When share sale proceeds are taxed as employment income

Q: Which tax charge applies if part is pay?

That depends on the form of the earn out: Cash earn out with no securities involved: ERSM110900 says the general earnings rules in Part 2 ITEPA normally need to be considered, rather than Part 7. Right to receive shares in the buyer: this can be a securities option within Chapter 5. Section 471(4) treats an option obtained by reason of holding employment related securities as obtained by reason of the same employment, so sellers who leave on completion can be caught as well as those who stay (ERSM110920). Forfeitable shares that vest on targets: these may be restricted securities taxed under section 426 when they vest (ERSM110930). Put and call options over retained shares: exercise can trigger Chapter 3D if the price exceeds market value at that time (ERSM80120). In each case HMRC says that if the earn out is shown to be consideration for the shares rather than value obtained by reason of employment, the market value of what is given up is taken to equal what is received, so no income tax charge arises (ERSM110920, ERSM110930, ERSM80120). The capital gains position on a genuine earn out is covered on earn outs and deferred consideration.

Q: How does this look in numbers?

Illustration only. A company is sold for £5m. A sales director who owns 10% and was given her shares when she joined would receive £500,000 if every share were paid equally. A side letter gives her £800,000 because she negotiated a bonus pool on exit. If the market value of her shares is £500,000, the £300,000 excess (less any disposal costs) is employment income under Chapter 3D in the year of sale. Her capital gain is calculated on £500,000 only. Had the extra £300,000 been paid equally to all sellers as a price adjustment, with no link to her role, it would have been capital.

Money an employee shareholder receives when their company is sold is normally a capital gain, but HMRC can tax part of it as employment income if it rewards work rather than paying for the shares. The two main routes are an earn out that is really pay for staying on, judged against the indicators in HMRC’s ERSM110940, and Chapter 3D of Part 7 ITEPA 2003, which taxes any amount an employee receives above the market value of employment related shares.

Tax investigation insurance from £108.75 a year (£9.06 a month).Pays up to £100,000 of your accountant's fees if HMRC opens an enquiry. No excess. Buy online in a few minutes.

See my price in 2 questions How the cover works Accountant? Offer cover to your clients or call 01795 841 310

Why would sale proceeds ever count as employment income?

The employment related securities rules in Part 7 ITEPA 2003 tax value obtained by reason of employment. HMRC’s guidance at ERSM110910 sets out the policy: where an earn out operates entirely to pay further proceeds of sale, with no element of remuneration, income tax and National Insurance should not be payable, but where it passes value to someone as a reward for services over a performance period, that element is within income tax and NICs.

The rules bite because of how widely shares count as employment related. Under section 421B, shares are employment related securities if the right or opportunity to acquire them was available by reason of an employment, and “employment” includes former and prospective employment. Shares made available by the employer, or a person connected with it, are treated as acquired by reason of employment unless the person offering them is an individual acting in the normal course of family or personal relationships. Managers offered shares by the company, and directors who acquired shares when joining, will therefore often hold employment related shares (see employment related securities basics).

Section 421B(7) keeps shares within the rules until 7 years after the employee has left the employer and connected companies, so a shareholder who left a few years before the sale can still be caught.

When is a higher price paid to one shareholder taxed as income?

Chapter 3D applies where employment related securities are disposed of so that no associated person remains entitled to them, for consideration that exceeds their market value at the time (section 446X). The excess counts as employment income for the tax year of disposal (section 446Y). ERSM80030 sets out the amount as the consideration, less market value, less any disposal expenses.

ERSM80010 lists typical situations: the employer buying back shares at an agreed value, the employer topping up the price on a sale to a third party, arrangements letting employees sell at a higher price than other shareholders on a takeover, and exchanges for more valuable securities. HMRC also notes at ERSM80110 that a “fair value” set by auditors for an internal share market is not the same as market value, and any excess paid over market value is likely to be charged.

The key authority is Grays Timber Products v HMRC [2010] UKSC 4, summarised at ERSM80130. A managing director held about 6% of a group under a side agreement entitling him to a larger share of any sale price above a target. On a sale for around £6m he received just over £1.4m, against just under £0.4m had all shares been paid equally. The Supreme Court held that rights personal to him were of no value to a hypothetical purchaser and so did not increase the market value of his shares. The excess was employment income.

