When an employee shareholder leaves, is it capital or income?

Why is the mechanism the whole question?

There is a conversation that happens in most growing companies about two years too late. Someone who was given shares early is leaving, everyone agrees they should not keep them, and the question is how to get them back.

By that point the answer is largely fixed. The articles of association say what they say. The election that would have shaped the leaver's position was either signed within fourteen days of acquisition or it was not. The company either has distributable reserves or it does not. What remains is choosing between mechanisms whose eligibility was determined by decisions nobody was thinking about at the time.

The stakes are not marginal. The same economic outcome, a leaver walking away with an agreed sum for their shares, can be taxed as a capital gain, as a distribution, or partly as employment income with payroll consequences attached. On a six-figure payment the spread between the best and worst outcome is frequently larger than the leaver's final year of salary.

Three things drive it:

• The articles. What happens on leaving, whether good and bad leavers are treated differently, how the price is set, and whether the company has flexibility about the route. This is a drafting question that becomes a tax question years later.
• The election history. Whether s 431 elections were made on acquisition, and on what basis the shares were valued at that point.
• The mechanism available. Purchase of own shares, sale to other shareholders or management, capital reduction, sale to an employee benefit trust, or simply letting the leaver keep the shares. Each has different conditions and a different tax profile, and not all of them will be available when the moment arrives.

In plain English

The leaver's tax bill is mostly decided by paperwork signed years earlier and by wording in the articles nobody read carefully. By the time someone is actually leaving, you are choosing between the options you left yourself, not designing from scratch.

What are the employment-related securities rules actually doing?

The employment-related securities rules in ITEPA 2003 Part 7 sit underneath every mechanism described below. They are the reason an exit that looks like a straightforward share sale can produce an employment income charge, and sometimes a payroll liability.

Two situations matter most on a leaver's disposal.

Restricted securities, and the s 431 election. Where restricted securities are acquired without a full election under ITEPA 2003 s 431, the restrictions are generally taken into account in determining their value at acquisition. A later charge can then arise under Part 7 Chapter 2 when a chargeable event occurs, such as the lifting of restrictions or a disposal. A full s 431 election instead values the securities as if the restrictions did not apply, typically accelerating tax to the acquisition so that subsequent growth falls outside the restricted securities charge.

The election is made jointly by employer and employee within fourteen days of acquisition, and the window cannot be extended. It is worth being precise about what it does and does not achieve. It addresses the Chapter 2 restricted securities regime. It does not immunise the shares against the rest of Part 7, and in particular it does not prevent a separate charge arising under Chapter 3D if the employee later disposes of the securities for more than their market value.

Consideration exceeding market value. Where an employee receives more for their shares than their market value, a charge can arise under Part 7 Chapter 3D on the excess. This is the one founders find counter-intuitive. HMRC will generally expect the market value of a leaver's minority holding to reflect discounts for the size of the stake and for the absence of a market. A price struck at a straight pro-rata share of the company's overall value can therefore be treated as a disposal at an overvalue, with the excess taxed as employment income.

Read that carefully, because it inverts the usual instinct. Being generous to a departing employee, by paying them a full pro-rata price rather than a discounted minority price, is the thing that creates the charge.

What an ERS charge actually costs. An ERS income tax charge does not automatically bring PAYE and National Insurance with it. Whether PAYE applies depends principally on whether the securities are readily convertible assets, and the National Insurance position requires the relevant conditions to be satisfied in their own right. The amount is employment income; PAYE and NIC may also arise, including where the securities are readily convertible assets, depending on the circumstances. That distinction matters commercially, because employer National Insurance is a company cost that appears in no one's model of the transaction.

Where ERS charges do apply, they are not simply additive with capital gains tax. The amount subject to employment income tax increases the base cost for capital gains purposes, so the same value is not taxed twice.

In plain English

Paying a leaver a generous price can cost them more than paying a fair one. HMRC expects a small shareholding in a private company to be worth less per share than a controlling one. Pay above that and the extra can be treated as employment income rather than sale proceeds.

