Tolley's CSR - Employee share plans
In the midst of the current economic downturn, employers still find they need to retain good employees, and often attract new ones. Remuneration can be an emotive subject, especially in today's climate of "fat cat" pay and "reward for failure", but over the years, participation in employee share plans has proved increasingly popular as an aid to retaining and attracting staff.
Equity incentives can be a challenging and complicated area, even for professional advisers, bringing together elements of company, tax, financial services and employment laws, as well as accounting and human resources issues.
This booklet provides an introduction to the subject of equity incentives, taking the reader through the main share plans available for an employer to implement, highlighting advantages and disadvantages of each one, and providing an analysis of the tax treatment for the employer and the employee. It also explains how employee benefit trusts can be used by employers, either in conjunction with a share plan, or as a vehicle to achieve genuine employee ownership on a co-operative basis.
The reader can expect an overview of what is a vast subject, leaving detailed and comprehensive coverage for another time.
The key to a successful incentive plan is to ask: as an employer, what I am trying to achieve by implementing the plan? Once an employer has considered the objectives behind the plan, it can be structured effectively and will have a better chance of operating successfully.
Some of the structural issues to consider include:
- will the plan be offered to all employees on the same basis, or to a particular tier of management with varying levels of participation?
- is the plan designed to offer a reward for past services, perhaps in addition to, or as a substitute for a cash bonus, or is it designed to attract staff loyalty until an exit is achieved for founders of the business?
- should the plan be designed to operate as tax efficiently as possible?
- are there external investors or other shareholders whose interests need to be considered? Companies whose shares are listed on the Main Market of London Stock Exchange plc should comply with investor guidelines such as those issued by the Association of British Insurers
- should shares or options be awarded by reference to a market value at the date of award, at a discount to that value or at nil cost to the employee?
- should there be performance conditions attaching to the vesting of any awards, and if so, should these be company wide, or based on individual targets?
- how should awards be treated if employees leave? Should they be deprived of their awards, or should they be entitled to keep them based on the contribution they have made to the business as an employee?
Employers should always ensure that their commercial objectives fit within the relevant legislative framework. Issues to consider include:
- UK company law and company authorities: ensure that an employee share plan falls within the definition of an "employees' share scheme" set out in the Companies Acts 1985 and 2006. This is defined as a scheme for encouraging or facilitating the holding of shares by, or for the benefit of employees or former employees of the company (and any parent or subsidiary companies) and their dependants. Care needs to be taken if shares or share options are granted to non-executive directors or consultants as they are not covered under this definition.
- The advantage of having an incentive plan fall within this definition under UK company law is that certain exemptions apply in respect of the directors' authority to allot shares, and statutory pre-emption rights on the allotment of, or grant of options over, unissued shares.
- securities laws: in the UK the issue of and dealing in shares and other securities is regulated in accordance with the Financial Services and Markets Act 2000. In most cases, specific exclusions from the restrictions in the Act will apply for awards made under an employee share plan, but it is sometimes a grey area, especially if non-employees can participate in the plan. Local overseas securities and exchange control laws should be considered if an employee share plan is implemented outside the UK.
- employment law: claims for compensation for loss of rights under an incentive plan can sometimes arise if an employee is dismissed wrongfully or unfairly. Age and sex discrimination are other areas that need to be considered when deciding who should be the potential participants in a plan.
- accounting implications: the Accounting Standard for Share Based Payment under either IFRS2 or its UK equivalent FRS20 has introduced a requirement for all companies to recognize an expense to their profit and loss account for all forms of equity instruments (whether shares or options) based on their fair value at the date of grant. How a share plan is structured can sometimes affect the amount of the expense to the P&L.
This chapter explains those plans whose participation can be at the discretion of, usually, the board of directors or remuneration committee. They can broadly be divided into the following categories:
Company Share Option Plans (CSOPs)
CSOPs are a form of option plan approved in advance of their implementation by HM Revenue & Customs (HMRC).
Tax analysis: except in limited circumstances, the grant of a CSOP option will not attract an income tax charge for the option holder. When the option is exercised (and shares acquired), provided that the exercise complies with the relevant legislation, income tax will not be chargeable on any gain in value of the underlying shares. On a disposal of the shares, capital gains tax is payable on the difference between the sale price and the price paid for the shares (not the market value at the date of acquisition).
