Income tax versus Capital Gains Tax
The central question in UK equity tax is whether a gain is taxed as employment income, at rates up to the additional rate, or as a capital gain, generally taxed at a lower rate. Tax-advantaged schemes such as EMI and CSOP are designed to convert what would otherwise be an income tax event at exercise into a capital gains event at sale, provided their conditions are met.
| Instrument | Tax at exercise or acquisition | Tax at sale |
|---|---|---|
| EMI option | None, if strike at agreed market value | CGT, BADR often available |
| CSOP option | None, if held 3 years or qualifying event | CGT, standard BADR rules |
| Unapproved option | Income tax and possible NIC on spread | CGT on gain since exercise |
| Growth shares with 431 election | Income tax on small unrestricted value at acquisition | CGT on gain since acquisition |
National Insurance contributions
When an unapproved option is exercised, or when a tax-advantaged option loses its favourable status, the spread between market value and strike price is treated as earnings, and both employee and employer National Insurance can apply if the shares are readily convertible into cash, for example because the company is being sold at the same time. Where the shares are not readily convertible into cash, employer NIC generally does not apply at that point, though income tax still does, a distinction that also matters for growth shares issued shortly before a sale.
Some option agreements let the employer pass its NIC liability to the employee through a joint NIC election. Employees should understand whether such an election applies to their grant, since it increases their effective tax cost.
BADR on option and share gains
Business Asset Disposal Relief (BADR), formerly known as Entrepreneurs' Relief, offers a reduced Capital Gains Tax rate on qualifying gains up to a lifetime limit. For most shareholders this requires holding at least 5 percent of the company's ordinary shares and voting rights for at least two years before sale, and being an officer or employee of the company throughout. EMI shares benefit from a relaxation of the 5 percent test, and the option holding period counts towards the two years.
BADR rates and the lifetime limit are set by government and have been reduced and adjusted in recent years. Confirm the current rate and limit with a UK tax adviser before relying on a specific outcome.
The annual ERS return
Any UK company that has granted EMI options, CSOP options, unapproved options or other reportable employment related securities during a tax year must register the relevant scheme with HMRC and file an Employment Related Securities (ERS) annual return online. The return is due by 6 July following the end of the tax year, which runs to 5 April.
- Register each scheme, including EMI, on HMRC's ERS online service before or shortly after the first grant
- File a return for every tax year in which the scheme is registered, even if there were no new grants, a nil return is still required
- Report each EMI grant separately within the 92 day EMI notification window, in addition to the annual return
- Late or missing ERS returns can result in automatic penalties and, for EMI, can jeopardise the tax-advantaged status of options
The 6 July deadline is easy to miss because it falls outside the usual self assessment calendar. Companies should calendar it separately and treat it as a fixed compliance date every year.
Income tax, NIC and CGT questions
- What is the main advantage of EMI or CSOP over unapproved options?
- They convert what would otherwise be an income tax and possible National Insurance charge at exercise into a Capital Gains Tax charge at eventual sale, which is usually a lower overall tax cost.
- Does a company need to file an ERS return if it made no grants this year?
- Yes, if a scheme is registered with HMRC, a nil return is still required for every tax year until the scheme is formally closed.
- What happens if the ERS return is filed late?
- HMRC can charge automatic penalties for late filing, and in the case of EMI, poor compliance can put the tax-advantaged status of options at risk.
- Is Business Asset Disposal Relief automatic for all employee shareholders?
- No. It requires meeting a shareholding percentage and holding period test, or for EMI shares, meeting the relaxed EMI specific version of that test.
General information for founders, not legal or tax advice. Thresholds and rates change, so confirm the current position with an adviser in the relevant country before granting.