We work with employers to explain the implications and draft the documentation on grant and exercise. We can also review arrangements for option holders.
Please do call us to discuss your query. We are happy to provide an initial outline of solutions and a fee estimate.
Why our clients work with us on unapproved options
- We have the experience you will need to provide shares for employees. We will use that experience to guide you to achieving the desired position.
- We cut down on the need for many different sets of advisers as we can handle the whole process for you.
- We will always provide practical solutions and have the capacity to deal with instructions promptly.
We have explained below some of the background points you will find useful when awarding unapproved options or phantom options.
- Why award unapproved options;
- Versatility of unapproved options;
- Taxation of unapproved options; and
- Alternatives to unapproved options and phantom options.
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 until exercise.
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 gains and entrepreneurs relief. Often a disposal has to be made as that is the only way the employee option holder has of funding his tax liability.
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.
Transfer of employers national insurance liability to the employee
Unapproved options are the only occasion when employers can pass their national insurance liability to the employee option holder. An election is required. If there is an election the employee will pay on exercise income tax plus his and the employer’s national insurance liability.
There is tax relief available to the employee in respect of the employer’s national insurance paid. But, a transfer can still leave an employee with a high tax burden.
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 or EMI options in smaller companies; and
- Cash based awards linked to the share value often referred to as phantom options.
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.