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EMPLOYEE SHARE SCHEMES – SHARING THE CAKE
Employee share (option) schemes are often seen as a key component of the remuneration packages of employees working for listed companies. The fact that the companies are listed provides a regular market for the disposal of the shares (which are often subject to trading restrictions for a period of time to provide a medium-term incentive arrangement).
Where we are dealing with a SME there is typically no regular market place for the shares and the advantage to the employee of holding shares (or options over shares) lies in the potential capital growth and the possibility of a sale in the future.
From the existing shareholders perspective, the interests of the employees are aligned with the shareholders.
Other, softer, factors can come into play, motivation, retention, lock ins and the possibility to pay below the going rate salaries, but the overall objective remains of ensuring that employees and shareholders have a common interest.
The rationale here is that as a consequence the company is more successful and rather than having 100% of a smaller cake the shareholders have, say, 80% of a much larger cake.
From a tax perspective there is a significant difference between the rate of tax on earned income (more so if NIC is also payable) and the rate payable on capital gains. Both shares and share options are taxable as employment income at a basic level under the monies worth principal basically on the difference between the price paid and the market value of the shares at the date of acquisition.
As can be expected there is a significant body of legislation (the Employment Related Securities (ERS) provisions found at Part 7 ITEPA 2003) which seeks to counter, broadly, the artificial manipulation of share values so that the enhanced growth falls within the capital gains rather than employment income provisions.
One point to note is that where shares are acquired at under value it is potentially not only that undervalue element but also the growth in value of that undervalue element which attracts an income tax liability.
There are of course a number of approved and tax advantageous schemes which typically provide that capital growth falls within the capital gains provisions. The one which many will be aware off and most commonly seen in the SME sector are Enterprise Management Incentives (EMI). This scheme uses options rather than shares, is highly flexible and has stood the test of time. There are, however, situations where an EMI or other tax approved scheme cannot be used, and we now look at a couple of non-approved schemes which in essence bring capital growth within the capital gains provisions and minimise the initial market value of the shares.
Also known as restricted, flowering or freezer share schemes, but all have standard features and are in essence the same animal. In summary such schemes seek to freeze the existing value of the company and then issue a new class of share which only have rights to the future growth of the company.
As an initial step the rights attaching to the existing shares are altered so that all of the value of the company at that stage is reflected in the value of those shares. A new class of growth shares is then allotted and again the rights attaching to these provide that the shares are only entitled to participate in the proceeds of sale of the company above the value of the company now locked into the value of the existing shares.
There are possible variations on this basic theme including ratchets so that the growth shares receive a disproportioned percentage of the sale price over an enhanced hurdle price.
The allotment of growth shares, gives employees the legal benefit of share ownership from day one. Where it is possible to implement an EMI scheme, consideration can be given to granting EMI options over growth shares thus combining the advantages of EMI options and growth shares. This is particularly attractive where employees are approaching the value limit for the granting of EMI options (currently £250,000) or to delay payment for the shares until the options are exercised.
The objective of growth shares is to bring the capital growth within the capital gains provisions. As mentioned above, it is important that market value is paid for the shares and that the scheme is carefully designed so as to not to fall foul of the ERS provisions. Careful drafting of the company’s articles is called for and it is important that the difference between intrinsic and extrinsic rights attaching to the growth shares is recognised.
The need for a s431 election should not be overlooked.
In essence two valuations are called for. Initially the existing value of the company to be frozen, normal valuation techniques can be utilised here. Followed by the market value of the growth shares at the date of allotment. In many respects the value of the growth shares is a product of the existing value of the company and the argument is that the growth shares, by definition, have no value on allotment – as all value is frozen into the existing shares.
HMRC do not necessarily share this view! Their argument can be summarised as – if a company wishes to incentivise or align the interests of its staff with those of the current shareholders why would a company go to all the trouble of making what are likely to be complex changes to its articles creating a new class of shares if there is no expectation that the shares could have a value in the future. Going back to basics, would a well informed purchaser pay more than a very nominal value for such shares. By definition the answer must be yes and an element of “hope” value recognised. There are various techniques for valuing such hope value.
JSOPs involve the acquisition of joint or split ownership shares and have many of the characteristics of restricted schemes and share the same legislative background. They are seen as particularly useful for listed or AIM companies, as they do not require extensive redrafting of articles and separate classes of shares but can be attractive to SMEs possibly where there are a number of employees involved.
In overview the steps are;
• The employee along with a third party, the co-owner, typically an employee trust jointly acquires the beneficial interest in shares.
• The employee and co-owner both own the entire interest in the share although typically the co-owner holds the legal title to the shares by virtue of a trust (drafted like a nominee agreement).
• The parties enter into a joint ownership agreement, this provides how the proceeds will be split when the shares are sold.
• Typically, this provides that the employee will only benefit when the sale proceeds exceed a fixed threshold. This is often set at the market value of the shares at date of allotment plus a small carrying cost accruing to the co-owner. In other words, the employee only benefits from future capital growth.
The employee holds shares from day one, the initial value of the holding will be small and only becomes valuable if and when the share price grows, that growth will fall within the capital gains provisions and possibly qualify for entrepreneur’s relief. Provided that the employee pays the market value for the shares there will be no tax or NIC cost on allotment and again the possible need for a s431 election should not be overlooked.
HMRC have removed the ability to agree a valuation and as with growth shares there is a need for a robust and defensible valuation contemporaneous valuation to be prepared. Whilst in theory hindsight cannot be used, should HMRC challenge the valuation they are likely to do this some time after the event with access to information as to the company’s performance after the valuation date, at best this is likely to colour their approach.
When dealing with SMEs the power of share schemes to provide value to both the existing shareholders and employees should not be overlooked. Often an EMI scheme provides a relatively simple and easily understood solution, however, this is not always the case and there are situations when an EMI scheme cannot be implemented (e.g. limits / disqualifying activities). Where this is the case there are other solutions.
Bearing in mind that the overall objective of the scheme is to align the interests of the existing shareholders and employees, whatever solution is adopted, it is important that the structure and benefits are fully explained to employees. It is all too easy to focus on the technicalities and commercial issues and loose sight of the softer issues.
Like this article? Read more about Employee Share Schemes and how they work…
Share schemes are a potentially attractive way for entrepreneurs and business owners to provide rewards to their key staff, while still retaining control over the company.
Nevertheless, it is important to recognise the potential tax implications and consider carefully whether share ownership, or share options, can be appropriately structured to get the desired result for both employer and employee without any unpleasant tax surprises.