The private equity model of issuing shares to an investee company’s senior executives is well established, but the structures used to incentivise and align second tier management and other employee share schemes are far more variable, and heavily dependent on their tax treatment at the relevant time. In this article we outline five of the most popular schemes used.
Note that, given the levels of complexity of some of the schemes, we have focused on the key benefits without addressing all requirements that may apply.
Non tax-advantaged scheme
1. Ordinary options
A common way for a company to incentivise its employees is through ordinary share options (technically called “employment related securities options”). An option gives the employee – or option holder – the right to acquire shares in the employer or ultimate parent company at a specified price (the “exercise price”) in agreed circumstances. With ordinary share options, there are no restrictions on the number of options that can be granted, and no statutory requirements which the employee or company need to fulfil.
For any option scheme, the tax impacts of three events need considering: (i) award of the option; (ii) exercise of the option/award of the option shares; and (iii) ultimate disposal of the shares – in each case, by the employee.
Award: no tax is payable by the employee on the grant of ordinary share options (this is, in fact, the default position for all option awards to employees – i.e., the award itself is not taxable).
Exercise: the option exercise is, in principle, a taxable event. Thus, income tax is chargeable to the employee on the difference between the exercise price paid for the shares (which is often minimal) and the market value of the shares at the time of share acquisition. The tax will be due under self-assessment when the employee files his or her annual tax return. However, sometimes employers help employees with the liability for the share acquisition generally through employee loans – although these come with their own tax consequences which are not discussed herein.
In addition, if the shares are “readily convertible assets” or “RCAs” then the share award also attracts employer’s and employee National Insurance contributions (“NICs”) on any amount which is subject to income tax. Broadly, shares are RCAs if they can easily be turned into cash – for example, because: (i) the shares are tradeable on a public market; (ii) the shares are unquoted but the company is in the process of being sold; or (iii) other arrangements exist for employees to transfer the shares, such as to an Employee Benefit Trust.
If the shares are RCAs, then any income tax and NIC liabilities must be collected by the employer via Pay As You Earn (“PAYE”). What this means is that the employer must make sure that it is able to obtain the cash necessary to pay the tax from the employee – for example, by having the right to sell some shares to fund the tax. It is also common for the employer to require an indemnity from the employee in this respect. One point to note is that RCAs also attract the 13.8% employer’s secondary Class 1 NICs – which can in principle be passed on to the employee here (although this is understandably not popular with employees).
Disposal: any subsequent gain realised by the employee on a disposal of the shares will be liable to capital gains tax.
The benefit of ordinary share options is their general flexibility and lack of restrictions. This does, however, come at the price of higher tax charges for both employee and employer.
2. Company share option scheme
The simplest tax-advantaged option is the “company share option scheme” or “CSOP”, although its scope and availability are limited (see commentary on conditions below). In terms of taxability:
Award: the grant of a CSOP to the employee is not taxable so long as the exercise price is no less than the market value on the grant date. It is relatively common (although not obligatory) to obtain confirmation of the share value from HMRC through a ruling.
Exercise: the principal benefit of a CSOP is the tax free option exercise where the exercise occurs at least three years (and no more than ten years) after the grant date. In those circumstances, so long as the employee pays the exercise price and that price equals the market value of the option shares measured at the time the CSOP was granted, then the exercise and award of the option shares will not be taxable for the employee.
Disposal: tax only becomes payable – in the form of capital gains tax – when the employee subsequently disposes of the shares (in that case, capital gains tax is due on any gain over the exercise price).
Various conditions relating to the company and the option holder need to be satisfied:
An employee can only hold CSOP options over £30,000 of shares in the employing company at any time (valued at the time of grant). The option holder must also be a full time employee or full time director (full time broadly means working at least 25 hours per week). Further, to obtain the tax benefits, CSOPs must normally be held for at least three years (and no more than ten) – although relief may be available for periods of less than 3 years in certain transfer scenarios, such as sale of the entire company, or permitted leavers for health or redundancy reasons.
In addition, the company whose shares are placed under option must either: (i) be listed on a recognised stock exchange; or (ii) not under the control of another company, and in each case the options must relate to ordinary shares.
Note that if a CSOP option is exercised in circumstances in which the relief is not available (because one or more of the conditions is not satisfied), the option is subject to income tax in the same way as applies to a non tax-advantaged employment-related share options described above.
3. Enterprise Management Incentives options
Probably the most popular employee incentive scheme is the Enterprise Management Incentive or “EMI”. In June 2018, HMRC published comprehensive research which showed that EMI improved employee retention, productivity and led to an improvement in the quality of employees applying for openings.
EMI is specifically targeted at small, higher-risk trading companies. Because of the significant tax benefits, to qualify to grant EMI options a company must be an independent trading company with gross assets of no more than £30 million, and fewer than the equivalent of 250 full-time employees.
There is a £3 million overall limit on the value of unexercised EMI option shares in a company at any one time (valued at the relevant dates of grant and ignoring certain restrictions on the shares).
Much like CSOP options, EMI options can only be granted to employees that work for the company at least 25 hours per week or, if less, 75% of their working time. Such individuals can acquire options over a share value of up to £250,000 (at the date of grant) but must not have a material interest in the company (more than 30% of the ordinary share capital).
