Selling Your Company and Want to Share the Proceeds? Don’t Let HMRC Turn It Into Income

For many founders, a company sale is not simply a financial event. It is often viewed as an opportunity to recognise and reward the individuals who have helped build the business – particularly senior employees, directors and key advisers who may not have been fully incentivised through formal equity structures at the outset.

However, this is precisely where well-intentioned planning can go wrong. What appears commercially fair can create significant and, in some cases, severe tax consequences if not structured properly and early enough.

Recent case law has reinforced a consistent message from HMRC: you cannot re-write economic outcomes at the point of sale without tax consequences. More importantly, where employees or directors are involved, the employment-related securities (ERS) rules can turn what is expected to be a capital gain into taxable income – often at much higher rates and with additional liabilities for the company.

The Employment-Related Securities Trap

At the centre of many of these issues is the concept of employment-related securities. In broad terms, shares are treated as ERS if they are acquired by reason of an individual’s employment. This is a deliberately wide definition and will usually capture shares held by:

• Employees
• Directors
• Individuals connected with them

In practice, this means that most “management equity” falls within the ERS regime.

The consequence is that special tax rules apply – and these rules are specifically designed to prevent value being delivered to employees in a way that avoids income tax.

Acquiring Shares at an Undervalue – A Common but Risky Approach

A scenario we frequently see is where a senior employee is introduced into the shareholding shortly before a sale. This may be done with the intention that they participate in the exit proceeds, even though they were not previously a shareholder.

Often, the shares are issued or transferred at a price which is significantly below what they are actually worth — particularly where a sale is already being negotiated or is realistically anticipated.

From a commercial perspective, this may feel entirely justified. The individual has contributed to the growth of the business and the founders want them to benefit. However, from a tax perspective, this is a high-risk position.

Where shares are acquired at an undervalue, the difference between:

• The price paid by the employee; and
• The actual market value of the shares at the time of acquisition

is treated as employment income.

If the company is already aware that a sale is imminent, HMRC will take a particularly robust approach to valuation. In those circumstances, the “true” market value may reflect the anticipated sale price – not the historic or book value of the shares.

The result is often a substantial and unexpected income tax charge at the point the shares are acquired.

The “Double Hit” Problem on Exit

The risk does not stop there.

Where undervalue has not been correctly identified and taxed upfront, HMRC may seek to impose charges at the point of sale. This can create a situation where:

• The employee receives a large cash sum on exit; but
• A significant portion of that sum is treated as employment income

This income element may be subject to:

• PAYE income tax (potentially at 45%)
• Employee’s National Insurance contributions
• Employer’s National Insurance contributions (which the company may be required to fund)

In effect, what was intended to be a capital return (potentially taxed at 10% or 20%) is recharacterised, at least in part, as employment income at much higher effective rates.

For the individual, this can come as a genuine shock. For the company, the exposure to employer’s NIC and PAYE compliance obligations can be equally problematic – particularly if no provision has been made.

Chapter 3D – When Sale Proceeds Become Income

Even where shares were originally acquired at market value, a further risk arises under Chapter 3D of the Income Tax (Earnings and Pensions) Act 2003.

This applies where shares are sold for more than their market value. The excess is treated as employment income.

This is particularly relevant where sale proceeds are allocated disproportionately – for example, where certain individuals receive more than their entitlement based on share rights.

The key point is that “market value” is not determined by what the parties agree between themselves. It is determined by reference to a hypothetical arm’s length transaction.

What the Courts Have Confirmed

Recent cases have reinforced HMRC’s position and provide important guidance for anyone planning an exit.

Grays Timber Products Ltd (Supreme Court)

This case confirmed that private arrangements between shareholders do not affect the market value of shares for tax purposes. If a shareholder receives more than their entitlement under the share rights, the excess cannot be justified by reference to a separate agreement.

The tax analysis is driven by the legal rights attached to the shares – not by informal or side arrangements.

CooperVision Lens Care Limited (First-tier Tribunal)

This more recent case highlights how aggressively HMRC may approach these issues in practice.

Certain director shareholders received significantly more than their pro rata entitlement on a sale. The company argued that the allocation reflected commercial reality and that the buyer accepted the structure.

The tribunal rejected this argument and emphasised several important principles:

• The total deal price reflects the value of the company as a whole, but that value must be allocated across shares according to their rights.
• Market value is determined by a hypothetical willing buyer and seller, not by internal agreements.
• High-level or caveated tax advice is not sufficient protection if the analysis is flawed or incomplete.

The company was found to have acted carelessly, allowing HMRC to assess over an extended period and impose PAYE and NIC liabilities.

Why This Is a Red Flag for Sellers

Certain situations should immediately prompt careful scrutiny:

• Introducing a senior employee into the shareholding shortly before a sale
• Issuing or transferring shares at a low or nominal value when a transaction is in contemplation
• Agreeing to “top up” certain individuals’ proceeds on exit
• Relying on informal understandings rather than formal share rights

In each of these scenarios, there is a real risk that HMRC will argue that value is being delivered by reason of employment – triggering income tax treatment.

How to Structure Things Properly

The key to avoiding these issues is early and deliberate planning. Trying to fix matters shortly before completion is where most problems arise.

Align share rights with intended outcomes
If certain individuals are intended to receive a greater share of exit proceeds, this should be reflected in the share structure itself. This may involve rebalancing shareholdings or introducing new classes of shares with appropriate economic rights.

Implement incentive arrangements early
Growth shares, EMI options and other structured incentive schemes can provide a tax-efficient route to rewarding key individuals. These arrangements are specifically designed to operate within the ERS framework and can significantly reduce risk if implemented correctly.

Be realistic about valuation
Where shares are issued or transferred, valuation must reflect the true position — particularly if a sale is in contemplation. Attempting to rely on historic or artificially low valuations is unlikely to withstand HMRC scrutiny.

Understand when income treatment may be appropriate
In some cases, it may be more straightforward to accept that certain payments are, in substance, remuneration. Structuring these as bonuses may provide clarity and avoid later disputes, even if the tax outcome is less favourable.

Take detailed, transaction-specific advice
Generic advice or high-level opinions are rarely sufficient in this area. The interaction between ERS rules, valuation and transaction structuring is highly fact-specific and requires careful analysis.

Final Thoughts

Rewarding key individuals on a company sale is entirely understandable and often essential to achieving a successful transaction. However, the tax rules in this area are both complex and unforgiving.

The combination of ERS rules, undervalue provisions and Chapter 3D means that attempts to deliver value informally or late in the process can lead to significant and unexpected tax liabilities — often at income tax rates, with additional National Insurance costs.

Handled properly and well in advance, these objectives can usually be achieved in a structured and tax-efficient way. Left too late, they can result in a costly surprise for both the individual and the company.

Need Advice on Structuring an Exit?

If you are considering a sale and want to:

• Introduce or reward key employees
• Avoid unexpected income tax and NIC charges
• Ensure your structure stands up to HMRC scrutiny

early advice is critical.

The Jonathan Lea Network works alongside experienced advisers to help founders plan and execute exits in a way that aligns commercial objectives with robust tax planning, reducing risk and avoiding unnecessary surprises.

We provide enquiries with an indicative scope of work and fee estimate, based on the information you share. We aim to respond within one working day.

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This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.