets are met. If they acquired the equity for less than this full value, an income tax charge would arise. Subsequently, however, HM Revenue & Customs accepted that the value of a security subject to ratchet arrangements should take account of the possibility of the ratchet not operating fully in favour of the managers concerned.

In the case of limited liability partnerships, HM Revenue & Customs will not normally seek to impose a tax charge on the recipient of employee related securities so long the price paid is the same as the price paid by non-employed investors.

A specific problem was identified in 2003/04 in relation to spin-out ventures from universities and other research institutions. Often these ventures receive an endowment of intellectual property rights ("IPR") from the research institution. However, if the employees working with this IPR were to be incentivised with shares or rights over shares in the companies concerned, they could be taxed on the value of the donated IPR. There was some evidence that this was resulting in a reduction in the number of spin-out companies being formed.

To address this problem the rules were amended with effect from 2nd December 2004 so that the intellectual property is disregarded when assessing the value of securities, or rights over securities, transferred from a research institution to researchers in a spin-out company.11

To benefit from this treatment the individuals must be "engaged", but not necessarily employed, in the development of the intellectual property that has been transferred, and the shares, or interests therein, must be acquired by the individuals within 183 days of the intellectual property being transferred from the university. Spin-outs set up before December 2004 were able to elect prior to 15th October 2005 for a tax treatment that would ensure, in broad terms, that no income tax and national insurance would be payable unless and until the company was successful.

Gifts of shares

If an employee receives a gift of shares in the employing company, or some other form of share-based value, the normal presumption is that the gift is a benefit of employment and subject to income tax. This applies whether the gift is in the form of new shares created by the company, or a transfer from an existing shareholder.12

If the gift is from an existing shareholder, it is a disposal for tax purposes and the value is taken to be the fair market value at the time, whether or not the donor receives anything in return. The gain represented by that value is normally subject to capital gains tax. In this scenario, therefore, both donor and donee pay tax on the value of the shares. It is worth noting however that if the gift of shares is made in the form of an option - that is, the opportunity to acquire the shares - the disposal price will be taken to be the exercise price of the option. If the exercise price is equal to or less than the acquisition cost to the donor, the donor will pay no capital gains tax.

In some cases, the gift may be made for family or other reasons unconnected with employment. If HM Revenue & Customs can be persuaded of this, the capital gains tax liability can in certain cases be passed to the recipient by means of a "roll-over election". The donor and donee jointly elect that the base cost for the donee will be the base cost for the donor. The donor must be an individual, and the shares must be unlisted or the donor must have an interest of 5 per cent. or more at the time of transfer.13 If the gift is from one spouse to another, the recipient will automatically be deemed to inherit the original acquisition cost of the other spouse.

If the trustees of a non-statutory employee trust gift shares to an employee in circumstances where the employee pays income tax on their value, HM Revenue & Customs will, by extra-statutory concession and subject to certain conditions, relieve the trustees of liability to capital gains tax on the same shares. The recipient must have a direct or indirect interest, with or without associates, of not more than 5 per cent. in the ordinary share capital.

Capital gains tax

Where capital gains tax applies to benefits from a share scheme, the rate is 18 per cent. on all gains.

The amount of gain subject to capital gains tax is reduced by the personal capital gains tax exemption of £9,600 per year (2008/09 tax year).14 To the extent that this allowance has not already been utilised, gains on the sale of shares acquired through an employee share scheme will be free of tax up to that limit. If sales are spread over several tax years multiple personal exemptions can be utilised.

This exemption is available to each partner in a marriage or civil partnership, and transfers between spouses or civil partners, if permitted by the articles of association, are tax free. Prior to sale of shares acquired, therefore, one spouse or civil partner could transfer sufficient shares to the other so that his/her capital gains tax exemption is also utilised.

Shares acquired through an SAYE Option Scheme or a Share Incentive Plan can be transferred directly to an Individual Savings Account (ISA) up to the annual ISA limit. If this is done within 90 days of acquisition of the shares, they can subsequently be sold free of tax. This opportunity is not available for shares acquired through the CSOP Scheme or Enterprise Management Incentive.

Capital gains tax is normally calculated via self-assessment. If an employee wishes to have an advance estimate of the tax that will become payable, application for a "post-transaction check" can be made to HM Revenue & Customs Shares and Assets Valuation, using form CG34.

