Section 431 elections – What are they and what are the tax benefits?

When employers offer shares or securities to their employees or directors, they often apply some restrictions on how these ‘employment-related securities’ can be used. This is particularly common in private companies (whose shares are not traded on the stock market).

For example, the recipient may be required to sell the shares if they leave the organisation, forbidden from selling them for a certain amount of time after receiving them, or compelled to forfeit them if they leave within a particular timeframe or do not meet pre-set performance conditions.

The market value of such ‘restricted securities’ for tax purposes is usually reduced to take account of this. However, that creates a risk that once the restrictions no longer apply, a second tax point will apply when the value of the shares may be greater than what they were originally – increasing the recipient’s tax liability. One way to avoid nasty surprises of this kind is for both parties to enter into a section 431 election.

In this article we explain what section 431 elections are, and the implications for employer and employee.

What is a section 431 election?

A section 431 election is a type of tax form that enables you to elect out of the default tax regime for restricted securities.

It is signed by both the employee and employer when the former subscribes for or acquires shares in the company they are employed by (or any member of the group for which they work for). Importantly, this must be done within 14 days of the employee acquiring the shares; if it is not, the election will be invalid.

HMRC may request the documentation at any time, so the signed document should be retained safely. Also, as with any similar share acquisition, the company must file a return to HMRC by 6 July following the tax year that the shares were acquired; this return includes confirmation of whether a section 431 election was made. This return to HMRC is still required even if the employee was not subject to tax on the acquisition of the shares – for example, if the price they paid was the same as the tax market value at that time.

The tax implications

Two different share values are used to determine the recipient’s tax liability:

Actual market value – this is the value of the share with the restrictions taken into account
Unrestricted market value – this is the value of the share ignoring any restrictions

Typically, restrictions will decrease the value of the shares, so the unrestricted market value will usually be greater than the actual market value.

To demonstrate the tax implications with and without a section 431, we will assume the following:

The actual market value of the shares is £100
The unrestricted market value of the shares is £150
The employee pays £100 for the shares
The shares are sold for £600

Tax without a section 431

Because the individual paid the actual market value, they would not have to pay any income tax at the time of the acquisition. However, when the restrictions no longer apply, such as when the shares are sold, the employee will then be subject to income tax on the ‘untaxed proportion’ from the time of acquisition. This is the same as proportion between the unrestricted market value and the original purchase price. In our example, the difference of £50 is 1/3 of the unrestricted market value.

When the shares are sold (or the restrictions otherwise no longer apply), this proportion is applied to the market value of the shares at that time. In our example, this value is £600, so the employee would be taxed on 1/3 of that: £200. So, assuming they are a 45% tax rate payer (and ignoring national insurance contributions to keep things simple) they would pay £90 in income tax.

Tax with a section 431

Using a section 431 produces a very different result.

The employee is now subject to tax at the time of acquisition, because the effect of the election is that the market value for tax purposes is now the unrestricted market value. Since the employee paid £100 and the unrestricted market value was £150, the amount of employment income is the difference of £50. Assuming again that they are a 45% taxpayer and ignoring NICs, their tax liability is £22.50. They do not have any further income tax liability when they sell the shares or after the restrictions no longer apply.

Capital gains tax

As with the sale of any shares (restricted or unrestricted), any gain may be subject to capital gains tax (CGT). The key figure when calculating this is the “base cost”, which is typically the original purchase price of the shares. The CGT regime for restricted shares is slightly different than for unrestricted ones, as the base cost is calculated after combining the original purchase price with any amount treated as employment income.

National insurance contributions – employee

We ignored employees’ NICs in the previous example. These apply where the shares are defined for tax purposes as ‘readily convertible assets’. When the employer is a private company, the shares will usually not be readily convertible assets on acquisition – but they will be when the shares are sold, for example as part of a sale of the overall company. For the 45% taxpayer in our example, this would add 2% national insurance contributions onto their tax bill.

National insurance contributions – employer

The issue is even greater for the employer, who without a section 431 would have a 15% employers’ NICs liability. (The apprenticeship levy would affect this, but again we have ignored this for simplicity.) With a section 431, however, this liability is removed.

We can help

It’s not unusual for people to overlook this effective way to reduce both sides’ tax liability, and given the strict 14-day time limit it’s important to act promptly.

Our specialist Employee Share Incentives team can help you with any questions about section 431 elections, including assisting with the section 431 election process and the HMRC reporting obligations. We can also advise on any possible solutions if this option has been overlooked. team. Feel free to get in touch at any time.

Important note: The calculations and figures provided in this article are for illustrative and educational purposes only. They do not constitute, and should not be construed as, tax, financial, or legal advice. We recommend that you consult with a qualified professional before making any financial decisions, as specific circumstances can change what advice is offered to you.

This article was co-authored by Trainee Elle Haddow.

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