Shares issued to an employee or director look like a simple transaction and are not. Two failures cause almost all the damage: no section 431 election within 14 days, and no annual return. Both are usually discovered years later, during a sale, when nothing can be done about either.
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The Quietest Large Exposure in an Owner-Managed Business
Shares given or sold cheaply to an employee or director are employment-related securities. That single classification brings a share transaction inside Part 7 of the Income Tax (Earnings and Pensions) Act 2003, with consequences that are frequently discovered years later during a due diligence exercise or an HMRC enquiry.
The exposure is quiet because nothing obviously goes wrong at the time. Shares are issued, the company continues, and the problem surfaces when the company is sold and the buyer’s advisers ask two questions: was a section 431 election made, and were the annual returns filed?
1. No section 431 election. The employee pays income tax on growth in value that they expected to be taxed as a capital gain, potentially at a much higher rate, with PAYE and National Insurance falling on the employer.
2. No annual return. Automatic penalties, and for tax-advantaged schemes, potential loss of the tax advantages altogether.
What Counts as Employment-Related
Securities are employment-related where the right or opportunity to acquire them is available by reason of an employment. The definition is deliberately wide, and there are two points advisers routinely get wrong:
- It catches directors as well as employees, including in small owner-managed companies.
- The family relationship exemption is narrow. Shares acquired from a family member are outside the regime only in limited circumstances. A transfer from parent to child who works in the business is frequently employment-related notwithstanding the family connection, and this is a very common misunderstanding in succession planning.
Section 431 Elections
Most shares in a private company are restricted securities. Articles typically contain pre-emption rights, compulsory transfer provisions on leaving, good leaver and bad leaver terms, or drag and tag arrangements. Any of those can be a restriction.
What happens without an election
Where restricted securities are acquired and no election is made, the charge on acquisition is calculated by reference to the restricted value. That produces a lower charge at the outset, which is why it appears attractive, but it leaves the growth in value within the employment income regime. On a subsequent chargeable event, typically the sale of the company, part of the gain is taxed as employment income with PAYE and National Insurance rather than as a capital gain.
What the election does
A joint election by employer and employee under section 431 disapplies the restricted securities rules, so that the acquisition is taxed by reference to the unrestricted market value. The employee accepts a higher charge now, and takes all subsequent growth outside the employment income regime.
The practical discipline
- Make the election on every acquisition of shares by an employee or director, unless there is a specific and documented reason not to.
- Sign it at completion, as part of the share issue paperwork, rather than as a follow-up action.
- Retain the signed election. It is not filed with HMRC, so the company’s own record is the only evidence it was made.
- Where an EMI option is exercised, check the position on the specific facts rather than assuming an election is unnecessary.
Annual Returns and Registration
A company that has a reportable event must register the scheme or arrangement online and file an annual return by 6 July following the end of the tax year. The obligation applies to non-tax-advantaged arrangements as well as to EMI, CSOP, SAYE and SIP.
Reportable events are broader than most companies expect and include acquisitions of employment-related securities, option grants and exercises, chargeable events on restricted securities, and various other transactions.
Penalties
- An initial automatic penalty for a late return, with further penalties as the delay continues, and a daily penalty for prolonged failure.
- Penalties for a materially inaccurate return, where the inaccuracy is careless or deliberate.
- Nil returns are still required once a scheme is registered. Companies routinely register, have no activity, and accrue penalties for failing to file nothing.
Valuation
Everything above depends on a value. For unquoted shares that value is a matter of judgment, and it is the point on which HMRC most often disagrees.
- Minority discounts are frequently claimed and frequently overstated.
- Restricted and unrestricted values are different figures and both may be needed.
- A valuation agreed for EMI purposes is agreed for a limited period and for that purpose. It is not a general agreement of value.
- Contemporaneous evidence matters. A valuation prepared at the time, on a stated basis, is far more defensible than one reconstructed during an enquiry.
If HMRC Opens an Enquiry
- Establish whether the securities were employment-related at all. This is the threshold question and it is not always answered correctly, particularly on family transfers.
- Locate the elections. Signed section 431 elections, dated within 14 days. If they exist, much of the exposure disappears.
- Reconstruct the reportable events and the filing history for each year.
- Test the valuation and the basis on which it was prepared.
- Separate the company’s exposure from the individual’s. PAYE and employer National Insurance fall on the company; the income tax charge is the individual’s. Their interests may diverge.
- Fight the behaviour category. A failure to make an election that nobody advised on is not a deliberate inaccuracy. Under HMRC v Tooth that requires knowledge of the error and an intention that HMRC rely on it.
- Consider the adviser’s position. A missed section 431 election on a transaction the adviser handled is a classic professional negligence claim, and the limitation position needs checking early: see our resource on professional negligence.
Frequently Asked Questions
What is a section 431 election and why does it matter?
A joint election by employer and employee disapplying the restricted securities rules, so that shares are taxed on acquisition by reference to their unrestricted market value. Without it, growth in value stays inside the employment income regime, and on a later chargeable event, usually the sale of the company, part of the gain is taxed as employment income with PAYE and National Insurance instead of as a capital gain.
Can a late section 431 election be fixed?
No. The election must be made within 14 days of the acquisition. There is no extension, no reasonable excuse and no retrospective remedy. A company that discovers the omission during a sale process has no fix available. The buyer will price the exposure or require an indemnity.
Are shares given to a family member employment-related?
Often yes, and this is one of the most common misunderstandings in succession planning. Securities are employment-related where the right or opportunity to acquire them is available by reason of an employment, and the family relationship exemption is narrow. A transfer from parent to child who works in the business is frequently caught notwithstanding the family connection.
We registered a share scheme but had no activity. Do we still file?
Yes. Once a scheme or arrangement is registered, a return is required for each tax year by 6 July following the end of the year, including a nil return where there has been no reportable event. Companies routinely register, have no activity, and accrue automatic penalties for failing to file nothing.
What is the biggest risk with EMI options?
Late notification of the grant to HMRC. That is a larger exposure than a filing penalty, because it can cost the tax advantages of the option entirely. There is a limited reasonable excuse route, but it should not be relied on as a plan. Valuation is the second risk: an agreement reached for EMI purposes is agreed for a limited period and for that purpose, not as a general agreement of value.