Entrepreneurs' relief

This limited relief is available to individuals from 6th April 2008 on disposals of shares or securities in a trading company 15 if the individual has for at least one year:

been an officer, including a non-executive director,or employee of the company or of a company in the same group of companies; and
owned at least 5 per cent of the ordinary voting share capital of the company.16
The disposal of any proportion of a business, whether more or less than 5 per cent., will qualify as long as the above criteria are met.

The relief, which is not given automatically and must be claimed, reduces the effective rate of capital gains tax to 10 per cent.17 Claims can be made on any number of occasions. The relief is limited to total gains of up to £1 million; this is a life-time limit. Losses on qualifying disposals can be deducted.

The 5 per cent. holding requirement means that entrepreneurs' relief is not available to most participants in employee share schemes. However, it may be of help to founder shareholders who wish to sell shares for the purposes of a share scheme, perhaps through an employee trust.

If a trading company holds non-trading assets, relief can still be claimed. It can also be claimed in respect of associated disposals, so that if for example a person owns both a business and the premises from which it trades, and sells both at the same time, the relief is available on the disposal proceeds of both.18 However, to qualify for relief, all or part of the business itself must be disposed of. A sale of an asset by a continuing business will not qualify.

Trustees can qualify for entrepreneurs' relief in certain circumstances, but if the beneficiary claims relief in his own right, the total gains on which relief is available to the trustees and beneficiary together cannot exceed £1 million.

Where securities are exchanged for other securities a taxpayer can often make an election under general tax rules to roll-over the capital gain into the new securities and pay the tax when the new securities are sold. However, entrepreneurs' relief will generally be available only in respect of the gains existing at the date of exchange, unless the individual qualifies separately in relation to the replacement securities. If he or she does not, and the shares are rolled over, the entrepreneur's relief will be lost. The taxpayer can avoid this result by electing to crystallise the tax liability at the point of exchange.

Sale by instalments

Once an employee has acquired shares, and paid any income tax due on the acquisition, subsequent gains will normally be subject to capital gains tax.19 The gain will be the sale proceeds less the acquisition price which, in the case of a share purchase will be the price paid; for a share option the exercise price; or, in the case of a Share Incentive Plan, the market value of the shares at the time they came out of trust.20 In a private company, the sale will often take place at a time when the company itself is being sold or floated. If the company is being sold, it is common for the purchase consideration to be payable by instalments, with payment being dependent perhaps on the results achieved by the company following sale.

The capital gains tax treatment will depend on whether the gains are "ascertainable" or "non-ascertainable." An ascertainable gain is one whose amount is known or can be calculated by reference to facts which are known at the date of sale. A gain is also ascertainable if the amount is known but the payment is contingent on some event, such as the achievement of a profit target. A gain is not ascertainable if the amount cannot be determined and this will apply whether or not the payment is contingent on some event. So a gain would be non-ascertainable if the amount is proportional to the profits achieved in a particular year, since the precise amount of these profits cannot be known in advance.

Where the instalments are ascertainable, the whole amount of tax is normally payable by reference to the date of the original transaction. However, if the payments stretch over 18 months or more, and at least one instalment falls due after the tax on the transaction would become payable, it is possible to apply for the tax to be paid by instalments. If the instalments are ascertainable but contingent, and one or more of the instalments are not paid, a claim can be made for the discharge or repayment of the relevant tax.

Where the gain is not ascertainable, the right to receive payments is regarded as a security in its own right. The value of that "security" is negotiated with HM Revenue & Customs and taxed by reference to the date of disposal. There is no right to apply for the tax to be paid by instalments since the taxpayer is deemed to have received the whole security at the date of disposal. When instalments are received, the value of the remaining right is computed. Gains or losses are then estimated on a cumulative basis and tax paid by reference to each occasion on which an instalment is received.

When the final payment is received, there will normally be a difference between the total payment and the value originally attributed to the "security". If there is a gain, additional tax will be, or will have been payable. If there is a capital loss, this cannot be set against income and normally can be offset only against any gains in the current or subsequent years. This will be of little comfort to a taxpayer with no other gains for that year. However, subject to complex rules, the taxpayer can elect to carry back capital losses on non-ascertainable deferred consideration and set them against the gains taxed on the original disposal.21 In this way, the seller can hope finally to obtain a fair result.

