Very basically, any employees or directors (including non-executive directors) of a company may be subject to employment income tax charges in respect of any equity interest they acquire or hold in the company. These charges may be collected via PAYE and be subject to NICs, and so it is often an issue for the employer company as well as the employee in question.
As a general rule of thumb, any interest in shares provided to employees at an undervalue will be taxed. This usually applies when the employee acquires the shares for less than their full market value, but can also apply when, for example, value is shifted into an employee’s shares (e.g. by amending the share rights in the company’s Articles). It usually means that options to acquire shares are generally not a tax efficient way of providing equity to employees (subject to certain government approved schemes - see “How can a company incentivise employees though equity in a tax efficient way?”) because when they are exercised the value at the date of exercise (often just before a sale, when value is likely to be high) is generally subject to income tax.
It is worth noting that a company’s idea of “full market value” for its shares can on occasion be different to HMRC’s idea of that value. If you are taking the view that the market value of the shares is zero, or very low, and therefore are hoping to avoid tax risks, then you should be careful to ensure that this is a reasonable position to take and ideally should take professional advice to back up this view.
Another common risk is under the ‘restricted securities’ rules which require an assessment to be made of a share’s ‘actual market value’ or ‘AMV’ and ‘unrestricted market value’ or ‘UMV’. The UMV is the value of the shares without any ‘restrictions’. Restrictions include potential forfeiture and restrictions on transfer. Most company Articles contain some form of restrictions and there is usually some difference between the AMV and UMV of a particular share.
A proportion of the value of a share can become taxable when certain events occur (usually a sale) based on the proportionate difference between AMV and UMV when the shares were acquired. For example, if AMV is £2 and UMV is £4 on acquisition, half of the value on sale will be subject to income tax (so if a share was being sold for £1,000 in future, £500 of that value would be subject to income tax).
The growth in value of shares is protected from these future income tax charges if an election is made by the employee and employer company within 14 days of acquiring the shares (commonly referred to as a ‘section 431 election’). The effect of the election is that the difference between AMV and UMV is subject to income tax at the date of acquisition (when the value is likely to be lower) rather than on any subsequent sale – so, using the example above, income tax would be due on £2 at the time of acquisition, rather than income tax being due on £500 on the future sale.
When any employee/director (or person connected with an employee) acquires shares it is nearly always best to sign a 431 election to avoid potentially significant later tax charges. A sample 431 election can be found here.