Back to basics: Restricted securities

When a company introduces a restricted share scheme, the employee takes ownership of the shares from the start of the arrangement. However, the restrictions reduce the value of the shares from what would otherwise be their market value.

Restricted securities arrangements provide a clear incentive for the employee to remain with the company and meet the performance conditions as, usually, the employee is obliged on leaving to sell the shares or to forfeit the right to the shares.

The timing of the acquisition of shares could be either immediate, with full beneficial ownership of the shares through a trust or full legal title if purchased into own the employee’s name at the outset or deferred, where the shares are held by trustees of a trust for the duration of the scheme and transferred at the maturity through the exercise of a nil-cost option.

Right at the heart of the determination of whether or not shares are to be treated restricted securities is the distinction between restrictions and the share’s inherent characteristics. Under ITEPA 2003 s 423(1)(a), the Structural Test restrictions arise through the share being subject to a 'contract, agreement, arrangement or condition' by which the shares are restricted and to be treated as restricted securities.

In contrast, the absence of particular rights may be an inherent characteristic of the share without having to be subject to a 'contract, agreement, arrangement or condition' in order to deny the exercise of those particular rights. In these circumstances, there is nothing to be restricted as they do not exist in the first place.

In applying this key distinction, it would appear that, in practice, for the restricted securities regime to apply there would normally be a restriction on the shares compared with other shares in the same class and the restriction would normally reduce the value of the shares compared with the other shares in the same class.

Under ITEPA 2003 s 423(1)(b), the Depressed Market Value Test, applies where 'the market value of the employment-related securities is less than it would be but for that provision.' In determining whether or not the shares are restricted securities, therefore, it is important to apply both the Structural Test under         s 423(1)(a) and the Depressed Market Value Test under  s 423(1)(b) as both of these features must be in place for the shares to be restricted securities under ITEPA 2003 Part 7 Ch 2.

For the restricted securities regime to apply, it is important to recognise that in relation to the shares:

• there must be an identifiable restriction;
• the restriction must reduce the value of the shares; and
• they must be restricted securities at the time of the acquisition.

There must be no equivocation on any of these three points if the shares are to be treated as restricted securities. Remember, in particular, when applying the structural test and the depressed value test, in tandem as they have to be, that, under ITEPA 2003 Part 7 Ch 2, the shares will only be restricted securities if at the precise time of their acquisition both of these tests apply. If there is no restriction at the date of acquisition but a restriction is imposed later then the shares are not restricted securities for these purposes.
 
When understanding the nature of a restriction, it is important to appreciate that restrictions as envisaged by the legislation in ITEPA 2003 Part 7 Ch 2 will typically be of a temporary nature and have the potential to be lifted at some point in the future. Suppose that the shares do not have voting rights and that the non-voting status of the shares is regarded as permanent.

Permanent non-voting status to a class of shares will not be categorised as a restriction. The shares in that class would simply have a value that reflects the fact that the shares do not possess voting rights.

Suppose that although never envisaged at the date of the acquisition of the shares the company in general meeting decides to attach voting rights to these shares. The question that then arises is how the shares would be viewed under the employment-securities legislation in the event that the restrictions were removed when this removal had never been envisaged.

The answer to this apparent conundrum is that it is then necessary to look beyond Chapter 2 to the rules on post-acquisition benefits from securities in ITEPA 2003 Part 7 Ch 4, under which a charge to income tax would arise on the basis that an incremental benefit had as a consequence of the employment.

When structuring the share for purposes of an employee share scheme, a key planning point that emerges at the outset is whether to structure the shares as restricted securities under Chapter 2 or convertible securities under ITEPA 2003 Part 7 Ch 3. As a general rule of thumb, if there appears to be a choice in the structuring of the share then it would normally be preferable for the shares to be categorised under Chapter 2, as restricted securities.

The preference for the restricted securities regime as opposed to the convertible securities regime is that it offers the opportunity for significant tax planning through the employee and the employer jointly agreeing to make an election under ITEPA 2003 s 425 or s 431. Making a tax election enables all future gain from the date of the acquisition to be subject to CGT instead of the more punitive income tax regime. 

Exceptions to the regime

Employment-related securities are not treated as restricted securities (or an interest therein) in the following cases (ITEPA 2003 s 424):

• Non-payment of outstanding calls: The employment-related securities are unpaid or partly paid shares that may be forfeited in the event of non-payment of outstanding calls and there is no restriction on the meeting of calls by the person who holds them; or
• Cessation through misconduct: The employment-related securities are to be offered for sale or transfer in the event of the cessation of employment as a result of misconduct.

