Enterprise Management Incentive (EMI) shares are commonly offered to employees or directors (either executive or non-executive) of limited companies as part of their remuneration package. Whilst EMI share schemes are already designed to be tax-advantageous, there are additional tax planning opportunities to further minimise your tax exposure when it comes to the disposal of the shares. One of the most popular methods is to use a section 431 election. The section 431 election is a legal document that confirms the employee or recipient of the share agrees to certain terms in order to be subject to capital gains tax (CGT) as opposed to income tax and National Insurance when the shares are sold. To understand how this works, why you should consider opting in to sign the section 431 election and what the benefits are, it is first necessary to understand the employment-related security rule.
What is the employment-related security rule?
There are tax laws in place which specifically govern how employees or directors (or even investors who later become directors in the company) should be taxed if they own and sell shares of a company they work for. The employment-related security rule was put in place because HMRC identified that where employees would normally be charged income tax on their salary, if they were to receive shares instead as part of their payment, then they would no longer be subject to income tax but CGT once it came to disposing of the shares.
In the case of EMI shares, employees usually pay for a much lower value of shares than what the shares would be worth to an external investor. This is of course beneficial to them as it allows them to make a greater gain once the shares are disposed of. Not only that, but upon disposal, the employee is subject to paying a 10% CGT rate as opposed to the income tax rates (20% for basic rate taxpayers, 40% for higher rate taxpayers and 45% for additional rate taxpayers). HMRC therefore saw this as an easy opportunity for mass tax avoidance.
To remedy this, HMRC insisted that, where restricted shares are issued, a portion of the gain will be subject to income tax rather than CGT. EMI shares fall under the definition of restricted shares by nature because employees are restricted by conditions of the EMI shares such as when they’re allowed to dispose of them (usually requiring consent from the investor class of shareholders). However, by choosing to use a section 431 election, the employee can agree to waive certain restrictions (including paying for a higher value of shares) in order to ensure that any future disposal of the shares does not fall into the scope of the employment-related security rule.
How do you use a Section 431 election for EMI shares?
When a company issues an EMI share option, there are two possible ways to value the shares for the employee:
- The Actual Market Value (AMV) – what the shares are worth due to the restrictions attached
- The Unrestricted Market Value (UMV) – what the shares would be worth if there were no restrictions (this is always higher than the AMV).
To use the section 431 election, the employee must pay for the UMV of the shares. They then need to sign the section 431 election within 14 days of receiving the shares. As explained above, this is a legal document which confirms that you have paid for the UMV for the shares and therefore want to be taxed as such. The company must then register with HMRC that the election has been made and they need to do this by 6 July in the following tax year in which the election was completed. The actual section 431 election document does not need to be sent to HMRC but should be filed safely by the company and provided to HMRC only if they ask for it.
How does a section 431 election work for EMI shares?
There are three possible ways of how you can be taxed when disposing of EMI shares. Two scenarios involve using a section 431 election that allows you to pay for CGT on the gain as opposed to income tax and national insurance contributions.
- How you’re taxed on EMI shares without a section 431 election
You pay £5.00 as the AMV for your EMI shares when the UMV is £10.00. You do not pay any income tax or national insurance contributions upon receipt of the shares. When you come to dispose of your shares, their value has doubled and are now worth £20.00. The gain made is therefore £15.00. 50% of this amount would be subject to income tax whilst the other 50% would be charged as CGT. This is because you paid 50% less than the UMV and so 50% is subject to income tax. To illustrate further, if you were a higher rate taxpayer, your total tax liability would be £3.75.
- How you’re taxed on EMI shares when you pay the UMV and complete the section 431 election
You pay £10.00 for your EMI shares which is the UMV and sign the section 431 election. You do not pay any income tax or national insurance contributions upon receipt of the shares. When you come to dispose of your shares, their value has doubled and are now worth £20.00. The gain made is therefore £10.00. 100% of the gain would be charged as CGT. If you were a higher rate taxpayer, your total tax liability would be £1.00.
- How you’re taxed on EMI shares when you pay AMV and complete the section 431 election
You pay £5.00 as the AMV for your EMI shares when the UMV is £10.00. You pay income tax on the difference in value where the shares are not readily convertible assets, or you pay income tax and national insurance if they are readily convertible assets. You then complete the section 431 election. When you come to dispose of the shares, their value has doubled and are now worth £20.00. The gain made is £10.00 because although you only paid £5.00 at AMV, you also paid income tax and so would be treated as if you had paid the UMV for the shares. 100% of the gain would be charged as CGT. If you were a higher rate taxpayer, your total tax liability would be £3.00 (this total accounts for the income tax you would have paid on the difference in value between the AMV and UMV).
In both instances where you choose to complete the section 431 election, you essentially decide to pay more upfront either for the cost of the shares, or in taxes, to pay less in tax upon the disposal of the shares. Due to the nature of EMI share option arrangements, the share value has the potential to increase significantly and therefore paying less tax on the gain is preferential. However, it must be noted that share value can of course decrease as well as increase and so careful consideration should be taken before deciding whether or not to proceed with a section 431 election.
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