Options and tax

The tax liabilities for individual and corporate option holders in different scenarios.

When options (whether unapproved, CSOPs, or other non-tax advantaged options) are granted to employees, individual contractors or companies, tax liabilities can arise at different times for each scenario. 

Here we’ll explain the three most common scenarios and tax implications for both parties. 

Use the table of contents below to see the different tax liabilities based on the relationship between the recipient and granting company: 

  1. Employees of the company
  2. Non-employed UK tax residents – individuals or companies 
  3. Non-UK tax residents

1. Granting to employees


When an employee, director or non-executive director (NED) is granted an option, initially there’s no tax due regardless of the exercise price. However, a tax liability is created when they exercise their options.

Once exercised, and if the shares can be sold immediately (for example at an exit event), both Income Tax and National Insurance are due on the difference between the exercise price and the sale price. 

For example, a total exercise price of £1,000 and a sale price of £5,000 would incur an Income Tax and NI liability on the £4,000 gain. 

This must be paid by the company via PAYE then reimbursed by the shareholder within 90 days. 

In cases where there isn’t an open market for the shares and they cannot be sold immediately, the option holder can decide whether to pay Income Tax at that point based on the Actual Market Value (AMV) or Unrestricted Market Value (UMV) of the shares. 

If they choose the likely higher UMV, they will have a higher Income Tax bill at the point of exercise, based on the difference between the exercise price and the UMV. 

But any gain from this point onwards will only be subject to Capital Gains Tax as they have already paid up all the Income Tax owed.

The recipient and employing company must complete a joint ITEPA S431 election within 14 days to ensure no further Income Tax is liable.

If they choose to be taxed based on the AMV, they will have a lower Income Tax bill at the point of exercise, based on the difference between the exercise price and the AMV. 

But on eventual sale, the percentage difference between AMV and UMV that was saved on exercise will be applied to any further gains, meaning they are likely to be exposed to both Income Tax and Capital Gains Tax. 

The table below explains the tax liabilities for each scenario where an option holder has 1,000 options with an exercise price of £1 per share. The AMV and UMV at the point of exercise are £2 and £3 respectively, and the eventual sale price is £8 per share. 

When using AMV as the tax point 

Number of options 

1,000 

Exercise price

£1.00 per share

AMV at point of exercise 

£2.00 per share

UMV at point of exercise 

£3.00 per share 

Total cost to exercise and Income Tax liability on exercise 

Total exercise price = £1,000 


AMV total = £2,000 


Tax liability = £1,000 


Marginal Income Tax rate % applied to £1,000 (e.g. 40%) 


Income Tax due on exercise = £400


UMV total = £3,000 


(Difference between AMV and UMV = 33.3%. 33.3% of any future gain will be subject to Income Tax, with the rest subject to CGT) 

Eventual share sale price 

£8.00 per share

Total sale price, tax liabilities on sale and net profit 

Total sale price = £8,000


Tax liabilities on sale:


Sale price less AMV at exercise = £6,000


£2,000 subject to marginal rate Income Tax (based on the 33.3% AMV-UMV difference on exercise) = £800


£4,000 (remaining 66.7%) subject to Capital Gains Tax at 20% = £800 

 

Total tax due = £1,600


Net profit = £5,000 (exercise price and taxes deducted)

 

When using UMV as the tax point 

Number of options 

1,000 

Exercise price

£1.00 per share

UMV at point of exercise 

£3.00 per share

Total cost to exercise and Income Tax liability on exercise 

Total exercise price = £1,000 


UMV total = £3,000 


Tax liability = £2,000 


Marginal Income Tax rate % applied to £2,000 (e.g. 40%) 


Income Tax due on exercise = £800

Eventual share sale price 

£8.00 per share

Total sale price, CGT liability on sale and net profit 

Total sale price = £8,000


Tax liabilities on sale: 


Sale price less UMV at exercise = £5,000 subject to Capital Gains Tax @ 20% 


CGT due = £1,000


Net profit = £5,200 (exercise price and taxes deducted)

For both scenarios, we’re assuming the option holder is a higher rate taxpayer and has already used their Capital Gains Tax allowance. 

 

While the initial tax liability is higher when using the UMV as the tax point on exercise, the potential upside is likely to be greater as you’re only exposed to CGT when you sell the shares, rather than a combination of CGT and Income Tax. 

2. Granting to UK tax residents non-employees (individuals or companies) 

When granting options to UK tax residents that aren’t employees, you can think of the options as payment for services.

If the option holder is an individual, receipt of the options is subject to Income Tax or Capital Gains Tax.

If the option holder is a company, receipt of the options is classed as revenue and subject to Corporation Tax. 

