Sweet equity and restricted securities: the key principles under ITEPA

Sweet equity is a small slice of a company’s ordinary shares, offered to management at a low price, that takes most of the upside if the business grows.

It usually appears in private equity and venture-backed deals. The investor puts in most of the money through “institutional strip” instruments, such as preference shares and loan notes, which rank first and carry a fixed return. Management then buys ordinary shares (the sweet equity) for a small amount. Those shares sit behind the investor’s money, so they are worth little today but gain fast if the company is sold for much more than the investor put in.

For example, an investor puts in £10 million, mostly as loan notes and preference shares, and management subscribes £100,000 for 10% of the ordinary shares. If the company later sells for £40 million, the strip takes its £10 million plus return first, and the ordinary shares take most of what is left. The gap between what management paid and what the shares later fetch is where the tax questions arise.

Shares you get because of your job or role are “employment-related securities”, and the employment income rules apply whether or not you paid for them.

That covers employees and directors, and it covers shares acquired through the job even if a family trust or a personal company holds them. The starting question is simple: did you pay full market value? If you paid less, the shortfall can be taxed as employment income, and the rules in Chapter 2 add further charges if the shares carry restrictions. A price that looks fair to the people agreeing the deal is not enough. It needs to stand up against a proper valuation.

Shares are restricted securities when a contract or arrangement contains a restriction that makes them worth less than they would be without it (section 423 ITEPA).

The legislation sets out three kinds of restriction, each applying only if the one before it does not:

1. Forfeiture, transfer or reversion (s423(2)). You can lose the shares, or have to hand them back, in certain circumstances and receive less than their market value ignoring that term. A typical “bad leaver” clause is the classic example.
2. Limits on your freedom (s423(3)). Restrictions on selling the shares or the proceeds, on keeping them, or on rights attached to them.
3. Disadvantage (s423(4)). Disposing of, keeping or exercising rights over the shares could cause a disadvantage to you or someone connected to you.

Most sweet equity shares are restricted in practice. Leaver provisions are standard in shareholders’ agreements, and transfer restrictions and some drag-along terms can also bring shares within these rules, depending on how they are drafted.

There are narrow exceptions (s424). For example, a requirement to offer the shares for sale if you leave because of misconduct does not on its own make shares restricted. These exceptions do not apply if avoiding tax or NIC is a main purpose of the arrangements.

Income tax can arise at two points: when you acquire the shares, and later when a “chargeable event” happens.

On acquisition. If you pay less than the actual market value of the shares (AMV, which takes the restrictions into account), the difference can be taxed as employment income. Where the restriction is forfeiture that will lapse within five years, section 425 removes the charge on acquisition, but the later charge remains.

On a chargeable event. Section 426 charges income tax when one of three things happens (s427):

• the restrictions are lifted (for example, on an exit or when forfeiture rights lapse);
• a restriction is varied;
• the shares are sold while still restricted, other than to an associated person.

The amount taxed is set by a formula in section 428. In simple terms, it is the unrestricted market value of the shares at the event, multiplied by the proportion by which you originally got a benefit. That proportion is the unrestricted value at acquisition, less what you paid and anything already taxed on acquisition, divided by that unrestricted value, adjusted for earlier charges and for any restriction still left afterwards.

The practical consequence is that the amount the restrictions take off the value on day one is not taxed on day one. It is carried forward as a percentage and applied to the value of the shares on the day the restrictions lift, which could be a much larger number.

A section 431(1) election tells the tax system to ignore every restriction when the shares are acquired, so tax is settled once, up front, and the later chargeable-event charges fall away.

The election works as follows:

• What it does. Market value at acquisition is worked out as if the restrictions did not exist, and sections 425 to 430 stop applying. Any tax due is charged at acquisition, on the unrestricted market value less what you paid.
• Who makes it. The employer and the employee make it jointly. The employee must be a party even if a spouse, a family trust or a personal company acquires the shares.
• When. Within 14 days of acquisition (s431(5)). There is no extension.
• How. In writing, signed by both of you. HMRC publishes sample forms, but it accepts any document, such as the subscription agreement, that records the same key terms, and verifiable electronic signatures are acceptable. It can be signed before the shares are issued, and it is irrevocable once they are acquired.

