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One of the best incentives which can be offered to key staff in a private company is a shareholding in the company. This is the ideal method to give them a stake in the business and a share in the results of it. It also links the employee to the employer on a long term basis and offers opportunities for rewarding them in a tax-efficient manner so that, with time, much of the profit from the shares will escape the ravages of income tax otherwise payable on earnings. The drawback is of course that if he or she leaves the employment, it may no longer be appropriate for an ex-staff member to continue with a shareholding. Hence it may be advisable to deal with this point at the outset by including pre-emption rights in the company’s Articles of Association, by which other shareholders may have the right to buy out the shares for fair value.
For the smaller company looking to recruit, retain and incentivise key employees, arrangements which allow for the discretionary grant of options, or allotment of shares, are usually best. Whilst the granting of options qualifying under the popular Enterprise Management Incentives (‘EMI’) provisions will meet the needs of many smaller trading companies, other arrangements will be necessary for some companies, where EMI statutory requirements cannot be met.
Whilst tax issues play a significant role in determining the appropriate framework for employee participation in share-ownership, it is important that in designing the scheme appropriate advice is taken by the company in relation to the key non-tax issues. These generally require a specialist mix of commercial and legal knowledge, embracing:
Income Tax – Shares Acquired At Undervalue
The basic tax position is that if an employee is allotted shares, and pays less than the market value (defined as what the employee could realise in money or money’s worth for the shares) then the element of ‘undervalue’ is an “emolument” chargeable to Income Tax at the employee’s marginal rate.
If the shares are readily convertible assets which for the independent private company would include the situation where the company is in the process of being taken over or floated, the company will be liable for employer’s National Insurance at 13.8%, and will have to account for the Income Tax on a PAYE basis. The employee will also be liable for employee’s National Insurance of at least 2% on top of the Income Tax charge, and in some cases 12%.
The better alternative may be an issue of nil paid shares. Under this method, the employee acquires the shares under an obligation to pay the market value of them as the subscription price, but he or she is not required to make any payment on being allocated the shares. This means that they are ‘nil paid’ and the amount due is left outstanding as ‘unpaid calls’ due to be paid at a future date, as agreed with the company. Payment can in fact be left outstanding indefinitely until the shares come to be disposed of; at that time the employee will have the funds to pay the calls due and can collect the balance as the profit made on the shares.
Because the shares are in theory acquired for full price, there is no income tax or National Insurance contributions charge on them at the time of issue.
Different rules apply if the shares are acquired in connection with tax avoidance arrangements, but HMRC has confirmed that a straightforward issue of nil paid shares is not regarded as being caught by these rules.
A taxable benefit arises each year on the employee equal to (currently) 4% of the unpaid calls. However, there is no benefit at all if the shares are in a closely controlled company (i.e. broadly one under the control of five or fewer shareholders) and if certain detailed conditions are satisfied (e.g. the shareholder works full time for the company in a managerial capacity).
There are practical issues to be borne in mind. For example if the company goes into winding up, the liquidator will be obliged to call for the amount due to be paid up on the shares, although this will simply cause a loss for the employee.
Income Tax – Options
Matters become a little more complex where the employee acquires the shares by exercising an option which was granted to him or her by reason of his/her employment. An option may be granted by the Company, over new shares, or by an existing shareholder (the proprietor perhaps, or an Employee Benefit Trust) over existing shares.
For the independent unquoted company, options will usually be of three types –
The class of ‘unapproved options’ includes all options which are not CSOP or EMI options, including CSOP and EMI options which for some reason have lost their approved or qualifying status.
In most cases Income Tax is not charged at the time the option is granted.
The option’s vesting date, that is the date on which the option first becomes capable of exercise, may be later than the date of grant – for example, the option may not be capable of exercise in the first three years. No tax charge arises in the UK on the vesting of any option.
Generally, the first date on which tax becomes an issue is the date on which the option is exercised. The three sorts of option are treated differently –
Schemes For Larger Enterprises
Other schemes not covered by this Memorandum include Approved Share Incentive Plans under Schedule 2 Income Tax (Earnings and Pensions) Act 2003 and SAYE Option Schemes under Schedule 3 Income Tax (Earnings and Pensions) Act 2003.
For the typical private company these tend to be over-costly in administrative terms, or over-restrictive in terms of, for example, the requirement to open the scheme to all employees. Such schemes are better suited to the larger scale organisation.
