Gifting shares to employees explained

Working with employers to achieve successful implementation

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Gifting shares to employees explained

Providing you can get the structure correct, gifting shares to employees can motivate employees to build your business. Statistics indicate that companies who encourage employee ownership outperform companies that lack employee ownership. We work with employers to achieve successful gifts of shares.

Structuring the gift for shareholders effectively 

The shares gifted to employers can come from either existing shares already owned by shareholders or from newly issued shares.  Looked at from a shareholder perspective the decision is between the impact of exiting shares compared with newly issued shares in terms of dilution and tax.

Existing shares – tax

Existing shareholders might agree to transfer a proportion of their existing shareholding as gifts to employees.  Unfortunately, this counts as a disposal for capital gains tax purposes. This route’s attractiveness depends on the capital gains tax bill that results from the transfer.  In addition, employees would receive dividends at the same rate as the shareholder who gifted the shares.

Existing shares – dilution

A benefit of using existing shares is that there is no dilution for other shareholders.

Newly issued shares

Using newly issued shares for the gift employee has some tax benefits for existing shareholders.  The advantages are:

  • The newly issued share route does not carry a capital gains tax charge for existing shareholders.
  • You can create a new class of shares for employees. The dividend rate paid on shares held by employees could differ from the existing shareholders’ dividend rate.

Newly issued shares – dilution

Newly issued shares dilute existing shareholders’ shareholding. It is possible to confine the dilution to specific shareholders. However, confining dilution can give rise to a tax charge for existing shareholders if they are caught by the anti tax avoidance  value shifting provisions.

Compared to an existing share transfer, newly issued shares are usually preferred.

Employee Benefit Trust

Employers could use an Employee Benefit Trust to gift shares to employees. The trust acts as a channel. It acquires shares from shareholders or subscribes for newly issued shares. Then the trust passes out the acquired shares.

Employers fund the Employee Benefit Trust. Employers can claim a corporation tax deduction for the funds provided. There are however strict rules concerning the time when this deduction can be claimed.

Usually Employee Benefit Trusts reside outside the UK.  Then the trusts’ assets are not subject to UK capital gains tax. UK resident Employee Benefit Trusts are less expensive to operate, but not as flexible as offshore trusts.

In recent years, employee benefit trusts have become less popular as a result of changes in tax legislation.

Protecting shareholders following gifting of shares to employees

When an employee leaves, unless otherwise stated, the employee retains the gifted shares. So, ex-employees continue to benefit from the company’s growth. Ex-employers can even stall an exit by refusing to sell the shares. Before gifting shares to employees, the company’s articles of association and the shareholders’ agreement should be revised to contain appropriate provisions to prevent this.

Use of good and bad leaver provisions when gifting shares

It is common to distinguish between good and bad leavers. Good leavers leave because of e.g. death, disability or the directors want them to continue to benefit.  Bad leavers are usually anybody who is not a good leaver and who does not continue to benefit from the company’s growth.

Retaining control of the shares gifted

It is also common to include powers in the shareholders’ agreement to force the employees to sell their shares when the controlling shareholders sell out. Without this power the business may be un-saleable.

Tax issues arising on the gifting of shares to an employee

The issue of gifting shares to employees contains some of the most draconian anti-avoidance legislation within HMRC’s powers. What should be simple, can be extremely complex. Unexpected and unplanned tax liabilities easily arise.

Basic income tax rule applying on the gifting of shares to employees

The basic rule is if an employer gifts shares to an employee then the employee is deemed to be in receipt of a benefit in kind on which income tax and sometimes national insurance is payable.

Using a bonus to settle the employee’s income tax liability

Employers gifting shares in businesses which are trading and making profits will need to consider how employees will fund the tax liability arising on the gift of shares.

One option is to vote the employees a bonus. This bonus covers the tax liability.  Bonus payments attract PAYE and National Insurance. However, the employer can use the bonus payments to reduce their corporation tax bill.

Taxation of gift of shares – starting point

Taxation of shares depends whether they are restricted securities. Most shares gifted to employees would be restricted securities.

Restrictions on shares gifted to employees

A restriction is anything that reduces the value of a share for example:

  • Compulsory transfer provisions in the articles of associations;
  • Provisions including risk of forfeiture; and
  • Good and bad leaver provisions.

Restrictions are commonly found in the company’s articles or shareholders’ agreement but they can be found in side letters and oral agreements as well.

Gifting shares with restrictions

If the shares gifted to employees have restrictions that impact on value, which is common, then there could be additional income tax charges under the restricted securities tax rules when the restrictions are lifted.

For example, a share which does not carry voting rights is not as valuable as a share which carries voting right.  If the restriction on voting rights is lifted and the employee is given voting rights the shares that were gifted to him increase in value.  This increase in value can attract further income tax liabilities for the employee.