The trade-off is real. You pay tax earlier, on shares that may be hard to sell and could turn out to be worth nothing. If the shares are later forfeited or lose value, you may have paid tax on value you never receive. In return, the future growth is no longer exposed to income tax and is taxed as a capital gain instead.

Some shares get a deemed election automatically: shares under tax-advantaged plans (s431A) and shares acquired in arrangements with a tax avoidance purpose (s431B). Where the parties believe they are paying full unrestricted value but HMRC has not agreed it, they can make a protective election as a safeguard, and HMRC says that on its own this is not evidence of a value difference.

Two values run through these rules, and each does a different job.

• Unrestricted market value (UMV): what the shares would be worth if the restrictions did not exist. It is used to work out limits and the chargeable-event formula in s428. For example, the EMI individual limit is tested against it.
• Actual market value (AMV): what they are actually worth with the restrictions in place, which is usually lower. This is the tax point at acquisition: the income tax charge is worked out on AMV less what you paid, so paying AMV means no charge on day one.

Sweet equity is often priced at or near AMV, which reflects the leaver terms and the fact that it sits behind the investor’s strip. That looks fair commercially, and because AMV is the tax point, paying AMV means no income tax on day one. UMV still matters, though. It feeds the s428 formula on a later chargeable event, and it is the value a section 431 election brings into charge at acquisition, as if the restrictions had never existed.

Because the numbers are so sensitive, the valuation should be done properly, by someone qualified, at the time the shares are issued. Where the value is uncertain, HMRC’s Shares and Assets Valuation team can agree a value in advance, which gives you something to rely on later.

For venture capital and private equity deals, HMRC has agreed a safe harbour with the British Private Equity and Venture Capital Association (BVCA) that can take much of the valuation risk out of sweet equity.

Under the memorandum of understanding, which HMRC publishes in its manual at ERSM30520, HMRC accepts that the price managers pay is the initial unrestricted market value when all of these conditions are met:

• the managers’ shares are ordinary capital;
• any preferred capital used as leverage is on commercial terms, with a return no lower than the most expensive comparable finance from unconnected investors;
• the managers pay no less per share than the investor pays for ordinary shares of the same class or with substantially the same rights;
• the managers buy at the same time as the investor;
• the shares carry no rights that other holders of ordinary capital do not have; and
• the managers are fully paid through salary and bonus under a separate employment contract.

Where the conditions are met, the s428 formula produces a nil result at the outset, leaver provisions under s423(2) are not treated as creating a discount, and tag-along and drag-along rights are accepted as not reducing value. The memorandum also says the outcome is the same whether or not a Chapter 2 election is made, although a protective election can still be worth considering.

It is a safe harbour only. It does not stop anyone arguing for a different result, and HMRC is not bound if avoidance is a main or significant purpose, or if the structure departs materially from the one described. Ratchets have their own separate conditions.

The company, not just you, has paperwork and possible payroll duties when sweet equity is issued.

• Payroll. A chargeable-event charge is treated as a notional payment, and PAYE applies where the shares are readily convertible assets. Broadly, that means shares that are quoted or subject to a current or future trading arrangement, with a further test for shares on which the company can claim a corporation tax deduction. Shares in a private company are often not readily convertible, but a planned exit or sale can change that, so the position needs checking at each event. National insurance follows its own rules and should be checked separately.
• Annual ERS return. The employer must file an employment related securities return by 6 July after the end of each tax year, including a nil return if nothing happened, and must register the scheme first if it has not filed before. Late returns attract automatic penalties. The return asks for the actual and unrestricted market value of each share at acquisition, the nature and length of the restriction, and whether a section 431 election was made, so keep the election and the valuation papers with the return.
• Your own records. Keep a signed copy of any section 431 election, the valuation evidence, and the shareholders’ agreement. You will want all three when you sell.

Growth that is not taxed as income is taxed as a capital gain when you sell, at 18% or 24% for disposals from 6 April 2026.

The 18% rate applies to gains that fall within your remaining basic rate band, and 24% to anything above it. Any amount already taxed as employment income, whether at acquisition or on a chargeable event, is added to your cost, so the same value is not taxed twice. The annual exempt amount is £3,000 for 2026 to 2027.

