Enter Your E-mail

Aidan Langley summarises the elections that are available in relation to restricted securities, and the issues to be taken into account by employers and employees in deciding whether to make them.

The Elections

Section 425 election

A Section 425 election relates to restricted and forfeitable securities, where the risk of forfeiture lasts for less than five years. The default position is that there is no general earnings charge on the acquisition of such securities [ITEPA 2003, s 425(2)].

If a Section 425 election is made, there is a general earnings charge on the restricted value of the securities [ITEPA 2003, s 425(3)].

A Section 425 election must be made jointly by the employer and the employee within 14 days of the acquisition date. Specimen forms can be downloaded from HM Revenue & Customs’ website:

http://www.hmrc.gov.uk/shareschemes/s425-1-pe.rtf for a one-part election and
http://www.hmrc.gov.uk/shareschemes/s425-2-pe.rtf for a two-part election.

Section 430 election

A Section 430 election can be made where there is a chargeable event in relation to restricted securities, but the securities remain restricted afterwards. The default position is that a proportion of the value of the securities is taxable at that time, and the remainder (OP) is taxable later.

OP is the outstanding proportion, i.e. the proportion of the UMV of the securities that is represented by the restrictions immediately after the chargeable event. It is only measured when a chargeable event occurs, but the securities remain restricted after the chargeable event.

It is calculated as (UMV-AMV)/UMV [ITEPA 2003, s 428(5)].

Example

The securities have an unrestricted market value (UMV) of £1,000 immediately following the chargeable event The actual CGT value (AMV) immediately following the chargeable event is only £900 because of the remaining restrictions

OP is 0.1 [(£1,000-£900)/£1,000].

If a Section 430 election is made, the taxable amount is calculated as if OP were zero [ITEPA 2003, s 430(1)]. The effect of this is to charge tax on any proportion of the value that has not already been taxed, and thereby preclude any further charge under the restricted securities provisions in relation to those securities.

A Section 430 election must be made jointly by the employer and the employee within 14 days of the chargeable event. Specimen forms can be downloaded from HM Revenue & Customs’ website at:

http://www.hmrc.gov.uk/shareschemes/s430-1-pe.rtf for a one-part election and http://www.hmrc.gov.uk/shareschemes/s430-2-pe.rtf for a two-part election

Section 431(1) election

A Section 431(1) election can be made at the acquisition date of any restricted securities.

The effect is that all restrictions on the securities are disregarded, so that there is a general earnings charge on the IUMV of the securities, which precludes any further charge under the restricted securities provisions in relation to those securities [ITEPA 2003, s431(1)].

A Section 431(1) election must be made jointly by the employer and the employee within 14 days of the acquisition date. Specimen forms can be downloaded from HM Revenue & Customs’ website at:

http://www.hmrc.gov.uk/shareschemes/s431-1-pe.rtf for a one part election and http://www.hmrc.gov.uk/shareschemes/s431-2-pe.rtf for a two-part election.

There are special forms for use where the shares have been acquired through an EMI option. These are at:

http://www.hmrc.gov.uk/shareschemes/emi_one_part_election_under_section_431_itepa_2003.pdf for the one part election and
http://www.hmrc.gov.uk/shareschemes/emi_two_part_election_under_section_431_itepa_2003.pdf for the two part election.

Section 431(2) election

A Section 431(2) election can be made at the acquisition date of any restricted securities.

The effect is that certain specified restrictions on the securities are disregarded in determining the amount charged to tax as general earnings charge. There may still be a further charge under the restricted securities provisions in relation to those securities, but it will ignore any increase in value as a result of the specified restrictions being lifted [ITEPA 2003, s 431(2)].

A Section 431(2) election must be made jointly by the employer and the employee within 14 days of the acquisition date. Specimen forms can be downloaded from HM Revenue & Customs’ website at:

http://www.hmrc.gov.uk/shareschemes/s431-1-pe.rtf for a one_part election and http://www.hmrc.gov.uk/shareschemes/s431-2-pe.rtf for a two-part election.

Deciding to Make an Election

Employee

In deciding whether to make an election the employee has to take account of the following factors:

• The amount of tax payable immediately as a result of making the election (t).
  
• The cost of funding t for the period before the securities can be disposed of (t multiplied by interest rate i for period p).
  
• The proportion of the IUMV of the securities that would be taxed immediately as a result of the election (v%).
  
• The expected gain on the securities (g).
  
• His marginal rate of capital gains tax (c).
  
• His expected marginal rate of income tax and NIC when the chargeable event occurs (r) - this depends on whether the securities are readily convertible assets and whether the employee pays the secondary NIC.
  
• The amount of tax deferred if the election is not made (t2). Normally t and t2 will be the same, but they could be different if, for example, the securities are not readily convertible assets when the election is made, but will be readily convertible assets when the chargeable event occurs.
  
• The likelihood of a chargeable event occurring (l).

It is worth making an election if: t2l + vlgr > t + tip + vlgc

Example 

Here is a simple example.

Assume that:

• There is certainty that a chargeable event will occur, so l is 1.
  
• The employee’s marginal rate of tax and NIC is and will continue to be 41%, so r is 0.41.
  
• The effect of the first two assumptions is that t and t2l are the same.
  
• The chargeable event will be a sale of the securities after two years with full business asset taper relief, so c is 0.1.
• The election being considered is a Section 431(1) election, so that v is 100%.
  

This resolves to: 0.41g > tip + 0.1g
This can be simplified as 0.31g > tip or g >

Tip

So in this simple example, it will be worth making an election if the expected growth in value of the securities is more than 3.23 times the cost of funding the upfront tax payment.

Employer

The decision for the employer is less complex than for the employee. If the securities are readily convertible assets, then by making the election, the employer crystallises an immediate secondary NIC liability. By not making the election, the employer defers any secondary NIC liability, but the eventual liability may be greater or smaller.

Similarly, if the securities are corporation tax deductible shares and the conditions for relief are fulfilled, then, by making the election, the employer crystallises an immediate corporation tax deduction. By not making the election, the employer defers the deduction, but the eventual deduction may be greater or smaller.

Reporting

The signed election form does not have to be sent to HM Revenue & Customs, but the employer must enter a note on Form 42 stating whether an election has been made and, if so, which election.

About ‘Employee Reward Structures

The above article is adapted from ‘Employee Reward Structures’, published by Spiramus Press Ltd. For further information and to order a copy of this title, click here.