Which exit mechanisms are available, and what does each cost?

Purchase of own shares

The default route for minority exits, and the one with the strictest conditions.

A purchase of own shares by an unquoted UK company is, in principle, both an income distribution and a capital disposal. Income treatment takes priority, with the consideration excluded from the capital gains computation to the extent it has been charged to income tax, so the two do not overlap (TCGA 1992 s 37). Whether the payment is a distribution at all is determined by CTA 2010 Part 23: broadly, the buyback is a distribution except to the extent it represents a repayment of capital or is made for new consideration. Where shares were originally issued at a premium, HMRC accepts that the premium can constitute new consideration on a subsequent buyback unless it has already been used to pay up capital, with the practical effect that an income charge often arises only where the proceeds exceed the original subscription price.

Capital treatment is available where the conditions in CTA 2010 s 1033 and the sections following it are met. Some are mechanical: a minimum five-year ownership period, and a requirement that the seller's interest is substantially reduced, tested at 75% of the previous holding. Others require judgement, in particular whether the company is a trading company and whether the buyback is for the benefit of the trade.

Two practical constraints bite hard in real companies. The Companies Act 2006 requires the purchase price to be paid in full at completion, which caps the technique at what the company can fund on the day and drives the use of multiple completion contracts. And the buyback must be reported to HMRC within 60 days where exempt distribution treatment applies, with an explanation of why the conditions are met, which is essentially the same information a clearance application would contain.

Advance clearance under CTA 2010 s 1044 is not strictly required but should be taken as a matter of course. Where a clearance has been obtained, the reporting obligation is simplified, since a copy of the clearance correspondence carries most of the detail.

Sale to other shareholders or to management

Sometimes the shareholders' agreement or articles provide for the leaver's shares to be offered to existing shareholders, to a parent entity, or to members of management the company wants to bring into ownership.

This is a real disposal, so capital gains treatment applies to the leaver in the ordinary way. It avoids the s 1033 conditions and the company law funding constraint entirely, because the company is not the purchaser. The ERS charges remain in point. Where they apply, a proportion of the proceeds is employment income, with PAYE and NIC arising depending on the circumstances, including whether the securities are readily convertible assets.

Capital reduction

Where the company has sufficient share capital, it may be possible to cancel some of the leaver's shares through a capital reduction and return capital to them up to the value of those shares. For this purpose, share capital comprises paid-up nominal share capital, share premium, capital redemption reserve and redenomination reserve.

In practice it is usually necessary to cancel all the nominal share capital held by the employee, in order to eliminate their holding, and if required to draw further capital from one of the other sources to cover any additional amount paid. Where the amount paid to the employee is less than the nominal share capital cancelled, the excess is transferred to distributable reserves.

Under the general principles in CTA 2010 Part 23, a repayment of capital is not treated as a distribution. The capital gains analysis then runs through TCGA 1992 s 122: a qualifying repayment of capital can constitute a capital distribution in respect of the shares, giving rise to a deemed disposal of an interest in them. Whether that amounts to a disposal of the entire holding depends on the mechanics, and in particular on whether all of the employee's shares are cancelled. The distinction is easy to skate over and it changes the computation.

Two further points need care. Where the shares convert to a different class on leaving, it is necessary to consider whether that conversion is a reorganisation under TCGA 1992 s 126, deferring the gain, or a chargeable disposal in its own right. And where a value freeze is used, the subsequent allocation of proceeds on an eventual exit must be supported by the terms of the articles. If proceeds are not allocated in accordance with the rights the articles confer, employment income charges can arise for the other employee shareholders under ITEPA 2003 Part 7 Chapter 3D, following the principles in Grays Timber Products Ltd v HMRC [2010] UKSC 4.

Capital reductions can also be used to cancel shares that have been forfeited under bad leaver provisions. Any capital released is credited to distributable reserves, and a capital loss will typically arise for the shareholder.

