Beware of unintended tax consequences when imposing holding periods on employee share awards

In light of recent comments from HM Revenue & Customs (HMRC), employers who operate a holding period following the vesting of employee share awards should consider requiring employees to make a specific tax election to ensure they are not subject to an unexpected and unwelcome tax charge.

It has become increasingly common in recent years for listed and financial services companies which operate executive share plans to impose an additional holding period after a share award has vested. Typically, executive share awards are subject to a performance period of three years at the end of which the award vests (assuming the conditions are met). Sufficient of the shares due to the employee are sold to cover the tax and national insurance contributions (NICs) due on vesting (or, in the case of an option, exercise). The balance of the shares are then required to be held for a further holding period of, say, two years during which they may not be disposed of. At the end of the holding period, the shares are released to the employee.

The usual tax treatment in this situation is for the full market value of the shares at vesting/exercise, less any consideration which the employee pays for them, to be subject to income tax and NICs. When the balance of the shares held during the holding period are released to the employee, no further income tax or NICs are payable at that stage. On disposal of the shares, a capital gains tax liability may arise on any gain since vesting/exercise.

Restricted securities regime

Recently, however, HMRC has cast doubt on this analysis and has suggested that a special tax regime known as the "restricted securities regime" will apply where there is a post-vesting holding period.

The restricted securities regime applies where an employee acquires shares which are subject to restrictions and those restrictions have the effect of reducing the market value of the shares. HMRC considers that a holding period during which the shares cannot be sold or transferred is a restriction for these purposes and that such a restriction would in principle have the effect of reducing the market value of the shares subject to the holding period, although each case will depend on its own facts.

On that basis, when the shares are acquired at vesting/exercise, only the discounted market value of those shares (taking account of the restriction) would be subject to income tax and NICs. For example, the effect of the holding period may be to reduce the market value of the shares by twenty per cent in which case only 80 per cent of their full market value would be taxed at vesting/exercise. When the shares are released at the end of the holding period and the restriction therefore falls away, twenty per cent of the full market value of the shares at that time would be subject to income tax and NICs (being the proportion of the value not taxed at vesting/exercise). Where the shares have gone up in value during the holding period, this would increase the overall amount of income tax and NICs payable.

Section 431 election

Under the relevant legislation, the employer and employee can enter into what is known as a "section 431 election" to take themselves outside of the restricted securities regime. The effect of the election is that the employee pays income tax and NICs on the full market value of the shares at vesting/exercise i.e. the restrictions are ignored. No income tax or NICs would then be due at the end of the holding period. This equates to the "usual" tax treatment described above.

A section 431 election can therefore be a useful tool to ensure that full market value is taxed at vesting/exercise with no risk of a further income tax or NICs charge on the expiry of the holding period. Most employees would prefer this tax treatment to that which applies under the restricted securities regime. If so, an election is now essential.

Action required

To be valid, a section 431 election must be entered into no more than 14 days after the shares are acquired at vesting (or, in the case of an option, exercise). Such an election can also be made in advance of vesting/exercise.

Assuming employers and employees wish to make an election, good practice would be to enter into the election at the time the award is granted in order to avoid the risk of forgetting to do so at vesting/exercise.

If awards have already been granted without an election being entered into but vesting/exercise has not yet occurred, it would be advisable to enter into an election immediately, although employers could also choose to wait until vesting/exercise.

If more than 14 days have elapsed since an award has vested or been exercised, it is too late to make an election. The possibility of HMRC seeking to re-assess the way in which such awards were taxed on vesting/exercise, so as to apply the restricted securities regime, cannot be ruled out but that will depend to some extent on the amounts involved.

HMRC's template for a section 431 election is available here.

An election can be made during a closed period under the Market Abuse Directive and is not notifiable.

Accounting treatment

It is also worth noting that the existence of a post-vesting holding period may reduce the amount of the accounting charge which companies need to include in their accounts in respect of employee share awards. This is something which is worth discussing with finance and treasury colleagues and with the company's auditors.

Share ownership guidelines

Many listed companies have adopted share ownership guidelines under which directors are expected to build up a holding of the company's shares until they reach a certain level and then maintain it. Provided such guidelines are carefully drafted and require directors to hold a fungible pool of shares rather than any particular shares, it is unlikely that HMRC would consider the existence of the guidelines to amount to a restriction attaching to any shares acquired by directors.