As you would expect, given the tax reliefs on exercise, there are some restrictions and conditions attaching to a CSOP. The principle ones are:
- an individual cannot be granted an option to acquire shares that have a market value in excess of £30,000 (by reference to the date of grant)
- to claim the tax reliefs on exercise, the option must exercised either: (i) on or after the third anniversary and not later than the tenth anniversary of the date of grant; or (ii) before the third anniversary of the date of grant and within six months of the option holder ceasing to be an employee or full-time director by reason of injury, disability, redundancy or retirement at a specified age; or (iii) by the option holder's personal representatives within 12 months after he or she has died
- options must be granted at a price which is not manifestly less than the market value of the shares at the date of grant
- options can only be granted to full time directors or qualifying employees
- shares held under option must form part of the ordinary share capital of the company, must be fully paid up on allotment, non-redeemable and not subject to any restrictions other than restrictions which attach to all shares of the same class or certain permitted restrictions
- a company cannot establish a CSOP using shares in its own subsidiary
- shares used in a CSOP must be in a company that is not under the control of another company; or be shares of a class listed on a recognised stock exchange; or shares in a company which is under the control of a listed company
Enterprise management incentives (EMIs)
EMI is a form of tax efficient option arrangement that was originally intended for high growth companies such as those coming out of the technology boom of the late 1990s. It has since become a very popular form of share option for a wide range of companies to grant to employees. Despite the tax reliefs, there is no requirement for HMRC to approve an EMI arrangement, which can reduce the cost and delay in implementing the plan and granting options.
Tax analysis: the grant of an EMI option will not attract an income tax charge for the option holder. When the option is exercised (and shares acquired), provided that there has not been a disqualifying event between grant and exercise (and the exercise price is equal to a market value calculated at the date of grant), income tax will not be chargeable on any gain in value of the underlying shares. On a disposal of the shares, capital gains tax is payable on the difference between the sale price and the price paid for the shares (not the market value at the date of acquisition).
EMI has the following main restrictions and conditions:
- broadly an individual cannot hold EMI options to acquire shares that have in aggregate a market value in excess of £120,000 (by reference to the date of grant)
- eligible individuals are those who work on average at least 25 hours per week, or if less, 75 per cent of their working time, with the EMI company or group
- the company (or at least one company in the group) must carry on a qualifying trade wholly or mainly in the UK, and not have more than 250 full time employees (or their part time equivalent)
- the group cannot have gross assets of more than £30m at the time options are granted
- the EMI company must be independent: not a 51% subsidiary of another company or under the control of another company without being a 51% subsidiary of that other company
- if the EMI company has subsidiaries, they must be qualifying (at least 51% owned by the parent)
EMI is a flexible arrangement, allowing options to be granted over a separate class of ordinary share, if this is appropriate. Options can either be granted under a formal plan (containing a set of rules), or under separate agreements with bespoke provisions depending on who is being granted the options. However, even when options are granted under a plan, an agreement (containing details such as the date of grant, exercise price, any restrictions attaching to the shares amongst other things) is still necessary to meet the EMI qualifying conditions.
Options can also be granted with an exercise price at a discount to the market value of the shares at the date of grant. This allows employers to offer options at a low price to maximise the gain achieved on exercise. Income tax is chargeable, however, on the amount of the discount, when the options are exercised.
Although no HMRC approval is required, the grant of EMI options must be notified to HMRC within 92 days of the date of grant. If this notification is not done, or the deadline is missed, then EMI options will not qualify for the income tax reliefs available if they are exercised.
Unapproved option arrangements
In some circumstances, employers or employees will not be able to meet the conditions for implementing a CSOP or EMI arrangement, or will have exceeded the financial limits set out under the relevant legislation. If this is so, then employers can grant unapproved options. These are flexible, but not tax efficient for the option holder.
Tax analysis: the grant of an unapproved option will not attract an income tax charge for the option holder. When the option is exercised (and shares acquired), income tax will be chargeable on any gain in value of the underlying shares. National insurance contributions may also be payable if the underlying shares are readily convertible into cash (such as on a sale of the whole company, or if the shares are listed on a stock exchange). On a disposal of the shares, capital gains tax is payable on the difference between the sale price and the market value of the shares at the date of acquisition.
Unapproved options are often appropriate for non-executive directors or consultants who are likely to fail to meet the employment conditions necessary for a CSOP or EMI option. International groups with relatively small numbers of employees in the UK may also find that unapproved options provide an easy way or providing an equity incentive locally, whilst failing to provide the tax reliefs that may be available to employees based in other jurisdictions.
The above tax analysis will apply to employees who are resident in the UK. The position of other employees will depend on their status. Taxation of shares and options acquired by internationally mobile employees is a complex area, and outside the scope of this issue.