PAYE and NICs

Generally, if an employee receives benefits in the form of shares that are subject to income tax and are readily convertible assets (see below) then the benefit will be treated as if it were cash remuneration and subject to PAYE and national insurance contributions ("NICs"). Income tax on equity benefits where the shares are not readily convertible assets are normally dealt with after the year end.

Employees pay employee national insurance contributions at 11 per cent. if the amount of benefit, together with their other income, is less than £40,040 per year and at an incremental rate of 1 per cent. in relation to taxable income above this figure. Employer NICs (also known as secondary contributions) are charged at a flat 12.8 per cent. (rates for 2008/09).22

Shares are readily convertible assets if, broadly, they can be traded on any public market or if "trading arrangements" are in place. Trading arrangements could include the operation of an internal market by an employee benefit trust, or arrangements made by a company to buy back shares from employees for cash on a pre-agreed formula. The authorities will deem trading arrangements to exist where active steps have been taken to set up the arrangements, even if they are not yet in place. HM Revenue & Customs has ruled that if a company undertakes, or has a firm intention to undertake, a members' voluntary liquidation which will result in a return of cash to shareholders, this will cause the shares to become "readily convertible".

Shares are also deemed "readily convertible" if their value to employees is not available as a deduction from taxable profit. This will apply if the shares were not acquired by an individual by reason of employment or if the company is:

not independent or not the subsidiary of a non-close listed company; or
not within the charge to corporation tax; or
not the employing company or, broadly, its parent company.

The purpose of these rules seems to be to prevent unlisted companies obtaining a tax advantage by offering shares in a subsidiary, offshore or unrelated company, the values of which might be manipulated.

PAYE is due on some share related benefits even if the shares concerned were not previously "readily convertible". If the shares are in fact sold for cash or other assets that are readily convertible, then the shares themselves are deemed to have become readily convertible. The same applies if the rights or benefits attaching to shares are enhanced, for example by conversion, and the employee receives cash or readily convertible assets in relation to that enhancement.

If an employment related security, such as an option, is exercised in circumstances where PAYE arises, this must be accounted for and paid according to strict regulations.

NIC elections

Contributions paid by the employer, known as secondary national insurance contributions, may result in a significant cash cost to the company. NIC liabilities can arise with statutory as well as non-statutory schemes, for example on a share option exercise outside the rules of the scheme or where either the grantor or recipient of share rights under a statutory scheme cease to qualify for tax advantages and/or NIC exemption. For details of how this may occur in the various statutory schemes, see the relevant sections of this Guide. The potential liability is a particular problem for smaller, rapidly growing companies since they may require all their cash and more to finance their growth.

To alleviate this problem, regulations have been introduced which in certain circumstances permit the employer and employee jointly to elect that any liability for employer NICs will be met by the employee.23 An indemnity can be given in respect of share options, conditional LTIPs, restricted securities, convertible securities and cash payments made to give up the rights to any of the foregoing.24 Accordingly an indemnity cannot be given in respect of the unconditional acquisition of unrestricted and non-convertible shares.25

At its simplest, the election can form part of the agreement creating the share incentive. In this case the participant agrees that as a condition of being able to realise any gains, he or she will indemnify the employer against the NICs. However, such an agreement does not transfer the legal liability from the employer to the employee. Some companies, and US companies in particular, insist on a transfer of legal liability so that in the event of default, HM Revenue & Customs must pursue the employee. This is permitted under UK law but an election transferring legal liability will normally be entered into as a separate deed and must be approved by HM Revenue & Customs before it can take effect. From 6th April 2007 a revised form of election must be used, which excludes liability to retrospective NICs arising from certain anti-avoidance legislation. Existing elections are however unaffected.

Where an election is made, the additional tax payable by the employee can be deducted from his or her taxable income, resulting in a net charge of 7.68 per cent. on the employee, assuming the employee pays 40 per cent. income tax and is not contracted out for state pension purposes (2008/09 rates).

Internationally mobile employees

An employee may be granted an option while resident and ordinarily resident in the UK but later exercise the option while abroad. This will be subject to UK tax, with adjustment for any double tax arrangements that may exist with the country where the gain was taken.