Worried about an HMRC check? Tax investigation insurance pays your accountant’s fees if HMRC opens an enquiry or compliance check. Solar Protect cover pays up to £100,000 with no excess. It never pays tax, interest or penalties.

From £108.75 a year (£9.06 a month) for individuals, £117.57 for sole traders and £207.50 for companies and partnerships, including IPT and the £20 admin fee.

See my price in 2 questions or call 01795 841 310.

★★★★★ Rated 4.9 out of 5 on Trustpilot from over 160 reviews

How does HMRC decide whether an earn out is price or pay?

ERSM110940 sets out the key indicators that an earn out is further sale consideration:

the sale agreement shows the earn out is part of the consideration for the shares
the value received from the earn out reflects the value of the shares given up
for sellers who stay on, the earn out does not make up for being paid less than a full salary
it is not conditional on future employment, beyond a reasonable requirement to stay to protect the value of the business sold
there are no personal performance targets
sellers who do not stay, or who are not employees, receive the earn out on the same terms

HMRC also looks at the negotiations on the level of the earn out, any clearances obtained under section 138 TCGA 1992 or the transactions in securities rules, and any sign that future bonuses were converted into purchase price, which points to remuneration. Where an earn out is partly price and partly reward, it is apportioned on a just and reasonable basis.

Which tax charge applies if part is pay?

That depends on the form of the earn out:

Cash earn out with no securities involved: ERSM110900 says the general earnings rules in Part 2 ITEPA normally need to be considered, rather than Part 7.
Right to receive shares in the buyer: this can be a securities option within Chapter 5. Section 471(4) treats an option obtained by reason of holding employment related securities as obtained by reason of the same employment, so sellers who leave on completion can be caught as well as those who stay (ERSM110920).
Forfeitable shares that vest on targets: these may be restricted securities taxed under section 426 when they vest (ERSM110930).
Put and call options over retained shares: exercise can trigger Chapter 3D if the price exceeds market value at that time (ERSM80120).

In each case HMRC says that if the earn out is shown to be consideration for the shares rather than value obtained by reason of employment, the market value of what is given up is taken to equal what is received, so no income tax charge arises (ERSM110920, ERSM110930, ERSM80120). The capital gains position on a genuine earn out is covered on earn outs and deferred consideration.

How are PAYE, reporting and capital gains handled?

ERSM170100 explains that a Chapter 3D amount is subject to PAYE if the securities are readily convertible assets. If they are not, PAYE still applies to any part of the consideration paid in money, and to an asset provided if that asset is itself readily convertible. A Chapter 3D disposal is a reportable event under section 421K(3)(f), so the company must include it on its employment related securities return, due by 6 July after the end of the tax year (section 421JA). See the ERS annual return.

The same money is not taxed twice. Section 37 TCGA 1992 excludes from the disposal consideration any amount charged to income tax as the seller’s income, so the gain is worked out on the price for the shares alone. Only that capital part can qualify for Business Asset Disposal Relief.

How does this look in numbers?

Illustration only. A company is sold for £5m. A sales director who owns 10% and was given her shares when she joined would receive £500,000 if every share were paid equally. A side letter gives her £800,000 because she negotiated a bonus pool on exit. If the market value of her shares is £500,000, the £300,000 excess (less any disposal costs) is employment income under Chapter 3D in the year of sale. Her capital gain is calculated on £500,000 only. Had the extra £300,000 been paid equally to all sellers as a price adjustment, with no link to her role, it would have been capital.

How can sellers and buyers reduce the risk?

Offer the same earn out terms per share to every seller, whether or not they stay.
Pay those who stay a market rate salary and bonus, documented separately from the price.
Avoid personal targets and leaver provisions in the earn out beyond what protects the value of the business.
Record the negotiations that set the price and the earn out.
Consider whether advance clearances are appropriate; see transactions in securities and management buyouts.

What mistakes come up most often?

Assuming founders’ shares cannot be employment related securities.
Paying a key manager a larger share of the price under a side agreement without considering Chapter 3D.
Making the earn out forfeitable if the seller resigns, which counts against it under ERSM110940.
Forgetting the 6 July reporting obligation for a Chapter 3D disposal.
Ignoring the 7 year tail for shareholders who left before the sale.

If HMRC opens a check into your return, tax investigation insurance pays your accountant’s fees. Solar Protect cover pays up to £100,000 with no excess; it never pays tax, interest or penalties. Read how our cover works or get a quote.

Related Accountapedia entries

Sources

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 24 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.