Effect of an election entered into upon gifting shares to employees

The employee and employer have 14 days from the date of gifting shares to employees to make an “election”, i.e. a choice. There is the right for both the employer and the employee to elect to pay the full tax charge on the unrestricted market value of the shares. Many employers make the election compulsory as they do not wish to run the risk of being required to operate PAYE and pay national insurance.

Impact of elections on the employees’ tax liability

If an election is signed an employee will pay a higher income tax rate on receipt of the gift.  However, when he sells the shares the tax rate will be at a lower capital gain tax rate. The rule is if you pay more tax upfront on the gifting of shares to the employee there won’t be any future restricted securities charges or income tax to pay.

If the employee pays income tax on the unrestricted tax market value on the gifting of shares and the shares increase in value, then the employee will pay capital gains tax and not income tax on the increased value on disposal of the shares originally gifted. However, this assumes no other special income tax charges arise.

For example, a share which does not carry voting rights is not as valuable as a share which carries voting right.  However, it is possible to elect that the employee pays tax on the value of the share which includes voting rights.  The advantage is, when the restriction is lifted and voting rights are given to employee there will be no income tax charge on the benefit the employee is deemed to receive when his non-voting shares become voting shares.   

Valuation of shares for tax purposes arising on gifting shares to employees

Gifting shares to an employee requires a valuation of shares to ascertain the tax payable on gifting shares to the employee.  We do offer advice on how to approach the question of the value of the shares for tax purposes.

Paying dividends on the shares gifted to employees

Dividends are taxed at lower rates than income and do not incur employer’s or employee’s national insurance. They are more tax efficient than salary.  £5,000 per annum of dividend payments is tax free so tax planning is possible.

Taxation of dividends paid to employees – examples

Example 1 – Higher rate taxpayer

Richard is a higher rate taxpayer with a significant portfolio of shares for which he receives £9,000 a year (net). His tax position is as follows:

Dividend income9,000
Taxable dividend income9,000
Tax at 0% (5,000)0
Tax at 32.5% (4,000)1,300
Tax due1,300

In comparison, a salary would be charged to income tax at 40%.

Example 2 – Additional rate taxpayer

Peter is an additional rate taxpayer with a portfolio of shares yielding £9,000 (net) worth of dividends each year. His tax position is as follows:

Dividend income9,000
Taxable dividend income9,000
Tax at 0% (5,000)0
Tax at 38.1% (4,000)1,524
Tax due1,524

In comparison, a salary would be charged to income tax at 45%.

Warning for employers

There will be tax issues if HMRC assess that the employer has paid dividends in place of salary.  Meticulous board minutes justifying decisions should be made contemporaneously. Within the HMRC armoury is a body of anti avoidance legislation known as the disguised remuneration rules which if imposed will decrease the tax advantage of receiving dividends.

Implementing the gifting of shares to employees

There are a number of steps for employers to consider before gifting shares to employees.  Some of the key steps include:

Is there a better alternative to gifting shares to employees

We advise employer to consider whether there are better alternatives to gifting shares to employees.  There are a variety of HMRC approved scheme such as EMI or CSOP which provide tax benefits and flexibility.

Record the gifting of shares

The employer should record the details relating to the value of the shares when they are gifted. This is because records will be required when dealing with:

  • The upfront income tax liability arising when gifting shares to employees;
  • Possibility of future income tax charges under the restricted security legislation if no election is made;
  • Helping employees who require support if they pay the tax liability through self assessment.

Review articles and shareholders’ agreement

If newly issued shares are used for the gift it may be necessary to obtain shareholders’ approval.  There are reporting requirements at Companies House for newly issued shares.

Commercially, it pays to have considered the rights attaching to the shares.  Often employers attach special rights and restrictions which will require an amendment to the shareholders’ agreement.

HMRC reporting obligations on the gift of shares

The gifting of shares is a reportable event which needs to be reported by an employer to HMRC via ERS online. Lifting restrictions on shares are also reportable events and we will tell you when to report them and how.

Depending on the circumstances, the employees may also have to report the gifting of shares via self-assessment. Sometimes the company will have to deduct tax under PAYE on behalf of the employee.  We explain the position so that you can get your HMRC reporting correct.

Valuation of the shares gifted

In private companies, where there is no ready market for the shares, the question of what are the shares gifted to employees worth in tax terms is far from straight forward in practice.  But, that question dictates the tax bill.

Protecting shareholders

We find most shareholders appreciate employers who retain a power of attorney so that if an employee leaves they have control of the shares.

Track record in dealing with gifting shares to employees

Clients come to us because we combine the legal knowledge required in protecting shareholders adequately with taxation knowledge and share valuation expertise. Our recent instructions from employers who have considered gifting shares to employees include:

  • Represented the shareholders of an established recruitment agency on the gift shares to a director;
  • Acting for a mobile telecommunications provider on the issue of equity to a key business development director;
  • Advised a computer software company on the tax issues arising when no-dividend paying shares held by an employee were converted to a new class of dividend paying shares; and
  • Advised a fashion design label on the tax implications of gifting shares to new recruits.