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When should you consider looking a gift horse in the mouth? – the implications of gifting employees shares.
As many business owners will know, attracting the ‘right’ employees can be a constant challenge. Therefore, when Mr or Mrs Right are found, the next step in the process is often to ensure that they do not leave!
Clearly, benefits such as an above market rate salary, a bonus scheme, gym membership and/or a company car are all genuine ‘perks’ and can give employees a sense of worth, competitors can offer the same on equal or better terms and also the value of these perks are taxable on the employee.
As such, a potentially better incentive to an employee is to gift them a stake in the company via the provision of shares. This way, the employee is encouraged to be an actual ‘owner’ of the business and will ideally look to stay with the company for the long term and see it grow in value.
Sounds good! However, this brings us back to the title of this piece, are there any hidden considerations when anticipating such a move? The answer, as with most things in tax, is yes.
Transferring shares to an employee as a gift.
Whilst the employer may feel like they are doing the right thing by their employee by gifting them a shareholding, and realistically any employee should be pleased to be rewarded as such, this type of arrangement is caught by some very detailed and unpleasant tax anti-avoidance rules known as ‘Employment Related Securities’ (“ERS”).
Under the ERS rules, where an acquisition of shares, or an interest in shares, forms part of an employee’s earnings or reward for their services as an employee, the market value of the shares received forms part of the employee’s taxable employment income.
As such, whilst a gift of shares is made to an employee in good faith and for good reason, the employee would find themselves with an additional income tax bill to foot. Depending on the value of the shareholding received, this may be an ‘acceptable’ charge to the employee and may be mitigated by means of paying an additional bonus, but it is important to note that there will be a charge to tax on the employee unless they are to pay the employer in full for the receipt of the shares. As such, this gift in good faith may not appear as lucrative to the employee as may be intended.
Gifting of shares as a means of ‘locking’ the employee.
The circumstance described above is an introduction to a complex area of tax and would be relevant in a simple case where the employer gifts the employee shares on the same terms as those already held. Quite often though, as an added means of incentivising the employee, the employer will want to put in place conditions attached to the shares to safeguard an event such as the employee leaving the company. An example of this would be a condition preventing the employee from realising value in the shares in the event of their employment being terminated.
Shares gifted to employees with restrictions in place are conveniently called ‘Restricted Securities’. Such shares do carry some value, and therefore would still result in an income tax charge on the employee, but that value can be significantly reduced by virtue of the restriction.
This scenario might be tempting therefore as a means of mitigating an initial upfront tax charge on the employee. However, when any such restrictions are lifted, the market value of the shares will naturally increase.
In such a case, the employee will suffer a further income tax charge based on the market value of the shares at the point the restriction is lifted. If the company has increased in value in the time between the initial reward to the employee and the point at which the restriction is lifted, this can be another unplanned tax charge for the employee.
A way to circumvent this would be for the employer to enter into an election with the employee which has the effect of treating the initial award of shares as being made at their unrestricted market value at the time of the gift.
(Indeed, this approach is recommended in any case of providing shares to an employee so as to avoid any unwarranted attention from HMRC).
This will avoid this (in effect) ‘double tax charge’ but will mean of course that the initial employment tax charge on the employee is based on a higher market value.
For completeness, any growth in value in the shares from the point the election is made to the point the restriction(s) is lifted will subject the employee to the lower rates of capital gains tax.
Temptations to avoid an income tax charge.
Given what we have said above has been interpreted by some to be somewhat ‘doom and gloom’, HMRC are aware of such instances where employer companies have sought to artificially depress the value of the company prior to awarding employee shares so as to avoid or significantly reduce a liability to income tax on the selected employees. Such instances of this occurring which have been challenged by HMRC, and to which HMRC have succeeded, have involved: –
In such cases, HMRC simply ‘overturn’ any actions undertaken prior to the award of shares to the employee, thereby subjecting the employee to income tax based on the full unrestricted market value of the shares.
Is there a better way?
This article is not intended to dissuade employers from considering making a gift of shares to their employees, indeed, we can readily talk about the many benefits in doing so. More, this article is to serve as an informative summary on a complex area of tax so as to ensure that employers are aware of some unseen tax implications which may put a dampener on their plans to reward their employees.
That being said, where the intention of the employer is to provide a reward and incentivisation to their employees via the offering of an equity stake in their company, there are many alternative tax-advantaged planning opportunities over a straightforward gift of shares.
Our technical director Andy Wood has recorded a short video detailing other possibility.
If there is anything that is of interest to you, or you simply wish to discuss options for employee incentivisation in general, please get in touch.
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