Unapproved share options are taxed as employment income when they are exercised, not when they are granted. The option holder pays income tax at their marginal rate on the difference between the strike price and the market value of the shares on the day of exercise. If those shares are readily convertible assets, National Insurance also applies and the employer must run the charge through PAYE. A separate Capital Gains Tax charge arises later, when the shares are sold.
When the Tax Charge Arises
Granting an unapproved option is not a taxable event. The charge lands at exercise. Under sections 476 and 477 of the Income Tax (Earnings and Pensions) Act 2003, the gain on exercise counts as employment income for the tax year in which the exercise happens.1legislation.gov.uk. Income Tax (Earnings and Pensions) Act 2003 – Section 476
The taxable amount is the market value of the shares at exercise minus the strike price paid. Acquire shares worth £50,000 for a strike price of £10,000 and the taxable gain is £40,000. That £40,000 sits on top of the option holder’s other earnings for the year and is taxed at their marginal rate.
For someone already earning £60,000 in 2025/26, the whole £40,000 falls inside the higher rate band and produces an income tax bill of £16,000 on the option gain alone. A large exercise can also push total income past £100,000, at which point the personal allowance tapers by £1 for every £2 of adjusted net income above that threshold and disappears entirely at £125,140.2GOV.UK. Income Tax Rates and Personal Allowances This effect catches a lot of option holders unprepared.
PAYE and Readily Convertible Assets
Whether the employer has to operate PAYE turns on whether the shares are readily convertible assets. Section 700 of ITEPA 2003 requires PAYE on the exercise gain where the option was granted on or after 27 November 1996 and the shares can be readily sold for cash.3HM Revenue & Customs. Employment Income Manual – EIM11875 – PAYE: Special Type of Income: Gains From Share Options
Shares in listed companies are almost always readily convertible. Private company shares become readily convertible if, for example, the company or another party has agreed to buy them back, or trading arrangements are likely to come into existence around the time of exercise.4HM Revenue & Customs. Employment Income Manual – EIM11877 – PAYE: Special Type of Income: Gains From Share Options If the shares are not readily convertible, PAYE does not apply and the option holder reports the gain through self-assessment instead.
National Insurance Contributions
When the shares are readily convertible assets, the same gain attracts National Insurance for both the employee and the employer.5HM Revenue & Customs. National Insurance Manual – Class 1 NICs: Securities: Readily Convertible Assets For 2025/26, employee Class 1 NICs run at 8% on earnings between £12,571 and £50,270 and 2% above that. The employer rate is 15% on earnings above £5,000, following the increase that took effect in April 2025.
The employer cost can be significant. On a £40,000 gain, employer NICs at 15% come to £6,000. HMRC allows the employer and the option holder to sign a joint NIC election agreeing that the employee will bear some or all of the employer NIC liability.6GOV.UK. Transfer Employer’s National Insurance to Employees The election has to be signed and dated by both parties to take effect. Many option agreements make signing one a condition of exercise, so the terms are worth reading before you commit.
If the shares are not readily convertible assets, no NICs are due on the exercise gain at all.
Section 431 Elections on Restricted Shares
Shares acquired on exercise sometimes carry restrictions, such as compulsory transfer provisions, dividend limits, or forfeiture conditions. Those restrictions reduce market value at exercise, which lowers the income tax charge in the short term. The catch is that when the restrictions later fall away, HMRC can treat the resulting uplift in value as further employment income under the restricted securities rules in ITEPA 2003. A second income tax bill then arrives, often unexpectedly.
A section 431 election prevents that. The option holder and employer file the election jointly within 14 days of the shares being acquired, agreeing that tax will be charged on the unrestricted market value at exercise. The restrictions are then ignored for income tax purposes, and any future growth is taxed only under CGT on sale. Because CGT rates are lower than income tax rates, this is usually the better outcome. Miss the 14-day window and the election cannot be made.
Capital Gains Tax on Sale
Selling the shares triggers a second, separate tax charge. The base cost for CGT is the strike price paid plus any amount already taxed as employment income on exercise. Pay £10,000 for shares, get taxed on a £40,000 gain, and your base cost is £50,000.7HM Revenue & Customs. HS287 Capital Gains Tax and Employee Share Schemes (2025) That mechanism stops the same value being taxed twice.
The gain is the sale price minus base cost. Sell those shares for £75,000 and the capital gain is £25,000. For 2025/26, CGT on shares is 18% for basic rate taxpayers and 24% for higher or additional rate taxpayers.8GOV.UK. Capital Gains Tax: What You Pay It On, Rates and Allowances Which rate applies depends on where the gain sits once added to your other taxable income for the year.
Every individual also has an annual exempt amount, currently £3,000.9GOV.UK. Capital Gains Tax Rates and Allowances The first £3,000 of gains in the year is tax-free, so a £25,000 gain becomes £22,000 taxable. The allowance has dropped from £12,300 a few years ago, so it shelters far less than it used to.
Employer Registration and Annual Returns
Any company operating an unapproved share option scheme has to register it with HMRC through the Employment Related Securities online service. Registration is due by 6 July following the end of the tax year in which the first reportable event occurs.10GOV.UK. Register Your Employment Related Securities Scheme HMRC issues a scheme reference number that is used for all future filings.
After registration, an annual return is due by 6 July each year for as long as the scheme exists. The return covers grants, exercises, assignments, releases, and cancellations during the previous tax year, and it is filed online, typically by the company secretary.11GOV.UK. Other Employment Related Securities Schemes or Arrangements: Guidance Notes A nil return is still required in years when nothing happened.
Late-filing penalties are automatic:
- One day late: £100
- Three months late: a further £300
- Six months late: another £300
- Nine months late: daily penalties of £10 per day may begin
Penalties apply per scheme, so a company running several ERS schemes that all miss the deadline faces separate penalties on each.12HM Revenue & Customs. ERSM140080 – Reporting Requirements Persistent non-compliance also tends to draw wider HMRC attention to the company’s payroll and tax affairs.