How free are ‘free’ shares really? considers Danielle Saul, BA (Hons) Cantab, ATT, ATII, a Tax Tutor with BPP Taxation Courses. The article was published in the November 2002 issue of Tax Adviser.
- Shares awarded at below market value can have hidden income tax implications
- Three different charges can arise under the Unapproved Employee Share Schemes legislation
- Separate rules govern the issue of partly paid shares issued to employees
There are many ways for an employee to hold shares in their employer company. They could obtain them by way of an approved share scheme, such as the Enterprise Management Incentive scheme or the (newly re-branded) Share Incentive Plan, or an unapproved option scheme. They could even go out into the open market and buy the shares. None of these choices is within the scope of this article, which instead focuses on shares awarded to Directors and employees directly, and primarily on those awarded at below market value – usually for ‘free’.
Such awards of shares are interesting because there are often hidden income tax implications which are not only important for tax advisers to be aware of, but also those students taking their ATII exams (especially those on the Corporate Specialist route) – and of course employee shareholders reading this article.
The initial tax charge
What is the immediate implication of making a free (or below market value) award of shares to an employee?
It may be obvious, but to spell it out – there is no such thing as ‘free’ when you are an employee obtaining anything from your employer. There are, of course, a limited number of ‘tax-free benefits’ – but shares are not one of them. Therefore, on the award of free shares there is an immediate charge to Sch. E under the normal charging provision, Income and Corporation Taxes Act 1988 (ICTA 1988), s. 19. The tax will be charged on the market value of the shares (less anything paid for the shares) – easy if they are shares in a quoted company, not so easy for unquoted company shares; Shares Valuation Division (SVD) need to be involved, which can be a lengthy process. The amount on which tax is charged will form the basis for the base cost of the shares for computing the gain on the eventual sale of those shares for capital gains tax (CGT) purposes.
What may not be obvious, however, is that the income tax charges do not necessarily end there.
‘Increase in value’ charges
The Revenue realised long ago that some employers were awarding their employees with shares that in some way increased in value only after having been acquired by the employee. This increase clearly could not fall within the initial ICTA 1988, s19 charge and so the Unapproved Employee Share Schemes legislation was introduced, Finance Act 1988 (FA 1988), s. 77-89, to ensure that any increase could not escape taxation. These charges therefore arise subsequent to the initial acquisition of shares, and can do so whether or not there has been an initial Sch. E charge. It should be noted that share options are completely outside the scope of the provisions of FA 1988, as are employments that are not chargeable under Sch. E Case I (i.e. broadly only United Kingdom (UK) resident and ordinarily resident employees and directors are caught.)
There are three different charges that can arise under the legislation.
The ‘post-acquisition’ charge – FA 1988, s. 78
In some cases, shares are issued with restrictions applying that are either removed or varied at some point in the future. Clearly, the existence of such restrictions depresses the value of the shares at issue, and consequently only a very low value is initially assessable under ICTA 1988, s. 19. Section 78 therefore levies a charge, at the date the restrictions are lifted, based on the increase in value to that date.
Section 78 also applies where rights are created or varied. An example, as envisaged by the Revenue in their Share Schemes Manual (SSM Ch. 5), is where a company issues shares to its employees, which have either no or limited voting rights, but which are at a later date awarded full voting rights. The increase in the value of the shares, as a consequence of the new or enhanced rights, is chargeable under ICTA 1988, s. 78.
The provisions can also bite where restrictions or rights of a different class of shares in the same company are removed or varied. Again, to use the Revenue’s own example: say employees of a company acquire ‘A’ shares, whilst third parties hold the ‘B’ shares, and these B shares are later made subject to a restriction (such as their voting rights cannot be exercised for a period of five years.) This enhances the degree of control of the A shareholders and hence the value of the A shares; a charge under s. 78 applies based on the increase in value.
For the charge to apply the shareholder must have been an employee or director in the seven years prior to the relevant chargeable event and the shares must be issued in a company that is an independent company at the time of the chargeable event. If it is a ‘dependent’ company at that time then s.79 applies instead (see below).
It should be noted that there could be more than one charge if there are successive chargeable events.
The ‘growth in value’ charge – FA 1988, s. 79
Where shares are issued in a ‘dependent subsidiary’ there will be an income tax charge on any growth in value of the shares either seven years from the date of acquisition of the shares or on the sale of the shares, if earlier.
A dependent subsidiary is, broadly, a 51 per cent subsidiary company that transacts all, or a substantial amount of, its business with other group companies.
Where a previously independent subsidiary becomes ‘dependent’ the tax charge occurs on the earlier of:
- seven years from the date of becoming a dependent subsidiary;
- the date that the shares are sold; and
- the company ceasing to be a dependent subsidiary.
There is a certification procedure which the principal company in the group can follow whereby the directors of that company provide the Revenue with a certificate that, during the relevant period of account:
- all, or substantially all of the company’s business is carried out with non-group companies; and
- that there is either no increase in value in the value of the subsidiary as a result of any intra-group transactions or any such increase does not exceed five per cent of the value of the subsidiary at the beginning of the period of account.
