Good tax planning: explaining ‘section 431’ elections

Want to pay slightly more tax upfront in order to decrease your overall tax liability on shares held in your employer company? Read on…

Most people understand that if you buy a share for £1 and later sell it for £10, you’ll have to pay capital gains tax on the £9 gain.

What is less well understood is that if you acquire shares in a company of which you are an employee or officer then not only may income tax be due in the year of acquisition but part of any gain on a future sale may also be subject to income tax rather than capital gains tax. Since income tax rates are generally higher, the taxpayer will usually want to avoid this, which is where a ‘section 431’ election (named after a section of the Income Tax (Earnings and Pensions) Act 2003) could help.

Restricted market value

Let’s assume an employee subscribes for a share in her employer company at its nominal value of £1.

The first question is what is the actual market value of that share on the subscription date? The actual market value is affected by restrictions attaching to the share. This company has two classes of share where one class is held by employees and the other by investors. All shares have equal voting, income and return of capital rights but shares in the employee class cannot be transferred without the consent of the holders of the investor class. This restriction may make the employee shares less valuable than the investor class of shares.

Taking the transfer restriction into account, let’s assume that the employee’s share has a restricted market value of £6 on the subscription date.

Unrestricted market value

The next question is what is the unrestricted market value of the share? This is the value the share would have if all restrictions were removed. For example, imagine that on the same day our employee got her share an arm’s length buyer bought shares in the investor class for £10 per share. This would be the unrestricted market value as the employee and investor classes of shares are identical save for the transfer restriction.

So, let’s look at the tax position, assuming the employee share is later sold for £100[1].

Tax – without an election

• Tax on acquiring the share: the employee shareholder must pay income tax on the difference between the subscription price (£1) and the restricted market value of that share on that date (£6). So that’s £5 x 40% = £2 income tax

The difference between the restricted and unrestricted price is £4, which is 40% of the unrestricted value. This is untaxed as income at this point.

• Tax on selling the share: at this point, 40% of the sale price (i.e. £40) is taxed as income.

So that’s £40 x 40% = £16 income tax

The base cost for capital gains tax is £6 (i.e. the restricted market value of the share on which tax has already been paid) so the gain on disposal is £94. Of this, £40 is taxed as income (above) and only the balance of £54 is subject to capital gains tax.

So that’s £54 x 10% = £5.40 capital gains tax

• Total tax with no election: £2 + £16 + £5.40 = £23.40

Tax – with an election

• Tax on acquiring the share: if the employee enters into a s431 election, she must pay income tax on the difference between the subscription price (£1) and the unrestricted market value of that share on that date (£10).

So that’s £9 x 40% = £3.60 income tax

• Tax on selling the share: no further income tax is payable but now the base cost for capital gains tax is £10 (i.e. the unrestricted market value of the share on which tax has already been paid) so the gain on disposal is £90.

So that’s £90 x 10% = £9 capital gains tax.

• Total tax with an election: £3.60 + £9 = £12.60 (rather than £23.40 above)

So, by entering into a section 431 election the shareholder had to pay slightly more tax when she acquired her share but her overall tax bill has halved because more of her sale proceeds were taxed as capital not income.

Shares can go down as well as up…

Of course, if the shares were to fall in value the employee could end up paying more in tax by making the election. But, if there is an expectation that the shares will rise in value then an election is generally a good thing!

[1] We’ve assumed the employee: (i) is a higher rate income tax payer (40%); (ii) will benefit from entrepreneurs’ relief on the sale (so CGT at 10%); and (iii) has exhausted her capital gains tax free allowance. To keep things simple, we’ve also ignored national insurance contributions.