Alternatively, an employee who is not domiciled or not ordinarily resident in the UK may receive share benefits overseas in relation to duties performed overseas. Such persons can elect to be taxed on their world wide income, in which case the amounts will be subject to UK tax in the normal way, or on the remittance basis, such that tax is paid only on income and gains remitted to the UK.

From 6th April 2008 most individuals who choose the remittance basis must pay an additional tax charge of £30,000 in relation to the unremitted amounts.26 It can be assumed that most participants in employee share schemes will not choose the remittance basis and will therefore pay UK tax on all their income and gains, subject to double taxation provisions.

Where employees choose the remittance basis, income and gains arising overseas are apportioned and amounts arising in respect of overseas duties are taxed only when remitted to the UK. It should be noted however that if the securities giving rise to the overseas income and gains are issued by a UK company, they are automatically deemed to be remitted to the UK for tax purposes and will therefore be subject to UK tax in the normal way.27

If apportionment is applied it is done on a straight line basis using the number of working days in the period 28 and the end of the apportionment period will be the date of vesting, rather than exercise, of the right in question. Certain restrictions, for example on the ability to sell shares following the vesting of an award, are ignored for the purposes of calculating the apportionment period.

Special rules apply to taxable amounts arising on share options and other rights to acquire securities granted before 6th April 2008 to persons who are either not domiciled in the UK or not ordinarily resident. The securities are treated as being acquired at less than market value and a notional loan is deemed to be created in respect of the undervalue from the grantor to the employee. This amount is then taxed when the securities are disposed of. This treatment is similar to a deferred purchase plan. Rights granted on or after 6th April 2008 are subject to the normal UK tax rules.

Double tax agreements normally deal with any overlap in the tax rules of different jurisdictions. Where an employee has paid tax in a country where there is no double tax agreement, HM Revenue & Customs will normally give unilateral relief against UK income tax in relation to the foreign tax paid.

Generally, the above rules apply to all gains in the tax year of departure from, or arrival in the UK, whether or not the individual was present in the UK at the time. Accordingly a gain realised in the tax year of departure would be subject to capital gains tax even if the individual never returned, though such tax might in practice never be collected. However, by extra statutory concession, if the individual was not resident in the UK for the whole of at least four out of the seven tax years immediately preceding the tax year of departure, the tax year is split so that no tax accrues on disposals following the actual date of departure. Similarly, if the employee has been non-resident in the UK for at least five tax years prior to arrival, only gains after the actual date of arrival will be subject to capital gains tax.

The above summary in relation to internationally mobile employees is only a general guide. Individual circumstances can vary considerably and professional advice should always be taken.

Stamp duty

When issued shares are transferred from one holder to another, stamp duty is normally payable by the acquiror at the rate of ½ per cent. on the amount of consideration, rounded up to the nearest £5. Transactions where the consideration is £1,000 or less are exempt.29 Duty is also payable if a share option is released in exchange for a consideration. If the consideration is deferred or payable in stages, perhaps contingent on certain conditions being satisfied, stamp duty is normally payable on the whole consideration at the outset. If all the payments are not in fact made, there is no provision for the recovery of the excess stamp duty. Exceptionally, if the amounts of deferred consideration cannot be estimated at the outset, it may be possible to pay stamp duty on each instalment of consideration when it is actually made.

Duty is therefore payable by employees on exercise of an option, whether statutory or non-statutory, if the shares acquired are already in issue but not if they are new shares issued by the company. Duty is also payable by employee benefit trusts when acquiring shares from existing shareholders. A special relief 30 prevents double duty on Partnership Shares or Dividend Shares acquired by employees from the trustees of a Share Incentive Plan.

Where there is no consideration, for example where the trustees make a free gift of shares to employees, no stamp duty is payable. No duty is payable on the acquisition of new shares issued by a company. Deeds establishing employee trusts are not normally subject to stamp duty as long as the trust contains no assets other than cash at the time of execution.

Corporation tax

Where an employee makes a profit from participation in a share scheme, this may be available as a deduction against the employer's profits for corporation tax purposes. This mirrors the treatment of salaries or cash bonuses, where employers can set the cost against taxable profits.