A receipt from the subsidiary company’s auditors addressed to the directors must be attached to the certificate stating that:
- they have enquired into the affairs of the company with regard to (i) and (ii) above; and
- they are not aware of anything to indicate that the opinion stated by the directors in the certificate is unreasonable.
This certification procedure must be followed every year, which can be a real burden for the parent company, especially where it is a non-UK company.
The ‘special benefits’ charge – FA 1988, s. 80
A special benefit is any ‘perk’ that is not available to at least 90 per cent of shareholders of the same class of shares. Any tax charge arises at the time that the ‘special’ benefit occurs.
An example of a special benefit, as given in the Revenue’s manual, could be where an employee buys shares and there is later a bonus issue offered to that employee, but not to other shareholders. The Sch. E charge will be the market value of the benefit, so if the employee is offered 50 free bonus shares, with a market value of £3 per share, the ‘special’ benefit would be £150.
The reason this charge is not often seen in practice is that other employee taxation provisions usually catch such benefits (for example the benefit in kind provisions.)
All companies must notify the Revenue of an award of shares to an employee within 92 days of the end of the fiscal year in which the shares are awarded.
If a charge does arise under the FA 1988 provisions, particulars of the charge need to be provided to the Revenue within 60 days.
Shares subject to the risk of forfeiture – ICTA 1988, s. 140A
Finance Act 1998 introduced a further tax charge in respect of shares issued to Sch. E Case I employees on or after 17 March 1998, which are either subject to the risk of forfeiture (‘only conditional’ shares) or are ‘convertible’.
‘Only conditional’ shares
Where shares are issued which will be forfeited if performance targets are not met or which are convertible into another class of share, there will be a tax charge, unless it can be shown that the shares are not ‘only conditional’.
Shares will not be 'only conditional' if either:
- the shares are issued partly paid and the risk of forfeiture relates to non-payment of the outstanding call; or
- the articles (or foreign equivalent) of the company require the shareholder to offer their shares if they cease to be a Director or employee of the company - if any other document contains this provision, the shares will be considered 'only conditional'; or
- any document provides that the shares are offered on the cessation of employment/office in the event of ‘misconduct’ (so watch out for good leaver/bad leaver provisions in transaction documentation); or
- the shareholder can obtain open market value or an equivalent amount on forfeiture.
If the shares are considered to be ‘only conditional’ and the risk of forfeiture lasts for less than five years (i.e. they cease to be ‘only conditional’ within five years), there is no tax charge on the issue of the shares (other than those charges applicable to partly paid shares (see below) or the unapproved share option schemes).
The tax charge occurs on the earlier of the risk of forfeiture being lifted or the shares being sold and is based on the market value of the shares less any amounts paid for the shares less any tax paid on acquisition and/or under s. 78 and 79 above.
If the risk of forfeiture lasts for more than five years, the normal Sch. E rules apply on the initial award of the shares and there is a further tax charge (calculated as above) when the risk is lifted or the shares are sold, whichever is sooner.
If the shares are actually forfeited, the original s. 19 tax charge is not disturbed, but there will not be a further tax charge.
One of the original provisions of s. 140A provided for an additional tax charge on top the initial s. 19 tax charge where the condition could exist for more than five years. This was fortunately repealed by Finance Act 1999.
If a s. 78 (restricted shares) or s. 79 (dependent subsidiary) charge coincides with a s. 140A (conditional shares) charge, s. 78 and 79 take priority and the full charge is calculated in accordance with that section in the first instance and is available as a deduction when calculating the s. 140A charge, thus eliminating any double taxation. If a charge arises because the shares are ‘only conditional’, this charge can be deducted from any later charge under the dependent subsidiary rules and vice versa.
There will be a tax charge at the date of conversion based on the market value at that date less a deduction for:
- amounts paid for the shares on either acquisition or conversion;
- any tax charge on acquisition;
- amounts charged under s. 78 prior to the conversion; and
- gains taxed from previous conversions.
There will be no charge if the majority of the convertible shares are not held by directors or employees.
The company providing the ‘only conditional’ or convertible shares must provide written details of any event giving rise to a charge to the Revenue within 30 days of the end of the tax year in which the event or conversion took place.
Partly paid shares
There are separate rules that govern the issue of partly paid shares to employees, for example where the price of the shares is settled in instalments. In this case, ICTA 1988, s. 162 operates to treat the amount remaining unpaid as a beneficial loan, and a tax charge is calculated according to the usual beneficial loan rules (so if the amount outstanding is less than £5,000, there is no charge). Any subsequent payment in respect of the shares is treated as a repayment of the loan and the benefit is reduced accordingly.
Section 162 applies to all cases of Sch. E.
Capital gains tax
The amounts charged under the above provisions can be added to the allowable cost when calculating the gain on disposal (Taxation of Chargeable Gains Act (TCGA 1992), s. 38(1).) It should be noted, however, that amounts chargeable under s. 162 in respect of partly paid shares are not allowable costs unless they relate to the write-off of the loan.
So if you or your real-life (or exam-based) client, are offered shares in your employer company, ignore the Unapproved Employee Share Schemes legislation at your peril…
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November 2002 by