Taxing The Gain On The Shares
However the employee acquired the shares, tax will be charged on any gain arising on the ultimate sale of the shares. Normally the gain is charged at a flat rate of 18% or 28%, depending on the level of taxable income of the employee for the fiscal year in which the shares are disposed of. In the vast majority of cases the 28% rate will apply, an exception being where the employee has shares carrying at least 5 per cent of the votes in a trading company in which case, under a relief known as entrepreneurs’ relief, the tax rate on the gain is 10 per cent up to an upper limit of £10 million of gains.
The base cost for calculating the gain on sale will depend on the acquisition history –
Under rules introduced in the Finance Act 2003, some of the gain on disposal of the shares may be subject to Income Tax, if the shares are ‘Restricted Securities’. The rules apply where shares are subject to risk of forfeiture, or restrictions on transfer (conditions which apply to almost all employee shares in private companies). They are complex in their application, and any private company proposing to issue shares to employees under non-HMRC approved arrangements should seek specialist taxation and valuation advice under this head.
The company and the employee can make a joint election in relation to the taxation of the Restricted Securities on their receipt by the employee, which will usually involve the employee paying more Income Tax up-front, in order to ensure the benefit of full Capital Gains Tax treatment when the shares are sold. In general it is usually considered advisable to make this election.
In the current economic climate, share options may have an exercise price which is far below the current market price of the shares; in these circumstances the options are commonly described as being ‘underwater’. There may in addition be a limited period during which the options can be exercised, so that what was at the outset intended to be a considerable employee incentive has ceased to be any incentive at all.
In the case of unquoted companies it may be possible to reduce the exercise price of the options to an appropriate level, although the scheme rules may prevent this or require shareholder approval. In addition if the options are under an HMRC approved scheme it is likely that the requirements for approval prevent reduction in the exercise price.
An alternative is to arrange a surrender of the existing options and a re-grant of new options with a reduced exercise price. This may be an acceptable route for unquoted companies and also smaller listed companies, but once again shareholder approval will probably be required. The tax rules relating to unapproved options contain a specific provision permitting the exchange of options without triggering tax liability,
but with EMI options no exchange will be possible if the existing options have used up the individuals maximum limit.
Tax Advantage And Flexibility
The general thrust of tax mitigation planning in employee share arrangements is twofold –
Generally, from the point of view of the employee, EMI options have traditionally been the most tax advantageous, although with the abolition of taper relief the main advantage no longer applies. The rules for qualifying (and retaining qualifying status) are complex, and will rule out some companies and/or employees. Certain activities, for example leasing or property development accounting for more than 20% of a company’s activity, disqualify the company from granting EMI options, and control vesting in another company (for example a Venture Capitalist company) would similarly disqualify the company. Only companies with fewer than 250 full time equivalent employees can award EMI options. It has been announced that the rules are to be relaxed so that foreign companies may issue EMI options so long as they have a UK business conducted through a branch or UK agent.
Also an employee cannot hold qualifying EMI options over more than £120,000 worth of shares (valued at date of grant, and ignoring any restrictions on transfer or risk of forfeiture).
The range of permitted trading activities under the CSOP scheme is broader than for EMI purposes, but in other respects the restrictions imposed on an approved scheme are draconian and frequently unworkable. A £30,000 value limit applies, and the vesting period must commence three years after the date of grant (unlike EMI, where the vesting date is entirely flexible). There is considerable less flexibility in the drafting of transfer and pre-emption provisions in the Articles of Association.
Direct allotment, and grant of unapproved options, are, on the face of it, the least tax advantageous routes from the employee’s point of view. However, in certain circumstances, the tax exposure may be mitigated through the design of special deferred performance-related shares with a low initial value. Such ‘unapproved’ arrangements offer the benefit of enhanced flexibility compared to EMI and CSOP-based schemes. Specialist advice should be taken in this area, particularly in the light of the ‘Restricted Securities’ provisions introduced in the Finance Act 2003.
Obtaining a Corporation Tax deduction in the company is governed by the provisions of the 2003 Finance Act. A deduction for the company is broadly matched with the benefit to the employee liable to Income Tax in each year, or the amount that would be liable but for the relief afforded by, for example, the EMI provisions.
FOR GENERAL INFORMATION ONLY
Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.
Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.