The precise nature of any such relief will depend on the nature of the scheme:

Share Incentive Plan: In general the value of shares acquired by the trustees of the Plan is available as a deduction against the employer's taxable profit in the tax year(s) that the shares are appropriated to employees. Share values are taken at the date of acquisition by the trustees.
Share option schemes: relief is available for statutory and non-statutory schemes in the tax year that exercise takes place on the difference between the price paid to exercise the option and the fair value of the relevant shares at the date of exercise.31
Acquisition of securities: Where employees acquire securities directly or through a Deferred Purchase Plan or Joint Ownership Plan, corporation tax relief may be available in respect of the year of award. However this will be limited to the amount, if any, by which the price paid for the securities, including any deferred amounts in the case of the Deferred Purchase Plan, represented a discount to fair market value at the date of award. No relief is available on any subsequent capital gains.

In order to qualify for corporation tax relief on the exercise of an option or the acquisition of securities, the following conditions must also be met:

the company whose shares are acquired is independent or is under the control of a listed company;32

the shares are not redeemable;
the shares are those of the employing company, its parent or, in general terms, a member of an owning consortium;
the employing company is within the charge to corporation tax;33 and
the recipient pays income tax and national insurance contributions on the benefit or would do so were it not for the fact that the scheme is a statutory scheme or the person is non-resident.

Care is needed in takeover situations if there are outstanding options in the company being acquired and the acquiror is unlisted. Any such options should be exercised at or before the time that the acquisition completes otherwise the options will be no longer be eligible for corporation tax relief. However, if the grantor of the options was an employee benefit trust, it may still be possible to claim relief.

If the shares concerned are subject to forfeiture, then corporation tax relief will be available to the extent that an income tax charge arises on the individual by virtue of the risk of forfeiture being lifted.

Companies must also report a separate accounting cost for most employee share incentives. This may or may not be the same as the available tax relief. If the company adopts International Accounting Standards 34 then IAS 12 requires that if the amount of profit on which tax relief is available exceeds the amount arrived at by the prescribed accounting techniques, only the lower amount may be reported.

Transfer pricing

The Taxes Acts require that groups of companies should account accurately for the costs of goods and services provided by one group company to another. The legislation was originally designed with the main purpose of preventing UK companies from transferring profits into low tax jurisdictions by means of artificial intra-group transactions.

In a group of companies, the parent or another group company may decide to offer share incentives to employees of one or more other group companies. This is likely to involve a transfer of value from the company establishing the scheme to one or more other companies whose employees are participating in the scheme. Normally, if all the companies in a group are within the UK, intra-group transactions will cancel each other out in terms of the group liability to corporation tax.

Guidance issued by HM Revenue & Customs in 2003 stated that the value of services provided by the company offering the scheme should include the value of the share options or other equity instruments. The value of the instruments should be estimated by means of an option pricing model. Where for example a parent company operated an employee share scheme for the benefit of employees of a subsidiary, the subsidiary would be deemed to make a taxable payment to the parent company. Since the valuation of share benefits under FRS 20 and IAS 2 is different to the valuation of these benefits for corporation tax purposes, it was quite possible for the deemed taxable payment to exceed the eventual value of the benefit on which corporation tax was claimed.35

This guidance still applies to accounting periods beginning before 1st January 2005 but in August 2005 HM Revenue & Customs issued revised guidance for later accounting periods. In summary, parent companies and/or subsidiaries are no longer required to account for transfer pricing in respect of the value of the equity instruments but must still account for the value of the services provided in establishing and administering the employee scheme. HM Revenue & Customs has indicated that it will use the tax arbitrage provisions of the Finance Act 2005 to negate any tax advantage arising from manipulation or misuse of the above rules.

