Employee share options are now a standard part of many employment packages. The risk is employers give away too much equity or fail to meet their HMRC reporting and payment obligations. We work with employers to design and implement workable arrangements and steer employers around the compliance hurdles. Our expertise in legal, tax and share valuation techniques is applied to solve the problems.
Our services in relation to unapproved options include:
We work with private companies, larger groups and foreign parents looking to roll out a share option plan for UK personnel. Most of our clients are in competitive sectors where retaining employees is important and they see share options as a tool.
Why award unapproved options?
An employee share option is a right to acquire shares in the employer company or an associated company or subsidiary in the future, typically when the company is sold. If the value of the shares under the unapproved option increases an employee benefits from the increase. If the value of the underlying shares drops there is no obligation to exercise the unapproved option.
Statistics show that having a stake in the employer company motivates to work towards exit more than a cash bonus.
Benefits of options
An option holder does not have the same rights as the shareholder. This means:
- The option holders and the terms of each award of an unapproved option are at the discretion of the board;
- There is total flexibility as to conditions required to be satisfied before exercise;
- No entitlement to a dividend;
- No entitlement to vote in shareholder meetings;
- No right to request access to company financials; and
- Options do not dilute existing shareholders until exercise.
Position compared with share awards
Unlike options, shares give the employee ownership of the company. If you gift shares to employees, in most cases, the articles of association or shareholders’ agreement will require amendment to deal with compulsory transfer situations such as leaving employment.
There is no need to change the articles of association or shareholders’ agreement for option holders until they become shareholders. In the case of options which are only exercisable upon sale of the business there may never be need to change the articles. This is because the option holder exercising upon the sale will only be a shareholder momentarily. Upon sale, exercise is usually wrapped up with the sale documentation to eliminate the risk of the option holder not consenting to the sale.
A share award gives rise to:
- An opportunity to bring profits made on the shares within the capital gains tax regime which carries a lower rate of tax than profits taxed to income.
- An immediate charge to income tax and often national insurance on any benefit conferred upon award of the shares. With an unapproved option there is no tax on award.
- Risk for the employee as if the shares decrease in value HMRC does not refund the income tax or national insurance paid on award.
- Immediate dilution for shareholders. With an unapproved option there is no dilution on grant.
Versatility of unapproved share options
Unapproved options are very flexible.
- Unapproved options can be awarded to consultants, non-executive directors and other staff who are not eligible for HMRC approved options.
- Unapproved options can be awarded over shares in a subsidiary or affiliated company.
- Unapproved options can be awarded over shares in UK companies or foreign parent subsidiaries.
- There are no restrictions on the percentage of equity awarded under the unapproved option.
- There are no restrictions on the value placed on the underlying shares.
- There are no restrictions on performance targets or exercise conditions set. It is common to draft vesting provisions – such as the total grant vests in annual increments over say four years.
- Accelerated vesting is possible. Exercise can be tied to a sale of the business or group. Re-organisations can be easily catered for.
- None of the restrictions imposed for HMRC approved options apply.
- No need to notify HMRC on award which creates less administration. However, as with any share plan operated for UK employees there is an annual reporting requirement to HMRC.
- There are no restrictions on the corporate structure of the business and therefore available for any business irrespective of share ownership.
- There are no security law restrictions on the issue of shares pursuant to exercise of an unapproved option.
- Shareholder approval to issue new shares is required and directors do need authority to allot new shares from shareholders.
- Unapproved options can be granted over existing share capital.
Many employers prefer share options to share awards because they are less risky for the employee and less administratively heavy on the employer.
We use our experience to help employers design the best arrangements for their business.
Taxation of unapproved share options
For UK resident option holders the gain made on exercise of the unapproved option will be assessed to income tax and usually national insurance.
If the option holder retains the shares acquired on exercise, any subsequent growth in value will be assessed to capital gains tax. However, in our experience, most option holders dispose of their shares acquired on exercise immediately following exercise and lose the benefit of the lower tax rates applicable to capital.
Tax reporting and payment of tax
The system for the payment of tax arising on the gain made on exercise varies according to the nature of the shares acquired on exercise.