Sale to an employee benefit trust

An employer can establish an employee benefit trust to buy and hold shares, creating a warehousing capacity and, in effect, an internal market for leavers.

There is an actual disposal of shares, so capital gains treatment should apply. Where the ERS charges are in point, a proportion of the proceeds is employment income, again with PAYE and NIC depending on the circumstances. The trust can be funded by employer contributions, by the onward sale of the shares, or by loan. There are significant tax and commercial considerations in establishing and operating an EBT and it is not a light-touch structure.

Frozen return value, and doing nothing

Two further options are worth naming because they are used more often than they are planned.

Where employees acquire shares on the understanding that value will be realised only on a planned exit event, the articles may defer realisation for leavers until that event, with proceeds typically capped at the value of the shares at the time of leaving. Leavers usually lose the right to dividends and votes but retain the shares. Implementing a value freeze needs both tax and legal advice, particularly on the conversion and allocation points noted above.

And sometimes the answer is that nothing happens. The employer may be relaxed about departing employees retaining shares, and no formal buyout mechanism exists. This is more common where a market for the shares is available. Private companies registered with the Private Intermittent Securities and Capital Exchange System, the FCA-supervised framework that opened in 2025 and saw its first trading event on the London Stock Exchange's Private Securities Market in early 2026, may increasingly take the same approach [2][3]. Transfers of shares on PISCES are exempt from stamp duty and SDRT [3].

In plain English

There are five or six ways to get shares back from someone who is leaving. They look similar commercially and they are taxed very differently. The one you can actually use depends on your reserves, your articles, and paperwork from years ago.

Does capital treatment mean an 18% rate?

Not by itself, and this is the assumption most likely to be wrong in a leaver conversation.

Securing capital treatment gets the return into the capital gains regime. The main rate there is 24% for higher and additional rate taxpayers. Business Asset Disposal Relief reduces the rate on the first £1m of lifetime qualifying gains, and that rate is 18% for qualifying disposals on or after 6 April 2026, having moved from 10% to 14% in April 2025 [1]. But BADR is a relief with its own conditions, tested against the individual, and a minority employee shareholder frequently fails them.

The ordinary conditions require the individual to have held the shares, and to have been an officer or employee, throughout a qualifying period of at least two years ending with the disposal, and require the company to be their personal company, which brings in shareholding and entitlement tests set at 5%. An employee holding half a percent of the equity is not going to satisfy a 5% test. The significant exception is shares acquired on the exercise of an EMI option, where the personal company requirement does not apply in the same way and the qualifying period runs from the grant of the option rather than the acquisition of the shares.

The practical consequence is worth stating plainly. For most small employee holdings, the realistic best outcome is a capital gain at 24%, not 18%. Where the shares came from EMI options, 18% is genuinely in play. Those are materially different numbers and the difference is decided by how the equity was delivered years earlier, not by the mechanism used to take it back.

In plain English

Getting capital treatment and getting the 18% rate are two different achievements. Most small employee shareholdings will not qualify for the lower rate, because the relief generally requires a 5% stake. EMI shares are the main exception, which is one more reason to use EMI where you can.

Where is HMRC pushing back hardest?

Two areas deserve particular attention, because the practical position has moved even though the legislation has not.

The benefit of the trade test. HMRC's approach to whether a buyback benefits the trade has tightened. HMRC appears less willing simply to accept that a buyback from a small exiting shareholder satisfies the test, though there does seem to be more scope where the departing shareholder is a key member of management. Where HMRC's threshold on percentage ownership now sits, and how it differs depending on the circumstances, is not settled. For the moment, a company seeking capital treatment on a buyback from a smaller shareholding should expect to need a robust analysis of the benefit to the trade, and should be warned that there remains a risk clearance is refused even where a commercial rationale exists.

Transactions in securities. The anti-avoidance provisions in ITA 2007 Part 13 apply broadly where a shareholder realises an income tax advantage. HMRC may seek to counteract a transaction by treating the proceeds as income, on the basis that a capital reduction is being used to extract value in capital form rather than by way of an income distribution.