There is nothing to stop employers operating the discretionary option plans described in Chapter 3 on an all employee basis. However, the following two plans must be offered to all eligible participants, and they operate in very different ways to the discretionary option plans.
Save As You Earn (SAYE)
SAYE option schemes, also known as Savings-Related Share Option Plans, require the approval of HMRC before they can be implemented. They must be open to all eligible employees after a qualifying period of service. They are often used by publicly listed companies with large numbers of employees.
Employees are offered the opportunity to enter into payroll savings arrangements (with a bank or building society) for three, five or seven years, at the end of which the savings may be used to exercise an option to acquire shares granted at the outset of the scheme.
Tax analysis: the grant of an SAYE option will not attract an income tax charge for the option holder. If the option is exercised, no income tax is payable provided that broadly the option is exercised after three years from the date of grant (this exemption applies even of the option is granted at a discount to the market value). On sale of the underlying shares, capital gains tax is payable on the difference between the sale price, and the price paid to acquire the shares. If the option is not exercised and the savings are kept, a small cash bonus is payable tax-free at the end of the savings period. These amounts change annually by reference to market swap rates.
- the exercise price of the option can be equal to the market value at date of grant, or up to a 20% discount to that market value
- monthly savings (deducted from salary/wages) must be between £5 and £250 over three, five or seven years
- shares acquired can be transferred into an Individual Savings Account or a Stakeholder Pension on a tax-free basis within ninety days of exercising the option
- the scheme must be open to all employees, although eligible employees and directors do not have to take part. All qualifying employees and directors must be eligible to take part on similar terms
- the company can specify a period of up to five years' employment for employees and directors before they can take part
- the employees and directors taking part must be subject to UK tax and must be employed at the time of grant and exercise (subject to certain provisions)
- participation in a SAYE scheme is not open to anyone who owns more than 25% of the ordinary share capital of the company (the material interest test). This only applies to companies that are broadly controlled by five or fewer persons
- the shares used must form part of the ordinary share capital of the employer and must satisfy other specified conditions (broadly these are the same as the conditions for CSOPs set out in Chapter 3)
SAYE schemes are not appropriate for senior executives, and other key employees, who are likely to participate in one or more of the discretionary option plans described in Chapter 3.
Share Incentive Plans (SIPs)
SIPs were introduced in 2000, as a replacement for the Approved Profit Sharing Scheme. They require prior approval of HMRC before awards of shares can be made under them.
As with SAYE, SIPs tend to be most popular with companies with large numbers of employees. They can provide significant tax reliefs for employees on the acquisition of shares in their employer. Companies often outsource the administration of their SIPs to specialist providers such a banks and building societies (which now provide internet or telephone based share dealing services to help ease the process of acquiring and disposing of shares through a SIP).
SIPs operate by allowing shares of various types to be acquired and held in a UK based trust for certain periods of time (generally between three and five years). The shares are held for the benefit of the participants, and at the end of the specified period, can be transferred to the individual (often tax free).
The principal features of a SIP are:
- Up to £3,000 worth of "free" shares can be awarded to each participant every tax year
- Up to £1,500 worth of "partnership" shares can be purchased by each participant every tax year out of his or her salary before the deduction of PAYE and national insurance
- For every one "partnership" share purchased by a participant, up to two free "matching" shares can be awarded every tax year
- If dividends are declared on shares held in a SIP, these can be reinvested in acquiring up to £1,500 of further shares per tax year
Tax analysis: when shares are awarded and held in trust, no tax charge arises. Broadly, there will be a charge to income tax when free and matching shares are withdrawn from the plan within five years from when the award was made. Any gain accruing to the trustees of the SIP will not be chargeable to tax. No capital gains tax is charged when the shares leave the plan, and an individual's acquisition cost for calculating any gain on subsequent sale of the shares is the shares' exit value (when they leave the plan). SIP shares can be transferred into an Individual Savings Account within 90 days of the date the shares leave the plan, subject to the annual financial caps relating to ISAs (the value being by reference to the date the shares leave the plan). This can further extend the capital gains tax exemption for SIP shares and be a welcome bonus for employees.
In addition to the tax reliefs for the participant, the company can obtain a corporation tax deduction on shares that are used as part of "free" or "matching" awards. The deduction is based on the market value when the shares are acquired by the trustees.
Similar conditions relating to share capital and independence apply to SIPs as they do to the other HMRC approved plans.
