SE11861 - PAYE on share transactions - example 2 - exercise of an option in an unapproved scheme prior to flotation

Example 2

• On 23 May 1999 an employer grants an employee an option over 1,000 shares in the company’s unapproved share scheme at £1 per share
• the employer is a private company, not listed on any exchange
• the option can be exercised between 1 January 2000 and 31 December 2003
• in March 2002 the company considers a possible flotation on the London Stock Exchange – a feasibility study highlights issues that the company needs to address first, but is broadly supportive of a flotation in late 2003
• as work continues towards the potential flotation the share price rises to £5 and in July 2003 the employee exercises the option and acquires shares worth £5,000.

Is the employer obliged to operate PAYE?

The option could not be exercised more than 10 years after grant and so there is no income tax liability when the option is granted (see Share Schemes Manual 3.3). On exercise the employee has realised a gain of £4,000 on the shares under Section 135 ICTA1988.

When the option is exercised the employee acquires shares in a private company and so the shares are not readily convertible assets by virtue of either Section 203F(2)(a) or (b) ICTA1988. However the shares may be readily convertible assets under subsection (2)(f) or (g), if there are trading arrangements in place, or likely to come into existence in future (see SE11810).

The employee acquires the shares knowing that the company is intending a flotation on the London Stock Exchange. After that event the shares will be capable of sale on the exchange and this represents a potential trading arrangement.

The shares are acquired several months before the intended flotation and it is possible that the flotation may never take place. But the feasibility report and continuing progress towards flotation make it “likely” that flotation will occur.

Consequently the employee acquires the shares subject to an understanding that trading arrangements are likely to come into existence and this satisfies the definition of a readily convertible asset in Section 203F(2)(g). Consequently the person who was the employer when the option was granted must operate PAYE on the gain made by the option holder on exercise of the option, by virtue of Section 203FB(2). If the option holder is no longer an employee of that person see SE11920.