Employee equity incentives are a powerful way to align the interests of employees with business success. Conditional equity milestones and flowering shares are popular structures that allow companies to incentivize employees while tying rewards to specific business goals. However, these schemes come with important tax and compliance obligations that businesses must navigate carefully.

In this blog, we’ll break down the key aspects of conditional equity milestones and flowering shares, how they are taxed, what paperwork is required, and how making a Section 431 election can optimize tax efficiency.

What Are Conditional Equity Milestones?

Conditional equity milestones involve awarding shares or options to employees, which only vest or become exercisable upon achieving predefined goals, such as:

• Revenue or profit targets
• Operational milestones (e.g., product launches)
• Time-based conditions (e.g., staying with the company for a specific period)

These awards encourage employees to contribute to long-term company growth while ensuring that ownership is earned based on performance.

Example:

A technology startup grants an executive 1,000 shares at £1 each, which will vest if the company achieves £5 million in revenue within three years. If the milestone isn’t met, the shares are forfeited.

What Are Flowering Shares?

Flowering shares, also known as growth shares or hurdle shares, are a type of equity that provides limited rights initially but gains value or rights once certain conditions are met, such as achieving a specific share value or business milestone.

Key Features of Flowering Shares:

• They often carry restricted rights until a set condition is achieved (e.g., the company’s valuation reaching a target level).
• Typically issued at a nominal value and linked to a “hurdle” that must be surpassed before they gain full rights.
• They allow companies to provide significant upside to employees without immediate dilution to existing shareholders.

Example:

An employee is granted flowering shares with an initial nominal value of £1 per share. The shares will only “flower” (i.e., acquire full economic rights) once the company’s share price exceeds £10. If the share price reaches £15, the employee benefits from the increase beyond the hurdle.

Understanding Restricted Securities and Readily Convertible Assets

What Are Restricted Securities?

Restricted securities are shares that have conditions or restrictions limiting their sale, transfer, or enjoyment of rights (such as voting or dividends) until specific conditions are met. Under ITEPA 2003, Part 7, Chapter 2, restricted securities are subject to special tax rules that allow taxation to be deferred until restrictions are lifted.

Examples of Restricted Securities:

Forfeiture Clauses:

• If an employee leaves the company before completing three years of service, the shares must be sold back to the company at the issue price.

Clawback Provisions:

• If the company fails to meet performance targets, the shares can be repurchased at a nominal value.

1. Transfer Restrictions:

• Shares cannot be sold to third parties without board approval.

Tax Impact:

• The restriction reduces the initial value of the shares for tax purposes.
• A Section 431 election can be made to pay tax on the unrestricted value at the time of grant.

Example Calculation Without a Section 431 Election:
An employee is granted shares at £1 each, with a restriction that they cannot sell them for three years. The unrestricted market value is £10 per share.

• Without an election, the employee is taxed on £1 at grant.
• When restrictions lift after three years, if the share value is now £15, the employee pays tax on the uplift to £15.

Example Calculation With a Section 431 Election:
If an election is made, the employee is taxed on £10 upfront, and any future increase to £15 will be subject to CGT instead of income tax.

What Are Readily Convertible Assets (RCAs)?

Readily Convertible Assets (RCAs) are shares or securities that can easily be converted into cash or have an established market for sale. HMRC considers shares to be RCAs if they can be sold without significant restrictions or if there is a known market for them.

Under ITEPA 2003, Section 702, RCAs are subject to PAYE and National Insurance Contributions (NICs) at the time of vesting.

Examples of Readily Convertible Assets:

Listed Shares:

• Shares of a publicly traded company are considered RCAs because they can be sold on the stock exchange instantly.
• Private Company Shares with Market Availability:
• If a private company has a contractual agreement with investors to buy shares from employees, the shares are RCAs.

Shares Subject to Takeover Offers:

• If the company is in merger talks and employees have a guaranteed exit opportunity, the shares are considered RCAs.

Tax Impact of RCAs:

• Employees must pay income tax and NICs through payroll when the shares vest or become convertible.
• Employers are responsible for withholding tax via PAYE.

Example of RCA Tax Calculation:
An employee receives shares in a company that is about to be acquired, making the shares readily convertible. The shares were granted at £2 but are worth £10 at vesting.

1,000×(£10−£2)=£8,000 taxable as income1,000 \times (£10 — £2) = £8,000 \text{ taxable as income}1,000×(£10−£2)=£8,000 taxable as income

Taxation through PAYE applies, and NICs are deducted from the employee’s paycheck.

Formal Paperwork Required

1. Share Grant Documentation

1. Share Award Agreement — Specifies vesting conditions and rights.
2. Board Resolutions — Approves the equity scheme.
3. Employment Contract Addendum — Documents the award terms.
4. New Articles of Association:

• Required for special share classes like flowering shares.

2. Section 431 Election Form

• Signed by both employer and employee within 14 days of acquisition.

3. Reporting Requirements

Equity grants must be reported to HMRC via the ERS return, due by 6th July following the tax year end (5th April).

Key Dates to Remember

ActionDeadlineGranting of sharesAs per company decisionSection 431 election14 days from grantHMRC ERS return filing6th July after tax year

Potential Pitfalls and Planning Tips

Plan for Cash Flow Needs:
Employees need to be aware of tax liabilities upfront if making a Section 431 election.

Seek Professional Valuations:
Defensible valuations at grant help mitigate HMRC scrutiny.

Avoid Common Mistakes:
Ensure all compliance paperwork is in order to prevent penalties.

Conclusion

Conditional equity milestones and flowering shares provide a strategic approach to employee incentives, aligning employee interests with business growth. However, understanding the tax implications and compliance requirements is crucial to making the most of these incentives.

Key Takeaways:

• Conditional equity milestones can be tax-efficient but require careful planning.
• Section 431 elections can significantly reduce tax burdens at the point of sale.
• Ensure all paperwork, including share agreements, board resolutions, and filings with HMRC, are in place.