The EMI share scheme rules are complex; among other things, eligibility is subject to an independence requirement, trading requirement and the EMI options must relate to ordinary shares. A condition that the company must not be under the control of another company at any time while the EMI options subsist means that EMI is not normally available for majority-owned portfolio companies of private equity funds. Similarly, certain trades do not qualify for EMI purposes – including banking, insurance, money-lending, debt-factoring, hire purchase financing or certain other financial activities.
Award: there is no income tax liability for the employee on the grant of the option.
Exercise: there is no income tax liability on exercise if the exercise price was at least equal to the market value of the shares at EMI option grant. If the exercise price was less than the market value of the shares at grant, then income tax is due on the difference between the exercise price and the market value at grant. In these circumstances, NICs may also be payable if the shares are RCAs.
Disposal: on a sale of the EMI option shares, capital gains tax will be payable on any gain over the market value at grant (that is, the difference between the sales proceeds and the market value of the shares at grant).
A particular benefit of shares acquired on the exercise of EMI options is that the EMI option holding period counts towards the 12 month holding period (extended to 24 months in the 2018 Autumn budget) for the shares, which is required for entrepreneurs’ relief to apply. However, for EMI option purposes, the entrepreneurs’ relief requirement that the individual hold 5% or more of the ordinary share capital does not apply. Therefore smaller holdings qualify, which is a significant benefit.
EMI option schemes are therefore attractive for employees, particularly given the generous individual value limits and the access to entrepreneurs’ relief. However, the conditions which employers must adhere to are relatively onerous, and will require ongoing monitoring – e.g. ensuring that the company does not come under the control of another company.
4. Restricted shares
Instead of granting options, an employer could decide to award actual shares to an employee in the form of “restricted securities”. These are shares which, when issued to the employee, are subject to contractual or other restrictions that do not permit the employee to benefit fully from the share rights until certain restrictions are lifted or conditions fulfilled. Commercially, a restricted share can be structured so that benefits accrue to the shareholder in essentially the same circumstances when an option would have vested or become exercisable. The principal benefit of restricted securities is that, if structured correctly, the employee should receive a security which has little value at the time of award, but which benefits from capital gains treatment on any subsequent growth including on ultimate disposal. However, from the company’s perspective, the employee will be a shareholder which is potentially more onerous for the company than issuing options (for example, a new share class and leaver mechanics may be required).
Regarding the tax points:
Award: the starting point for taxing restricted shares acquired as a result of employment is that any value provided to the employee above any payment made for the shares will be taxed as employment income when received. However, where the shares are subject to substantial restrictions, the actual market value is likely to be small, leading to little income tax at the time of the award. For example, the employer may issue securities subject to vesting restrictions, or forfeiture in specified circumstances.
When the restrictions later fall away or are lifted, the shares are likely to become more valuable so that further income tax charges will arise. To avoid these additional charges, it is customary to make a tax election (a “section 431” election under the Income Tax (Earnings and Pensions) Act 2003) which treats the security as if all restrictions had been lifted at the time of the acquisition.
In these circumstances, employees will be subject to income tax on the unrestricted market value on the acquisition of such the security, but no further tax charges will arise when restrictions are lifted or varied. This initial unrestricted market value will often be small. The employee can either pay the market value (potentially through assistance with a loan), or be taxed to income on such amount.
Disposal: the principal benefit of restricted shares is that, assuming a section 431 election has been made, the entire gain above the initial fair market value will be subject to capital gains tax. This compares favourably with non tax-advantaged options, for example, where a company does not qualify for EMI benefits.
5. Phantom share / option plans
Contrary to its name, a phantom share/option plan does not involve an actual grant of shares or options. Rather, the employee receives a contractual right (granted by the employer) to a cash payment at an agreed time or in connection with a specified event in the future, where the amount of the payment is tied to the market value of the company’s shares. For example, the amount of the pay-out will increase as the share price rises, and decrease if it falls. Phantom share grants can be tied to bespoke vesting schedules, for example, with the pay-out being tied to a change of control or liquidity event such as an IPO or acquisition.
The principal benefit of phantom shares is the flexibility of the agreement and the minimal legal and tax filing paperwork involved. Thus the company is able to deliver a cash incentive that tracks the value of the employing company’s shares without affecting its actual shareholder structure. This can be particularly useful if the company’s constitutional documentation prohibits additional share issuances, or a controlling member will not allow such action.
Further, phantom schemes allow the employer to tailor the type of growth that it wishes to encourage. Unlike schemes which involve the actual grant of an interest in share capital, phantom schemes can be tailored to encourage certain types of value. For example, a company in the process of a merger can exclude such a merger from enhancing the value of the shares for the purposes of a phantom scheme, thus preventing employees exploiting firm-wide efforts in which they may have had little involvement.
The major downside of phantom share/option plans is the lack of tax advantage. Any payment to an employee pursuant to a phantom scheme is treated as general earnings for income tax, so that income tax and NICs (both employee and employer) are payable. Payment pursuant to a phantom scheme is essentially a normal cash bonus which is calculated by reference to the value of shares.
With special thanks to Daniel Lewin and Sam Burford from the MJ Hudson team who provided expert input for this article.
Is this brief too brief? Want to know more about employee share schemes? (of course you do) Expert legal advice is on hand from MJ Hudson’s Corporate and Tax teams. Just contact our M&A and corporate law team team or your usual MJ Hudson contact and we’ll gladly help.