Restricted Securities

When an individual acquires shares in their employer’s company for an amount less than their market value (MV), they are typically subject to income tax. The tax charge is based on the value of the shares at the date of acquisition.

This scenario can present an opportunity for employers to reduce the tax liability by artificially lowering the MV of shares. This is achieved by placing restrictions on the shares, such as making them subject to forfeiture under certain conditions, limiting the employee's ability to dispose of the shares, or making them convertible. These actions result in the shares having a low initial value, with the potential for additional value to be injected into the shares at a later date.

It is important to understand that anti-avoidance provisions exist to address situations where an employee receives employment-related securities subject to restrictions that affect their value.

Key Provisions in Section 423 ITEPA 2003

Section 423 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) identifies two primary types of restrictions:

Shares subject to forfeiture restrictions
Shares subject to other types of restrictions

Forfeiture Restrictions

For shares awarded to an employee that are subject to forfeiture restrictions at a value below their MV, the tax charge depends on whether the forfeiture restriction will end within five years or after five years.

If the forfeiture restriction ends within five years of the award, no tax charge arises at the time of issue. However, tax will be due when the restriction is lifted, and the taxable amount will be based on a percentage of the value of the shares immediately after the restriction is removed.
If the forfeiture restriction is lifted after five years, tax is due at the time of the award, based on the restricted MV at the date of issue. A further tax charge will arise when the restriction is lifted, calculated as a percentage of the value of the shares immediately after the restriction is removed.

Other Restrictions

If shares are subject to other types of restrictions (e.g. restrictions on sale) tax is charged at the time of the issue based on the restricted MV at the date of acquisition. A further tax charge applies when the restriction is removed.

It’s important to note that the five-year rule applies only to forfeiture restrictions and not to other types of restrictions.

Notable Elections

Two key elections under ITEPA 2003 may impact the tax treatment of restricted securities:

Section 425(3) ITEPA 2003: If the forfeiture restriction will cease within five years, the employee and employer can jointly elect for the exemption on acquisition not to apply. This election means the employee will be taxed as if the forfeiture restriction continues for more than five years. If the shares are forfeited or sold for less than their restricted MV no tax recovery is available for the tax already paid.
Section 431 ITEPA 2003: This election disregards any restrictions on the shares, and the employee is taxed on the full, unrestricted value of the shares at the date of acquisition. Once this election is made no further tax charge arises when the restriction is lifted.

Both elections are irrevocable and must be made jointly by the employer and employee within 14 days of the award of the shares.