There are circumstances in which HMRC will grant clearance under ITA 2007 s 701, for example where the company has no distributable reserves and a capital reduction is therefore the only mechanism available as a matter of company law to cancel the leaver's shares. There is also a reasonable argument that, since an income tax charge on a purchase of own shares would arise only to the extent proceeds exceed the original subscription price for shares issued at a premium, an income tax advantage from a capital reduction would arise only in the same circumstances. On that basis it should be possible to use a capital reduction to return small amounts without the provisions applying. Statutory clearance is strongly recommended in any event.

Which elections, clearances and deadlines apply?

Held as a single list, because each item usually belongs to a different adviser and none of them are automatic. Each should be confirmed against current statutory wording rather than taken from a checklist.

• ITEPA 2003 s 431 election. Fourteen days from acquisition of the restricted securities. Joint election by employer and employee. The shortest and least forgiving deadline in employee share work, and the window cannot be extended.
• CTA 2010 s 1044 clearance for a purchase of own shares. Not strictly required, but it simplifies the subsequent reporting and settles the position in advance.
• Buyback reporting to HMRC. Within 60 days where exempt distribution treatment applies, with an explanation of why the conditions are believed to be met. In practice HMRC will often accept late reporting, but where the conditions have not technically been met, a late report may not be accepted.
• ITA 2007 s 701 clearance for transactions in securities, on a capital reduction or any arrangement where an income tax advantage could be asserted.
• Annual ERS return. Due by 6 July following the end of the tax year, covering reportable events on employment-related securities.
• EMI exercise following a disqualifying event. Ninety days from the event.
• US: IRC §83(b) election. Thirty days from transfer of the property, where a US taxpayer receives restricted stock. Conceptually the closest US analogue to a s 431 election, and a separate filing with its own deadline.

What changes when the leaver is in the US?

Everything above still applies to the UK company. What follows is what a UK company discovers the first time a leaver is a US taxpayer, or the company itself has crossed.

Both countries ask whether a buyback is capital or income, and they ask different questions

This is the point most likely to catch a UK company out, because the shape of the problem looks familiar and the test is not.

The UK asks whether the conditions in CTA 2010 s 1033 are met: trading company, five-year ownership, substantial reduction, benefit of the trade. The US asks an entirely different question. Under IRC §302, a redemption is treated as an exchange, and therefore capital, only if it satisfies one of the tests in §302(b): a complete termination of the shareholder's interest, a substantially disproportionate redemption, or a redemption not essentially equivalent to a dividend. Fail all of them and the payment is treated as a distribution under §301. The attribution rules in §318 can treat shares held by family members and related entities as owned by the leaver, which is capable of defeating a redemption that looks complete on the register.

The two tests overlap in spirit and not in mechanics. A buyback can therefore be capital in one jurisdiction and a distribution in the other, on the same facts and the same payment. Where the leaver is a US taxpayer holding shares in a UK company, or a UK leaver holding shares in a US parent, that mismatch has to be modelled rather than assumed away, along with the foreign tax credit position that results.

UK share plans do very little for a US employee

EMI is a UK income tax and National Insurance relief. It requires the company to meet the conditions in ITEPA 2003 Sch 5, including a UK permanent establishment and the employee's committed working time. It provides no US federal tax preference, which is the important point for a US-resident employee: the relief does not reduce the liability they are principally exposed to.

That is not the same as saying the UK relief is necessarily worthless to them. An internationally mobile employee can retain UK exposure depending on the duties they performed and their residence history, and the ERS rules require a fact-specific allocation between UK and non-UK periods. The right approach is to model the UK and US consequences in parallel rather than to assume either one drops away.

