Out-Law Guide | 03 Aug 2011 | 11:06 am | 8 min. read
There are a number of different types of share incentive arrangements that private companies may consider offering to directors and senior management. The type of arrangement which is most appropriate for a particular company is likely to depend, among other things, on whether the company is backed by a venture capitalist and how flexible the arrangement needs to be.
Share options are contractual rights to acquire shares in a company at some time in the future, at a price per share ("exercise price") which is fixed when the options are granted rather when the shares are acquired. The options may be granted by the company itself, or by a third party such as an employees' trust.
Share options are typically – and may be required to be – granted with an exercise price fixed at or above the market value at the date of the grant. However, some share options may be granted with an exercise price which is less than market value, or with no exercise price at all. These options can lead to complications, as English company law prevents a company from issuing shares at less than their nominal value.
Market value options only provide a reward to the employee to the extent that the value of the shares increases above the market value at the date of the original grant. Discounted or no-cost share options will provide the employee with some or all of the historic value of the shares, so that even if the shares fall in value there may still be some benefit to the participant. The employee may be entitled to take up a share option on the achievement of performance targets, after a certain time period has passed or when a particular event - such as a sale or flotation - occurs.
Participation in share option schemes is voluntary, and until deciding to exercise the options and acquiring the shares a participant will not bear any financial risk if the shares fall in value. Equally, until the time that share options are exercised, the participant is not a shareholder and has no right to vote at shareholder meetings or receive any dividends.
Enterprise management incentive (EMI) options are intended to help smaller, high risk companies with growth potential to recruit and retain high calibre employees. There are a number of strict legal requirements which must be satisfied in order for share options to qualify as EMIs, but options which do qualify carry generous tax advantages to participants. They are covered in detail in our separate Out-Law Guide.
If a company is unable to grant EMI options because it is too large, it may qualify to establish a tax-advantaged "company share option plan" (CSOP). In order to grant CSOP options, the company must be a listed company or, if unlisted, must be "independent" and not controlled by another company. The shares must satisfy various requirements (covered in detail in our separate Out-Law Guide).
If the company does not qualify to grant EMIs or CSOPs, or wishes to grant options greater than the strict participation limits for these plans, it may establish other share option plans which do not benefit from any special tax regime. There are no specific legal or participation requirements for such plans and these can be granted below, at or above the market value of the shares at the grant date.
The obvious disadvantage is that there are no special forms of tax relief available. Income tax (and possibly NICs) will be due on the exercise of options, on any financial advantage between the exercise price and the market value of the shares at the date of the exercise. CGT may be due on the sale of any shares if they have increased in value, on any difference between the value of the shares at exercise and the sale proceeds, subject to the employee's annual exemption.
As these share plans do not need to comply with the strict legal requirements of other tax-advantaged plans, they can be more flexible and easier to operate. However, if a tax-advantaged arrangement is available, tax savings will usually make it more cost-effective to both employee and employer to take advantage of such a plan and only use non-tax-advantage options to 'top up' entitlements.
Direct share purchase
As an alternative to share options, the company or a third party (such as an employees' trust) may invite selected employees to acquire shares immediately, subject to restrictions (for example, preventing the employee from selling the shares for a fixed period of time or requiring participants to sell back or even forfeit any shares should they leave the company's employment).
Unless the acquisition of these shares is at market value, it is likely that income tax (and possibly NICs) will be payable on purchase and also possible on subsequent disposal of the shares. If the participant chooses to be taxed upfront for the full market value of the shares, by making what is known as a "section 431 election", then any growth in value will be subject to CGT.
An employee acquiring shares under a direct share purchase scheme becomes the legal owner immediately, and has the same right as other holders of the same class of shares to receive any dividends and to vote at shareholders' meetings. However, the employee also bears the full financial risk that the shares may fall in value.
Direct purchase arrangements can be set up for that the employee receives a special class of shares, and can only benefit if the company is sold or floated at or above a certain value per share and which may require the employee to achieve particular performance targets. These conditional arrangements are sometimes known as "flowering" or "growth" shares. However, these arrangements are potentially more complex and may be subject to scrutiny by HMRC who have announced an intended review of these types of structures.
