Possibly one of the most neglected and common areas of Pay As You Earn (“PAYE”) failure is where shares are sold by employees or ex-employees. Chapter 3D of the employment-related securities (“ERS”) legislation (Part 7 ITEPA 2003) imposes an employment tax charge where the amount received is in excess of the market value for UK tax purposes, with the excess amount being treated as employment income.
Why is it an issue?
As this usually involves a cash payment to the (ex-) employee, the employing company will generally have the obligation to withhold income tax and National Insurance contributions under the PAYE system. HMRC are likely to seek to recover this tax from the employing company and have up to six tax years to do so. There may be a s.222 ITEPA charge (i.e. the company is treated as paying the tax on behalf of the employee, so it is taxed as a further benefit or “tax on tax”) if the company has failed to recover the tax from the employee within 90 days of the end of the tax year in which the disposal took place. Interest and penalties may also be payable. To top it off, recovering tax from an ex-employee might be difficult if not impossible.
In short, it can become an expensive headache if the company doesn’t consider it in advance of the disposal. The obligation of the employing company is to operate PAYE based on a “reasonable best estimate” of the market value of the shares, so it is strongly advised to have contemporaneous evidence that this has been considered.
The charge can apply at any time the shares are sold by past/present/future employees or officers (the definition of employment-related securities is very wide). The most common scenarios include:
- Shares being bought back from an employee who has ceased employment in ‘good leaver’ circumstances
- Shares being sold by employees where an internal market has been created, e.g. an employee benefit trust might be used to buy/sell shares
- Shares of the same class being sold at different prices on a transaction
- Shares being sold by employees pursuant to a put option (depending on how the option is drafted and where the provision is contained).
- The price paid to a ‘good leaver’ is based on provisions set out in the articles of association and therefore it is OK
- The price being paid reflects a formula in the articles of association or put option agreement and therefore it is fine
- The price is a result of a commercial negotiation and therefore it must be market value.
In practice, the position must be based on the specific facts and circumstances. Sometimes the precise drafting of provisions in the articles of association may have a bearing on the conclusions. The market value of shares for UK tax purposes is based on the relevant legislation and case law, which might be higher or lower than the price agreed.
What guidance is available?
Fortunately, Chapter 3D is the one area of the employment-related securities legislation that has been tested through the Supreme Court (the Grays Timber case). The judgement provided clarification on the appropriate interpretation and application – primarily reinforcing what was already known as well as debunking some earlier HMRC guidance on the topic. The definition of “market value” is based on sections 272 and 273 of TCGA 1992 and the well-established methods of determining market value on this basis should be applied.
Any contractual arrangements that that are not direct incidents of the ownership of the shares are disregarded in the determination of market value. The key principle is whether the rights or restrictions would be of enduring benefit or detriment to the hypothetical purchaser (who could be anyone and is not necessarily an employee).
The specifics of the Grays Timber case were actually straight forward. The managing director had acquired shares in the company, and he was entitled to an enhanced payment on the sale of the company by virtue of provisions that were set out in the shareholders’ agreement. Those provisions were not reflected in the share rights set out in the articles of association and were personal to the managing director, so they would not be of enduring benefit to a hypothetical purchaser of those shares.
The wider application of this guidance can get trickier. The basis of determining a good leaver price may be clearly set out in the articles of association but the ability to receive that price depends on the specific circumstances of the taxpayer so it may be higher than the price that might be agreed between a hypothetical purchaser and vendor. The right to sell shares based on a pre-determined formula might be included in the articles of association but the nuance of the drafting might determine whether or not a hypothetical purchaser would be willing to pay the same price.
How can Parmentier Arthur help?
At Parmentier Arthur, we have many years of combined experience (within HMRC and of negotiating with HMRC) of the relevant issues for companies of all sizes. In many cases, the price to be paid will already be agreed, so we can provide valuation advice to assist you in operating PAYE on a “reasonable best estimate” reflecting the commercial circumstances and the appropriate interpretation of the relevant legislation and case law. In other cases, the price may yet need to be determined based on provisions set out in the articles of association or other agreement – in which case we can assist with the determination of the price and the market value for UK tax purposes.
Please enquire if in any doubt as we are always happy to discuss. The best time to consider some of these issues is often before the shares are issued, so don’t necessarily wait until it becomes a problem.