Employment-related securities and the family company

The Supreme Court clarifies when options and shares are treated as ‘employment-related’ – what’s the risk for family companies?

What’s your income tax risk?

The Supreme Court’s decision in Vermilion matters to family-owned companies as it clarifies aspects of how a deeming rule for options – and a similarly worded deeming rule for securities – can bring shares and other securities in family companies within the scope of the employment-related securities (ERS) rules. Where these rules apply, in certain circumstances PAYE / income tax and NIC can arise when family members acquire, whilst they hold, and/or when they dispose of shares in a family-owned company. This article summarises the potential income tax implications of the ERS legislation for family shareholders, the associated withholding and reporting obligation for the company, and what both family companies and their shareholders should consider following Vermilion.

Why Vermilion matters for family companies

The Supreme Court handed down its judgment in Revenue and Customs Commissioners v Vermilion Holdings Ltd on 25 October 2023 (see our earlier article). 

In summary, the issue in this case was whether shares under option were subject to tax as employment income on acquisition (as HMRC considered), or only to Capital Gains Tax on disposal (as the taxpayer and his employer maintained).

This turned on whether the options were ‘employment-related’, which they would be if:

  • The right or opportunity to acquire them was, as a matter of fact, made available by reason of an office or employment; or
  • The circumstances in which the options were granted meant they were deemed to be employment-related in the absence of any actual link with an office or employment.

The Supreme Court ultimately decided that, regardless of why it was acquired, the option was treated as employment-related under a deeming provision because the right or opportunity to acquire it was made available by the employer.  

What happens if the ERS rules apply?

In summary, the ERS legislation aims to tax as employment income any value received by reason of an office or employment on the acquisition, holding, or disposal of shares and other securities (according to the specific ERS charging provisions applicable to the securities or option in question).

But as securities can be deemed to be ERS, amounts can also be taxed as employment income in relation to shares that have no actual connection with an office or employment, and which are not intended to pass any employment reward to their holder (e.g., shares in a family company acquired by an individual in their capacity as a family member).

If ERS income tax charges arise on securities that are, or are deemed to be, ‘readily convertible assets’, PAYE, NIC and – in some cases – Apprenticeship Levy obligations will also arise. Any PAYE due on ERS that is not ‘made good’ to the employer within 90 days of the end of the tax year can trigger additional ‘tax on tax’ charges for the employee and employer. The employer must also report certain transactions in ERS to HMRC by 6 July following the end of the tax year.

However, the ERS legislation is complex. How it applies in specific circumstances depends on the particular facts. In some cases, shares and other securities can be within the scope of the ERS legislation without any relevant income tax charges arising (although certain reporting obligations will still arise). 

When are family company shares deemed to be ERS?

The question here, as confirmed by Vermilion, is who made available the right or opportunity to acquire the relevant shares – and not why that right or opportunity arose.

Shares made available by the employer

Shares in a family company are deemed to be ERS if the right or opportunity to acquire them is made available to an individual by their employer.

For example, if an individual subscribes to a rights issue by a family company of which they are a director, those shares will be deemed to have been acquired by reason of employment as the right to acquire them was made available by the employer (i.e., the family company which issues the shares).

Similarly, if an individual becomes a director of a newco incorporated as part of a company reorganisation, and they are then issued shares in that newco in exchange for their shares in a family company, those consideration shares made available by their employer will be deemed to be ERS, even if the original holding of shares in the family company were not connected with an office or employment.

As the decision in Vermilion confirms, in these examples the fact that shares are acquired by individuals acting in their capacity as shareholders is irrelevant to whether the shares in question are ERS.

An employer reporting obligation arises in respect of the acquisition of shares that are deemed to be ERS but, depending on the specific facts, employment income tax charges might not arise on acquisition (e.g., if tax market value consideration was given for the shares). However, if – for example – those shares were subsequently sold for an amount that exceeds their tax market value, PAYE and NIC would arise on the ‘excess’ disposal proceeds. Post-acquisition employment-related securities charges could also arise in relation to ERS in other circumstances (and would also give rise to employer reporting obligations).

Shares made available by a person ‘connected’ with the employer

Family company shares will also be deemed to be ERS if the right or opportunity to acquire them is made available to someone by a person who is ‘connected’ with their employer.

Persons ‘connected’ with an employing family company include controlling shareholders (such as a holding company or another family member) and trustees of family trusts that hold shares in the company if it is ‘close’ for tax purposes.

This is subject to an important exclusion from the deeming rule where the person ‘connected’ to the employer who makes the relevant right or opportunity to acquire shares available is an individual acting in the normal course of their domestic, family, or personal relationships.

HMRC’s guidance states that they ‘take a common-sense view of this exception’ and gives the example of a father on retirement transferring all the shares in a family company to his son and daughter, who also work for the company, solely because they are his children.

However, in some circumstances HMRC might take the view that less common transactions are not entered into in the ‘normal course’ of domestic, family, or personal relationships, and so are not excluded from the scope of the deeming rule.

Additionally, it is important to appreciate that the exclusion for securities acquired from an individual in the normal course of domestic, family, or personal relationships applies only to the deeming rule and if, for example, an individual were to transfer shares to a family member because they worked for the family company (e.g., where a shareholders’ agreement restricts share ownership to ‘working’ family members), those shares would be ERS as a matter of fact.

What should family companies and their shareholders do?

Whilst the Supreme Court’s decision in Vermilion was perhaps expected by many advisers, it does overturn guidance previously given in this case by the First-tier Tribunal and the Court of Session (Inner House) on how the relevant ERS deeming rule applies.

Family companies should therefore review whether any shares or other securities they issued are ERS because:

  • They were, as a matter of fact, made available to the person who holds them by reason of an office or employment (whether held by that person or by someone else); or
  • They were made available by that person’s employer, or by a person connected with their employer in circumstances where the family, domestic, or personal relationships exclusion does not apply.

Where shares or other securities which are, or are deemed to be, ERS have been acquired, several parties including (if different) the employer, the company that issued the securities, and the person from whom they were acquired, must report the acquisition to HMRC (though a report from one responsible party removes the obligation from the others).

Family companies and shareholders should also review whether any historical employment income tax charges have arisen in relation to any ERS and, if so, whether based on the relevant facts PAYE, NIC and, where relevant, Apprenticeship Levy, should have been accounted for, or whether such charges should be assessable under self-assessment by the relevant individual.

Any self-assessment, payroll withholding, and reporting errors or omissions should be disclosed to HMRC and corrected.

Additionally, any prospective transaction involving ERS, or which affects the rights or restrictions attaching to ERS or to any other securities in the relevant company, should be carefully considered to ensure that any employment tax risks are identified in advance. In connection with this, family companies may benefit from analysing and tracking the status of family shareholdings as ERS from as early as possible a stage in their development.

If you would like to discuss the potential implications of the ERS rules for family companies, please contact the authors or your usual KPMG in the UK contact.