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For some time now, conversations in the UK have centred around elections, from local council elections to the upcoming general election, and even the US election in November. However, in the world of employment-related securities (ERS), we frequently discuss a different kind of election: the section 431 election. Let’s briefly explore the importance of the section 431 election and its potential impact for employers and employees.

Restricted securities

When an employee acquires shares (or other securities like loan notes) due to their employment, those shares will be employment-related securities (ERS). In privately owned companies, these shares often have restrictions that decrease their market value. These restrictions can include leaver provisions and limitations on the sale of securities. Consequently, such shares are considered restricted securities for ERS purposes.

Acquisition of restricted securities

The restricted securities rules introduce two different concepts of market value: actual market value (AMV) and unrestricted market value (UMV). We calculate the AMV by considering the effect of restrictions on the shares’ market value, while the UMV represents the value of the shares ignoring any restrictions.

When an employee acquires restricted securities and does not make a section 431 election, the following occurs:

• the differences between the price paid by the employee and the AMV of the shares at the acquisition date becomes employment income;
• this employment income is subject to income tax at the employee’s marginal rate; and
• PAYE and employee/employer National Insurance contributions (NIC) (and Apprenticeship Levy, if relevant) may apply in certain circumstances, such as when the shares are in a listed company or if there are specific trading arrangements for the shares. 

Disposal of restricted securities

Where no section 431 election has been entered into, further restricted securities tax charges may apply at a later date unless an amount at least equal to UMV was paid for the shares. Specifically, a restricted securities tax charge may arise when the restrictions are lifted or varied, or when the shares are disposed of.

The amount taxed on one of these events is generally based on the untaxed amount when the shares were acquired (being the difference between the AMV and UMV at the date of acquisition). The untaxed percentage would apply to the UMV of the shares at the date of the event. To illustrate: 

• suppose that the UMV of a share at acquisition was £1, the AMV was £0.80, that no section 431 election was made, and that the employee paid £0.50. This means that 20% of the UMV has not been taxed or paid for at acquisition (income tax at acquisition would only arise on the £0.80 AMV minus the £0.50 paid);
• if the UMV of the share is £10 when restrictions are lifted or the share is sold, a tax charge would arise on 20% of the UMV of £10 (£2); and
• in total this would mean that income tax would be charged on a value of £2.30 (being £0.30 on acquisition and £2 on the disposal of the shares).

The restricted securities rules can result in substantial unexpected income tax and NIC charges when shares are sold, even if AMV has been paid for the shares. This is a common issue that arises on transactions. However, entering into a section 431 election on the acquisition of the shares could mitigate these tax/NIC charges.

Section 431 election

When an employee enters into a section 431 election, the shares are taxed based on the UMV at the date of acquisition, rather than the AMV. This shift in tax timing means that the entire value of the shares is subject to income tax at the point of acquisition (when the value is typically lower). Without a section 431 election, a portion of the value would be taxed later when the value is expected to be higher. Opting for a section 431 election results in a higher tax charge upon acquisition because the UMV is used to value the shares, disregarding any restrictions that might reduce their market value.

However, being taxed on the UMV ensures that no income tax is charged when the restrictions are lifted or when the shares are sold. Let’s revisit the previous example to understand the impact of the section 431 election:

• using the same AMV and UMV figures as before, income tax at acquisition would be based on the UMV of £1 minus the £0.50 paid, rather than the AMV of £0.80 minus the £0.50 paid; and
• no income tax charge would apply upon share disposal or when restrictions are lifted. This means that income tax would be assessed on a value of £0.50, compared to £2.30 if no section 431 election had been made.

In general, it is advisable to make a section 431 election when acquiring restricted securities that are expected to appreciate in value. However, there is a key drawback: if these shares are later forfeited or decrease in value, the taxpayer may have paid more tax than necessary.

To be valid, a section 431 election must be submitted within 14 days of share acquisition and cannot be made retrospectively. If no section 431 election was made at acquisition, alternative elections exist to mitigate future income tax and NIC charges related to the disposal of restricted securities.

If you would like more information or have any queries about the areas mentioned above, please contact Martin Cooper or your usual 91̽»¨contact.