The US-side questions are separate and need answering on their own terms:

• Valuation. Options granted to US taxpayers with an exercise price below fair market value at grant risk falling within IRC §409A, with penalty consequences for the individual. The practical answer is an independent valuation supporting the exercise price. A UK company that has only ever obtained an HMRC valuation for EMI purposes has not solved this.
• Option type. Incentive stock options under IRC §422 carry statutory conditions, and in practice most UK companies grant non-qualified options to US employees, taxed on exercise as compensation with payroll withholding.
• Securities law. Compensatory equity granted to US employees needs a federal exemption, commonly Rule 701, and state blue sky positions need checking. This is a legal workstream that runs in parallel with the tax one and is easy to leave until after grant.
• Payroll. A charge arising on a US employee's shares generally requires US federal and state payroll withholding. Where an employee has worked in both countries, the charge may need apportioning between them, and the UK/US social security agreement determines which system the contributions belong in.

An employee benefit trust looks different from the US side

An EBT is a well-understood UK structure. To a US taxpayer beneficiary it is a foreign trust, which brings its own characterisation questions and potentially its own US reporting obligations for the individual. A UK company establishing an EBT that will hold shares for, or make payments to, US employees should take US advice on the point before the trust is settled rather than after. The UK analysis does not answer the US question, and the reporting obligations fall on people who will not know they have them.

Where the leaver is non-UK resident

A former employee who has moved to the US and later disposes of shares in the UK company raises a split analysis that is easy to get wrong in one direction.

The capital gain is generally outside UK taxing rights for a non-resident, subject to the temporary non-residence rules where the absence is short. But an employment income charge under Part 7 is a different animal from a capital gain: it is employment income, and the UK's taxing rights over it depend on where the relevant duties were performed rather than on where the individual now lives, with the internationally mobile employee rules governing the allocation. It is entirely possible for the same payment to fall outside UK capital gains tax while its ERS component remains within UK charge and requires UK payroll operation. Anyone assuming "they have left the UK, so this is not a UK problem" should check that assumption specifically.

In plain English

Two tax systems can look at the same buyback and reach opposite conclusions about whether it is a sale or a dividend, because they ask different questions. And an employee who has moved to the US is not automatically outside UK tax on the employment element, even where they are outside UK tax on the gain.

What breaks at a US inflection point?

Employee equity is one of the things most reliably damaged by a structural step taken for other reasons. Three moments matter.

A Delaware flip or a US-led round. Options granted while the company was independent survive a reorganisation on their own terms. Options merely promised do not. A change of ownership will commonly cause a disqualifying event for EMI purposes, including through loss of independence, unless the replacement option provisions in ITEPA 2003 Sch 5 or another relevant provision apply. Exercising within ninety days of the event generally prevents growth after the disqualifying event from being taxed as employment income under the EMI rules. That is not the same as saying every EMI and BADR benefit survives every transaction intact, and the wider consequences of the step still need working through. It is the most time-sensitive item on the list and it is routinely discovered late.

The first US hire who receives equity. The moment a US taxpayer holds or is promised shares, the §409A, option type, securities law and payroll questions above all become live at once. The cheapest time to answer them is before the first grant, when the answer is a plan design decision. The most expensive is during diligence, when it is a disclosure.

A sale or a secondary. A buyer's advisers will test the option register against the board minutes, the valuations against the grant prices, and the ERS annual returns against the events that actually happened. Employee equity problems have a particular quality in diligence: they are individually small, numerous, and they attach to named people who are still employed by the business the buyer is acquiring.

What should a founder do now?

The pattern is the same one that governs most UK-to-US structuring. Nobody gives bad advice. The advice is sequential, the interaction between the pieces is where the damage happens, and by the time the interaction becomes visible the cheap fixes have expired.