In terms of the documents needed to implement a SIP, a formal set of plan rules is required, as well as an executed trust deed and ancillary agreements regulating the acquisition of free and partnership shares. All documents need the prior written approval of HMRC before awards can be made to employees.
An employee benefit trust (EBT) is a discretionary trust established by a company for the benefit of the employees (whether past, current or future) of that company. EBTs are sometimes referred to as Employee Share Ownership Plans or ESOPs.
Beneficiaries under an EBT commonly include not just employees but also ex-employees and their spouses and minor children. The trust is used to hold shares in the sponsoring company which can then be used to provide share awards or similar incentives to employees, including satisfying the exercise of share options under those plans described in Chapter 3.
The company will establish the trust and appoint the trustees who may be directors, employees or professional or independent persons. It is sometimes preferable to set up a wholly owned subsidiary to act as the trustee. Whoever the trustees are, it is important that they remain independent from the company that created the EBT. The trustee's primary responsibility is to its beneficiaries.
Advantages of an EBT
There are a number of potential advantages for a company in having an EBT. It is important for the company to have clear reasons for setting up the trust, given the additional expense and administration that goes with running an EBT.
To avoid dilution
Where a company has established a share option or other share plan for its employees, these incentives will normally be satisfied by the issue of new shares to the employee concerned. This will dilute the percentage shareholdings of the existing shareholders. The effect of this dilution can be undesirable for listed companies since it will impact on key ratios (earnings per share, price/earnings ratios). Listed companies are also subject to institutional investor guidelines, such as those issued by the Association of British Insurers. For unlisted companies, this dilution can be problematic, for example by affecting controlling interests held by individual shareholders and investors.
By using shares already in issue, dilution can be avoided or mitigated. As an EBT can own shares in the company that created it (whilst the company cannot own the shares in itself), the EBT can acquire shares either on the stock market (for listed companies, particularly where the price is low) or from existing shareholders who want to sell their shares.
To act as a warehouse
For unlisted companies, an EBT is a useful vehicle for warehousing shares, for example where one shareholder wishes or is required to sell his shares but no buyer can be found for those shares (or the company wishes to prevent shares being sold to a third party). An EBT can be used to acquire these shares with funds provided by the company and the shares can then be used to satisfy employee share options when they are exercised.
To create an internal market
The use of an EBT can create a market in the shares of a private company, helping to make a share incentive or option scheme more attractive to employees. Employees may take comfort from the fact that, depending on the rules of the particular scheme in operation, they may have the ability to sell their shares to the EBT at market value and convert their benefit into cash.
To administer specific share plans
A UK based EBT must be used in connection with a Share Incentive Plan (described further in Chapter 4). Certain other unapproved executive share plans such as deferred or bonus matching plans (which are outside the scope of this booklet) are based on the use of shares held in an EBT that are released to participants at a later date provided certain performance or other conditions are met.
If an EBT is established offshore (as many are), any gain in value of the shares held by the trustees can be sheltered from a capital gains tax charge because non-UK resident trustees are exempt from UK capital gains tax (even if the shares are in a UK company). Where such an EBT is held offshore, usually the trustee will be one of the many professional trustees offering such services in the Channel Islands or the Isle of Man.
5.3 Converting to employee ownership
A further use of an EBT is as a vehicle for converting a company to an employee controlled company. Employee control can take various forms but the principal ones are:
- control by employees as individual shareholders, who own directly more than 50% of a company's voting share capital
- control by an employee trust, where more than 50% of a company's voting share capital is held directly by the trustees for the benefit of all employees
- control by a combination of an employee trust and employee shareholders, which would typically involve more than 50% of the voting share capital being held by the employee trust, and the balance being held by employees, who might acquire shares through participating in one or more share or option plan adopted by the company
The most well known example of a UK employee owned business is that of the John Lewis Partnership. All shares in the capital of John Lewis plc are held by a trustee company, for the benefit of all employees of the business.
Funding an EBT
The most common methods of funding an EBT are as follows:
- A loan from the company is often the most efficient form of finance for an EBT. The EBT would repay the loan when the trustees are in funds, for example following the receipt of payment from employees to whom shares are transferred following the exercise of an option. There will be no need for the EBT to provide security or give warranties or undertakings.
- The EBT may be funded by money borrowed from a bank or existing shareholder. Such a loan would normally be guaranteed by the company or may be secured by a charge over the assets of the EBT. The EBT will normally have to make interest payments to the lender that it may be able to fund using dividend income. Alternatively, the company may have to donate an amount equal to the interest payable.
- A company may also make irrevocable donations to an EBT.
For further information, please contact Mark Gearing.