- If the shares acquired are unquoted and there is no market for the shares such as an employee benefit trust or a confirmed sale – the employee is required to report to HMRC and pay the tax liability arising. There is no national insurance to pay.
- If the shares acquired are quoted or there is a market for the shares – referred to as “readily convertible assets” in HMRC parlance – the employer is required to operate income tax and national insurance under PAYE and report to HMRC.
- If a capital gain arises – the employee is required to report and pay capital gains tax to HMRC. There is no obligation on the employer to report or pay capital gains tax.
The tax reporting where unapproved options are exercised by consultants and non-executive directors can be tricky and there are grey areas. We do provide specialist advice.
Illustration of tax payable on unapproved options
Emp Loyee received an unapproved share option over 5,000 shares. The shares under option were worth £10 each but the exercise price was set at nil.
Two years later Emp Loyee exercises the option over 5,000 shares. The shares are now worth £20 each. Emp Loyee will pay income tax on exercise (5,000 x £20 x 40%/45% = £40,000/£45,000) and employer’s and employee’s national insurance contributions (13.8% and 2% respectively).
When the shares are sold two years after exercise at £35 each the difference between the sale proceeds of £175,000 and the value already subjected to income tax being £100,000 = £75,000 will be subject to capital gains tax at 20% or 10% depending upon the circumstances.
Alternatives to unapproved options
The alternatives are between:
- HMRC approved options; and
- Cash based awards linked to the share value often referred to as phantom options.
HMRC approved options
The choice of HMRC approved option plans is comprehensive. Each type of HMRC approved option plan offers different benefits and carries different qualifying conditions. In all cases, HMRC approved options carry tax benefits compared with unapproved options.
The following option plans are capable of approval under HMRC legislation:
- EMI options – most tax efficient type of approved option available and targeted at start ups and smaller SMEs. Decision on who to benefit and the terms of the award is discretionary – i.e. do not have to be made available to the entire workforce.
- CSOP options – usually implemented by larger companies that do not qualify for EMI. CSOP options do not have to be made available to the entire workforce. CSOP options are popular with US and other overseas businesses wanting to motivate the UK workforce. There are restrictions on the value of shares which can be placed under option which can be prohibitive.
- SIP – all employee share incentive plans designed for the entire workforce to be eligible to participate. A SIP can include HMRC approved options as well as free shares and matching shares. SIPs tend to be implemented by larger quoted UK and over shares in international companies awarded to the UK workforce.
- SAYE – all employee share incentive options scheme designed for the entire workforce and linked with a savings plan. Again, aimed at larger quoted UK and international companies rolling out shares to the UK workforce.
We do recommend that you consider awarding HMRC approved options before deciding upon unapproved options. The main reason is because of the tax savings offered to employees under HMRC approved options.
A phantom option does not involve the issue of shares. The idea is that a cash bonus is paid to an employee which is measured against the performance of shares in the employer or its group. Payment under the phantom option plan is treated as income and subject to income tax and national insurance under PAYE.
A phantom option would be considered where the issue of shares is not desired – usually because of an inability to obtain shareholder approval, for example joint venture companies.
Track record in successfully implementing unapproved share options
Our recent instructions involving share options plans included:
- Design and implementation of a multijurisdictional scheme for a Jersey based parent company with subsidiaries in the UK, Dubai, USA and Russia. We carried out an extensive viability analysis, designed the scheme for the holding company and rolled out the scheme across the different jurisdictions through our global network. The scheme included the facility to award HMRC approved options to the UK work force;
- Assisted in seven rounds of unapproved option grants to key employees of a successful finance company. The trade meant that the business could not qualify for any of the HMRC approved option arrangements;
- Designed a bespoke performance based share option scheme for three key employees of an e-gaming company. The existing shareholdings meant that the employees did not qualify for HMRC approved options;
- Advised on an issue of unapproved options to a CEO of a subsidiary of a property development company ultimately controlled by an off shore trust;
- Acted on behalf of a director buying into a successful bakery business based in South Kensington. The director received a mixture of shares and unapproved options.
There are many cases where implementation of an HMRC approved share options is not possible because either the proposed participant or the business falls foul of legislative conditions. Many employers implement unapproved options outside of legislative constrictions.
We design unapproved share options to match your shareholder objectives and drive your business forward.