The Executive Joint Share Ownership Plan (ExSOP™) is a share incentive structure devised by Pinsent Masons, the law firm behind OUT-LAW. ExSOP™ awards grant the same financial benefit to participants as share options, delivering any growth in value of the shares - however, the ExSOP™ does this without transferring full legal ownership of the shares to the participant. This means that, after an initial upfront income tax (and possibly NICs) charge on the participant, only CGT will be payable in any growth in value.
As the participant in an ExSOP™ would normally hold an interest in the award shares, rather than the full legal ownership (title), the day to day administration of the ExSOP™ would be simpler than for direct share purchase or a deferred payment plan. ExSOP™ can be used as a "top up" to EMI limits, or as an alternative to which are not tax-advantaged share options for companies or individuals who do not qualify for EMIs. It also has advantages where the shares have a high market value, and the participant would be unwilling or unable to pay the full amount.
Employers will not be entitled to statutory relief from UK corporation tax for the growth in value of the shares accruing to the employee under an ExSOP™ scheme, but such relief may be available for the share-based payment expense arising in respect of the award. See later in this guide for more on UK corporation tax relief.
Private companies often use employees' trusts as part of their share incentive arrangements. These can be funded by the company either to initially obtain (subscribe to) shares or, more frequently, to purchase or acquire shares from departing shareholders. These shares can then be used to satisfy more share options, sold to an incoming shareholder or employee or provide shares for a share purchase plan or an ExSOP™.
Employees' trusts are usually situated offshore (for example, the Channel Islands) so that any increase in the value of shares held in the trust will be outside the scope of UK CGT.
New tax anti-avoidance rules on "disguised remuneration" are in full effect from 6 April 2011 and will potentially affect any arrangement involving an employee trust. There are a number of exclusions which may apply to ensure that share incentive arrangements with no tax avoidance motive can be operated without triggering any tax under the new rules, but companies will need to consider the position carefully in each case.
UK corporation tax relief
Share incentives may entitle companies to a statutory UK corporation tax deduction. This tax relief is available if the shares acquired by a participant are in an independent company, or a company which is, or is controlled by, a listed company (other than a company which is "close" for UK tax purposes. In order to take advantage of the relief, the employer company must currently be paying UK corporation tax.
For share option plans, the tax relief is given in the accounting period during which the options are exercised, for the amount of the option gain.
Where shares, or interests in shares, are acquired upfront under a direct share purchase plan or ExSOP™ award, statutory corporation tax relief will only be available in relation to this upfront value of the shares and not any increase in share value on disposal. However, relief in relation to any expenses incurred in the issue of the award may be available in certain cases.
Under UK Financial Reporting Standard (FRS) 20, companies must show the "cost" of providing share-based incentives to employees in their company profit and loss accounts, based on the fair value of the award. This cost can be calculated using a widely-available option-pricing model such as the Black-Scholes formula. Costs calculated using such formulae will vary depending on whether the option is linked to performance on the stock market and whether it is granted at market value or at a discount. This means that discounted or nil-cost arrangements will generally result in higher accounting charges than a market value share issue.
Direct share acquisition arrangements are charged in relation to the actual cost of providing the shares to the participant, therefore the cost for accounting purposes will depend on whether these shares are acquired at market value, a discount or nil cost.
If a company is eligible to issue shares under an EMI arrangement, this type of share award will generally be the most appropriate available providing any awards are made within the EMI individual limit. The company can determine the exercise price, any performance-related conditions and the exercise provisions, including whether an employee can take up such a share option before leaving the company. The company may grant these share options on different terms to different employees.
If a company does not meet the strict EMI legal requirements, which are not tax-advantaged, it will need to weigh up the relative benefits and costs of unapproved share options and less traditional share acquisition arrangements, including the ExSOP™– including whether a corporation tax deduction will be available and any increase in accounting costs. The company should also take into account the practical aspects and administrative costs of each type of arrangement.