Business Asset Disposal Relief (BADR) now has the same 18% rate for qualifying gains. For shares you generally need to have been an employee or officer of the company, and to have held at least 5% of both the shares and the voting rights, for at least two years before the sale, in a trading company. Many sweet equity holders hold well under 5%, so BADR is often out of reach, and the choice between income tax and capital gains tax at the earlier stages matters even more.

With a section 431 election, Maya pays £12,800 in tax on a £50,000 gain, against £14,400 without one, because the election fixes the income tax at the start.

Maya subscribes for 10,000 sweet equity shares at £0.80 each (£8,000). The shares are subject to bad-leaver forfeiture, so the actual market value (AMV) is £8,000, the same as she pays, but ignoring restrictions the unrestricted market value (UMV) is £10,000. The restrictions lift on an exit in year four, when the shares are worth £60,000 and she sells for that amount.

Assumptions: higher-rate taxpayer (40% income tax, 24% CGT), no national insurance, annual exempt amount ignored. The example assumes a deal outside the BVCA safe harbour, where the unrestricted value is higher than the price paid. Inside the safe harbour, the price paid is accepted as the unrestricted value and no charge arises.

Without an election. AMV equals the price paid, so nothing is taxed at acquisition. At the exit, the s428 formula applies. The proportion carried forward is (£10,000 − £8,000) ÷ £10,000 = 20%. Taxable amount = £60,000 × 20% = £12,000 of employment income. Her cost for capital gains is £8,000 + £12,000 = £20,000, so the gain is £40,000.

With an election. At acquisition she pays tax on £10,000 − £8,000 = £2,000 of income. Her cost for capital gains is £10,000, so the gain at exit is £50,000.

The bigger the growth, the bigger the difference, because without an election the 20% is applied to an ever larger value.

Most sweet equity tax problems come from the same few mistakes.

• Missing the 14 days. The deadline for a section 431 election cannot be extended, and the election cannot be made later.
• Assuming the election is automatic. It is deemed only for tax-advantaged plan shares and in avoidance cases. Ordinary sweet equity needs a signed, joint election.
• Relying on an old valuation. A price agreed months before completion may not reflect the value on the day the shares are issued.
• Forgetting later events. A refinancing, a share-for-share exchange or a change to the leaver terms can be a chargeable event or a variation (s430A has specific rules for exchanges).
• Ignoring who holds the shares. Shares held through a family trust or personal company are still caught, and the employee must still sign the election.
• Treating the shareholders’ agreement as boilerplate. The leaver terms, transfer restrictions and drag-along provisions decide whether the shares are restricted at all.

• Shares you get through your role are employment-related securities, and restrictions such as leaver clauses can make them restricted securities (s423).
• Without an election, the value the restrictions take off at acquisition is carried forward and applied to the full value of the shares when the restrictions lift (s426 to s428).
• A joint section 431 election within 14 days of acquisition fixes the tax up front and leaves future growth to capital gains tax.
• In a venture or private equity deal, check whether the BVCA safe harbour applies. If it does not, get a proper valuation, keep the paperwork, and make sure the company files its annual ERS return by 6 July.

This post gives general information, not personal tax or legal advice. The rules depend on the facts of each case, so take advice before you sign a subscription agreement or an election.

• ITEPA 2003, Part 7 Chapter 2 (restricted securities)
• HMRC ERSM30300: restricted securities acquired on or after 16 April 2003
• HMRC ERSM30400: restricted securities, calculation of charge
• HMRC ERSM30420: calculation of charge, simple examples
• HMRC ERSM30450: elections to exclude outstanding restrictions
• HMRC ERSM30460: elections to exclude outstanding restrictions, further issues
• HMRC ERSM30520: BVCA memorandum of understanding
• HMRC ERSM170020: PAYE and NICs
• HMRC ERSM170100: PAYE and NICs on special charges
• GOV.UK: other employment related securities schemes, guidance notes
• GOV.UK: Capital Gains Tax rates
• GOV.UK: Business Asset Disposal Relief
• Forvis Mazars: understanding ERS returns