This applies also to office holders, such as non-executive directors, and to benefits passing to persons connected with employees or office holders in circumstances where the benefit arises by virtue of the employment or office.»
If a person A provides services to company B through a personal services company C, and either A or C receives equity based rewards, income tax is payable. This also applies if A receives equity based rewards while employed by company D which is connected with B ("connected" is defined, broadly, by reference to family relationship or common ownership).»
Assuming that the gift is by reason of employment, which is the normal case. Gifts of shares between individuals for other reasons (for example family relationships) are treated differently.»
On any occasion when income tax is due on the release of a restriction, credit is given for tax paid in relation to any previous chargeable events. »
An automatic election under s 431(1) is deemed to be made when an employee acquires shares under any of the government sponsored schemes, namely the Enterprise Management Incentive, SAYE Option Scheme, Share Incentive Plan or CSOP Scheme, provided that the shares are acquired in circumstances where no tax arises. This would exclude, for example, EMI options granted with an exercise price less than fair market value at grant.»
If there are more than a few employees a two-part form can be completed which the employer needs to sign only once in respect of all the employees.»
HM Revenue & Customs accepts that making a section 431(1) election does not of itself imply that the fair value of the shares differs from the unrestricted value.»
Elections are also available under section 431(2), to disapply the value of specified restrictions for tax purposes, and section 430, to switch to the unrestricted share value for tax purposes following a chargeable event. The 14-day rule applies to these also.»
There is an exemption either where all the shares of a class convert at the same time, there is no avoidance motive and the company is employee controlled (through holdings of that class) or a majority of the share class are not employment-related securities.»
There appears to be no recognition of the intrinsic value that an individual may bring to a joint investment situation, for example in terms of client relationships or intellectual property rights.»
The legislation provides that if this treatment applies there will be an automatic s 431(1) election although it is also possible to opt out of this election.»
But see The Share Incentive Plan.»
Alternatively, the donor can be the trustees of a trust and either the shares must be unlisted or the trustees must have an interest of 25 per cent. or more.»
Trustees of discretionary employee trusts, including Share Incentive Plan trusts, have an annual exempt amount (£4,800 in 2008/09) equal to half the personal rate.»
The term "trading" includes professions and vocations, but not property letting (other than furnished holiday letting). As well as companies, the relief is available on sales of unincorporated businesses including partnerships. If a business is simply discontinued but the assets are later sold, the relief is available on the disposal of the assets for a period of up to 3 years from cessation of the business.»
The disposal of any proportion of a business - whether more or less than 5 per cent. - will qualify as long as the 5 per cent. ownership and involvement criteria are met.»
The relief operates by reducing the capital gains tax payable by 4/9ths and must be claimed on or before the first anniversary of the 31st January following the relevant tax year.»
This also applies to members of partnerships who make associated disposals. However in all cases the relief is restricted if the asset in question was used for non-business purposes at some time during its ownership.»
However if the gains have been created artificially for tax-avoidance reasons then, broadly, they will be subject to income tax.»
Irrespective of whether income tax was paid on all or part of their value at that time.»
The complexity arises from potential interactions with a number of other available reliefs, such as those relating to the Enterprise Investment Scheme and Venture Capital Trusts, and for situations involving multiple gains and losses. These matters are beyond the scope of this Guide.»
The rate is 9.1 per cent. if the employee is contracted out in relation to a salary related scheme or 11.4 per cent. if contracted out in relation to a money purchase scheme (2008/09 rates). »
The regulations are contained in the Child Support, Pensions and Social Security Act 2000 and the Finance Act 2000, as amended. »
It appears that the indemnity can be entered into after the grant of a non-statutory option as long as the indemnity is signed before exercise.»
It follows that if a section 431 election is signed on the acquisition of shares, an NIC election cannot be signed in relation to the same shares since, from a tax point of view, the shares are unrestricted.»
They will also lose their personal tax-free allowances for income tax and capital gains tax.»
At the time of writing we understand that concessions to this rule are being considered.»
Normally based on 260 working days per year. At the time of writing HMRC has indicated that it may change this method of apportionment.»
For paperless transactions Stamp Duty Reserve Tax is payable but in this case the charge is not rounded up to the nearest £5.»
This relief applies when trustees purchase shares for subsequent appropriation as Partnership Shares. When the shares are purchased by employees, no second charge to stamp duty arises.»
In an unquoted company fair value is negotiated with HM Revenue & Customs. Any price paid to receive an option is added to the exercise price for the purposes of this calculation.»
"Listed" in this context includes overseas exchanges "recognised" by HM Revenue & Customs. However shares in a subsidiary of a listed company that is close or would be close if it were in the UK, will not qualify for relief.»
Therefore options exercised by employees of an overseas subsidiary of a UK parent company will not generate relief. »
Mandatory for UK listed companies for accounting periods beginning on or after 1st January 2005 and for AIM quoted companies, on or after 1st January 2007.»
In some circumstances, FRS 20 allows post-grant adjustments.»

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