Section 431 elections: An overview of how and why they are used

Introduction

In a corporate transaction, where shares are being transferred or issued to employees or directors, it is common practice for these individuals to be advised or required to sign a section 431 election. This blog examines what a section 431 election is, its rationale and how it is used in the context of employment-related securities.

Establishing the context in which section 431 elections are used

i.   Employment Related Securities:

Employees or directors who transact to acquire shares in the company that they work for, or a company that is part of a group of companies for which they work, fall within the special tax rules that apply to employment related securities. Additionally, these rules are also applicable to investors who are subsequently appointed as a director or employee of the company.

These rules are designed under the employment related securities legislation to ensure that growth capital income from shares is taxed at the appropriate higher tax rate for income tax, as opposed to being taxed at the lower tax rate for capital gains tax.

ii.   Restricted Securities

It is common practice for employment related securities to have restrictions attached to them. When directors and employees dispose of their shares (e.g. selling their shares back to the company), the provisions of the employment related securities legislation will apply. The impact of these special tax rules is that the growth capital of the shares is taxed at the higher rate for income tax (45%), as opposed to the lower rate for capital gains tax (20% or 10% if Business Asset Disposal Relief is available).

iii.   Valuing Employment Related Securities

Employment-related securities have two values for tax purposes:

1. Actual market value (“AMV”) – This is the value that the shares are actually worth; and
2. Unrestricted Market (“UMV”) – Value of shares if they had no restrictions attached to them.

A Section 431 election can assist employees with navigating the tax issues that arise from the different valuations of shares, when acquiring or subscribing to shares in their employing company.

Section 431 Election: Function and Purpose

What is a section 431 election and what is its role?

When you make a section 431 election (which is something you can only do within a period of 14 days after first receiving the security), you are making the statement that you want to be treated for tax valuation purposes as though you have received the security without any restrictions on it (such as leaver restrictions requiring the sale back of the security if you leave the business). In other words, you are saying that you want to use the unrestricted market value (UMV) for the purposes of working out whether you have any income tax liability triggered on receiving the security.

The alternative position is that you do not make a section 431 election and so for tax purposes are treated as receiving the security for its actual market value (AMV), which if there are restrictions on the securities means you are probably receiving something of lesser value.

You might wonder why you would want to be treated as receiving a higher valued security for the purposes of working out whether you have any income tax liability; after all, why would you potentially want a higher tax bill? You make the election so that you don’t run the risk of being subject to another income tax liability trigger event. This is because the employment related securities legislation taxes as a separate event any increase in value of a security you hold arising out of a restriction being lifted.

By way of example, if you receive a share that has a restriction on it that requires you to give the share back to the company if you cease to be an employee within 3 years, then you will be assessed for income tax on the value of the share with the restriction in place, and then when you hit 3 years you will be assessed to income tax again on the increase in value of the share created by the restriction being lifted. Giving a section 431 election can avoid this happening because you chose at the outset to be taxed as though there was no restriction. Making the election stops any capital gain on the share created over 3 years from being subject to income tax.

Next Steps following the signing of a Section 431 Election

After an employment related security scheme has been issued, which includes one-off awards or gifts of shares under a Section 431 Election, the company must register with HMRC here whether an election has been made. This must be registered by July 6th following the tax year with which the election was established.

Please note the document itself does not need to be sent to HMRC and should be filed away, however it must be made available if HMRC ever asks for it.

For further information about what you need to register with HMRC following a section 431 election being entered into and how please have a look at the following link here.

How can we help you?

If you have any questions regarding employment related securities, section 431 elections, transferring shares and establishing employee share schemes, please do not hesitate to contact us. Our corporate team here at The Jonathan Lea Network has broad corporate law capabilities and extensive experience of advising on share buybacks and share option agreements.

Be sure to check out our other related article that discusses issuing share options to employees and consultants.

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 2023.