(The examples below reference Income Tax and Capital Gains Tax. The same process applies to corporate option holders, except they will be charged Corporation Tax) 

The options, or ‘payment,’ can be conditional or unconditional, meaning if there’s a vesting schedule, the recipient must fulfil the conditions of the agreement for their options to vest (this normally equates to a further supply of goods or services). 

If the options are unconditional, the recipient essentially receives payment in full on the grant date, which would suggest the options aren't linked to a further supply of goods or services. Any future increase in value will be subject to Capital Gains Tax once the options are realised. 

 

Each scenario creates a different tax liability… 

Unconditional options tax liability 

There are potentially three tax liabilities created for unconditional options: 

  1. On the grant of the options: Income Tax based on a supply paid for by the grant 
  2. On exercise of the options: Capital Gains Tax based on the value of shares acquired 
  3. On the sale of the shares: Capital Gains Tax based on the sale proceeds 

A tax liability is created on the grant of the options when the recipient receives immediate value from the options and no conditions are attached. For example, when: 

  • The exercise price is set below the current market value (MV) of the shares
  • The options vest immediately 

If both apply, the recipient must invoice the granting company for the goods and services plus VAT on the difference between the exercise price and MV. 

For example, if a contractor is granted 1,000 options with an exercise price of £1 and the current MV is £2, they would invoice the granting company £1,200 (£1,000 x VAT @ 20%):  

  • The company granting the options would pay the option holder the VAT and recover the same amount from HMRC. 
  • The option holder would book the £1,000 as income in the form of a valuable option and account the VAT receipt to HMRC. 

As there’s no vesting schedule, tax will be due at the time of grant, so their initial tax liability will look like this:

  • Exercise price = £1 per share 
  • MV at grant = £2 per share 
  • Total cost to exercise = £1,000 
  • Current MV of their shares = £2,000 
  • Income Tax liability = £1,000 
  • Marginal tax rate (e.g. 40%) = £400

A Capital Gains Tax liability arises when the contractor exercises their options, on the difference between the MV at grant and MV at exercise. Continuing with the example above, when the recipient exercises their 1,000 options:  

  • MV at grant = £2 per share 
  • MV at exercise = £4 per share 
  • Amount subject to CGT = £2,000 
  • Marginal tax rate (e.g. 20%) = £400

And finally, when the contractor sells their shares, CGT will be due on the difference between MV at exercise and the eventual sale price. 

Conditional options tax liability 

Like unconditional options, there are potentially three tax liabilities created for conditional options. 

The key difference is that an Income Tax liability arises when the options are granted and every time they vest – as the recipient receives value for supplies on the grant date and on each vesting date. 

This tax liability is the difference between the exercise price and the MV when the options are granted and subsequent increases as they vest.  

And similarly to unconditional options, if the exercise price is below MV, the recipient will invoice the granting company for the supplies plus VAT (or declare it as revenue for corporate option holders) on the difference between the two each time their options vest. 

Tax upon vesting

Continuing with the analogy of options as payment for services, the vesting of the options is treated as consideration for a supply. So a tax liability is created – and VAT is charged – whenever the options vest (a payment is made). 

For example, a contractor is granted 1,000 options with an exercise price of £1 per share, and 250 vest each year over a 4-year period. 

The table below shows the contractor’s share value, tax liabilities and VAT charges as their options vest each year. 

Year

Exercise price = £1 per share


Current MV = £3 per share


Total cost to exercise = £250


Total share value = £750


Tax liability = £500


Marginal Income Tax % applied (e.g. 40%) = £200


VAT charged to the company = £100

Year 2

Exercise price = £1 per share


Current MV = £4 per share 


Total cost to exercise = £250 


Total share value = £1,000 


Tax liability = £750


Marginal Income Tax % applied = £300


VAT charged to the company = £150

Year 3

Exercise price = £1 per share


Current MV = £5 per share


Total cost to exercise = £250 


Total share value = £1,250 


Tax liability = £1,000 


Marginal Income Tax % applied  = £400


VAT charged to the company = £200

Year 4 

Exercise price = £1 per share


Current MV = £6 per share 


Total cost to exercise = £250 


Total share value = £1,500 


Tax liability = £1,250 


Marginal Income Tax % applied = £500


VAT charged to the company = £250

For this scenario, we’re assuming the option holder is a higher tax rate payer. 

 

Each time the contractor’s options vest, they may decide to exercise their options immediately or on a future date. 

If they exercise immediately there will be no Capital Gains Tax charge on exercise.

If they exercise at a later date and the MV of the shares has increased, they will be subject to CGT on the increase. 

And when the contractor sells their shares, CGT will be due on the difference between MV at exercise and the eventual sale price. 

3. Granting to non-UK tax residents (individuals or companies)


When a non-UK tax resident or corporation is granted an option in a UK company they will be taxed in their local jurisdiction and should seek advice accordingly.

 

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