Key challenges in applying these rules

Note the following potential difficulties:

• Determining the market value: The market value has to be determined on the basis of different assumptions and at times when the securities are not necessarily sold at arm’s length. This difficulty is compounded by the fact that the definition of 'securities' now operates with a much wider jurisdiction and includes instruments for which it is difficult to establish a market value.
• The decision on tax elections: Determining whether or not to make a tax election requires very careful thought at the time of the acquisition of the securities or the interest in securities.

In practice, both the employee and the employer must be involved in the decision for the reason that as a matter of law the election cannot be made without the support of both employee and employer.
 

The tax rules on acquisition of the shares

One of the following situations applies on the acquisition of employment-related securities which are also restricted securities (or an interest therein):

The special rule situation: The employee will not be subject to income tax or NICs at the time the restricted securities (or an interest therein) are acquired where any forfeiture or compulsory transfer restrictions cease within the period of five years following the acquisition.

The condition is that the forfeiture or compulsory transfer restrictions do not last for more than five years. This is the special rule where there are forfeiture or compulsory transfer restrictions that do not last for more than five years.

Note, however, that the employee may elect under ITEPA 2003 s 425 to be subject to income tax on the unrestricted market value at the date of acquisition less any consideration paid for the shares in order to secure CGT treatment for all gain following acquisition.

Where under s 425 there is no tax charge on acquisition, income tax could still arise in relation to the following (by virtue of s 425(2)):

• acquisition on conversion (under the rules in ITEPA 2003 Part 7 Ch 3 for convertible securities);
• acquisition for less than market value (under the rules in ITEPA 2003 Part 7 Ch 3C); or
• acquisition that follows exercise of a securities option (under the rules in ITEPA 2003 Part 7 Ch 5).

The non-special rule situation: The employee will be subject to income tax or NICs at the time the restricted securities are acquired or an interest in restricted securities is acquired in circumstances where they are not subject to forfeiture or compulsory transfer restrictions but have restrictions, any other type of restriction such as, for example, in relation to dividend rights or voting rights or winding-up rights.

In these circumstances, at the time of the acquisition of the shares, they will be subject to income tax and NICs on the difference between the then restricted value and any amount paid for the shares as consideration by the employee.

In this situation, the employee may elect under ITEPA 2003 s 431 to be subject to income tax on the unrestricted market value at the date of acquisition less any consideration paid for the shares in order to secure CGT treatment for all gain following acquisition.

The administrative features of the elections are that:

• the election is made by agreement between employer and employee;
• it is irrevocable;
• it follows a form that is approved by HMRC; and
• it must be made in the period up to 14 days after the acquisition or the chargeable event, as appropriate.

The tax rules for chargeable events

The following rules apply for employment-related securities which are restricted securities (or an interest therein).

Note that the term 'chargeable' in this context relates to income tax and NICs, not CGT. Under ITEPA 2003 s 427, income tax will arise in relation to the following circumstances:

• when restrictions that cause the employment-related securities to be either restricted securities or an interest in restricted securities are lifted (s 427(3)(a));
• when restrictions that cause the employment-related securities to be either restricted securities or an interest in restricted securities are varied (s 427(3)(b)); or
• on a disposal for consideration of the employment-related securities at a time when they are still either restricted securities or an interest in restricted securities (s 427(3)(c)).

NICs will also arise on the occasion of these events if the shares are classified as readily convertible assets in accordance with ITEPA 2003 s 702, and the NIC Regulations.

The rules stipulate that:

• when a chargeable event occurs a charge to income tax arises on such proportion of the unrestricted market value of the shares that has not already been charged to income tax. The income tax charge will arise on the proportion of the value of the shares at acquisition that was not subject to income tax;
• if there is more than one chargeable event, then the untaxed proportion will be reduced on each occasion until it reaches zero. Thereafter, any gain in value of the shares falls wholly within the CGT regime;  and
• once there is no untaxed proportion remaining any further gain falls into the CGT regime.

Considerations when making a tax election

It is important to consider the following key issues when deciding whether or not to make a tax election are:

• What is initial outlay and is it affordable?
• What is the expected growth potential of the shares?

The interaction with the CGT legislation

The disposal of the securities triggers CGT in the normal way. The consideration for the acquisition is taken under TCGA 1992 s 149AA to be the aggregate of:

• the initial purchase consideration, ie, the actual amount or value given for the securities by the purchaser; and
• any income taxable amounts, ie, any amount charged to income tax under the general charging provision on ITEPA 2003 Pt 3 Ch 1 (taxable amounts).

Additionally, if the disposal of the securities is a chargeable event or is the first disposal after a chargeable event, then any amount that is counted as employment income is added to the consideration for the acquisition. (See the worked example.)

David Craddock is an Independent Consultant, lecturer and writer, specialising in employee share ownership and reward management. He has a varied clientele from major public limited companies with international considerations to small and medium-sized private concerns. Email: d.craddock@virgin.net; tel: 01782 519925.