• Read the articles as a tax document. What do they actually say happens on leaving? Is the price mechanism defined, and does it produce something HMRC would recognise as market value for a minority holding? Is there flexibility about the method, or has one route been mandated?
• Audit the s 431 elections. For every employee shareholder, was one made, and was it made within fourteen days? This is a finite, answerable question, and while it does not settle the whole Part 7 analysis, it settles a significant part of it.
• Check whether BADR is realistically available. For most small holdings it is not, unless the shares came from EMI options. Knowing that before a conversation with a leaver prevents an expectation being set that cannot be met.
• Know your reserves position before you need it. A purchase of own shares requires distributable reserves and payment in full at completion. If the position is thin, the mechanism is not available and the alternatives take longer to arrange.
• Anticipate the leaver, not just the exit. Share plans are designed for the upside. The leaver scenarios are where the disputes and the unexpected charges arise, and they can be planned at the point the scheme is established for almost no additional cost.
• Answer the US questions before the first US grant. Valuation, option type, securities exemption and payroll. Four questions, cheap to answer in advance, expensive to remediate.
• Take the clearances. Sections 1044 and 701 as applicable, and expect the benefit of the trade analysis to need real work rather than assertion.

The right moves in the wrong order still break outcomes. In employee equity the wrong order is almost always the one where the mechanism is chosen after the person has already resigned.

For a founder with a leaver situation forming, or a share plan being designed ahead of a US expansion, the Structure Review works through this on your own facts, and the free Exposure Score is a reasonable first pass on where the structural pressure sits. The companion briefing on selling a UK company to a US buyer covers what happens to the same arrangements at the point of exit.

This article is general commentary and not advice, and no action should be taken on it without advice on the specific facts. Rates, thresholds and statutory references should be confirmed against enacted legislation and current HMRC and IRS guidance. Several areas covered here are unusually sensitive to the particular facts: valuation of minority holdings, whether securities are readily convertible assets, HMRC's practice on the benefit of the trade test, eligibility for Business Asset Disposal Relief, US entity and trust classification, and the allocation of employment income for internationally mobile employees can each differ materially between taxpayers and between arrangements that appear similar.

Sources

1. HMRC, Business Asset Disposal Relief guidance, and Autumn Budget 2024 measures: BADR rate of 18% for qualifying disposals on or after 6 April 2026, 14% from 6 April 2025; £1m lifetime limit; main CGT rate 24%; qualifying conditions including the two-year qualifying period, the officer or employee requirement, and the personal company tests, with modified conditions for shares acquired under EMI options. https://www.gov.uk/business-asset-disposal-relief
2. Financial Conduct Authority, PISCES: platforms for trading private company shares: final rules published June 2025, operating within a sandbox, with the Treasury to report to Parliament by June 2030. https://www.fca.org.uk/markets/pisces-private-intermittent-securities-capital-exchange-system
3. Watson Farley & Williams, Developments in the London equity capital markets: PISCES and share digitisation (March 2026): LSE Private Securities Market first transaction announced February 2026; transfers on PISCES exempt from stamp duty and SDRT with effect from 3 July 2025. https://www.wfw.com/articles/developments-in-the-london-equity-capital-markets-pisces-and-share-digitisation/
4. On the UK mechanisms and HMRC's evolving practice, see Chris Holmes and Rachel Tucker (BDO LLP), Employee shareholder exits: capital or income?, Tax Adviser (CIOT), June 2026.

UK statutory and case references cited above: ITEPA 2003 Part 7 (in particular Chapters 2, 3D and the internationally mobile employee provisions), ss 431, 702, 716A and Sch 5; TCGA 1992 ss 37, 122, 126, and the Business Asset Disposal Relief provisions in Part 5 Chapter 3; CTA 2010 Part 23 (in particular ss 1000, 1025), ss 1033 to 1043, s 1044; ITA 2007 Part 13; Companies Act 2006 Part 18 and ss 641 to 644; Grays Timber Products Ltd v HMRC [2010] UKSC 4; Rae v Lazard Investment Co Ltd (1963) 41 TC 1; HMRC Company Taxation Manual CTM17520; HMRC Employment Related Securities Manual. US references: IRC §§83(b), 301, 302, 318, 409A, 422; SEC Rule 701; UK/US Agreement on Social Security.