Companies face a number of challenges when looking to establish equity incentives to attract and retain their workforce. For private companies, there is a degree of flexibility in the design/structure of such incentives.
Whilst EMI is the most popular type of equity incentive to offer UK employees, it is not always the best fit for employers. The business and/or participant may not meet the qualifying criteria or the cost of the equity prohibitively high to incentivise. There are viable alternatives that can offer great tax efficiencies that we explore below.
Companies face a number of challenges when looking to establish equity incentives to attract and retain their workforce. For private companies, there is a degree of flexibility in the design/structure of such incentives. Uppermost will be a desire that incentives should be aligned with business goals (which may include an exit) and also provide an attractive reward and suitable ‘lock-in’ for employees.
Where companies may (and often do) struggle is over the type of equity incentives to establish and what may be ‘right’ for them. Key drivers will be to ensure incentives retain their effectiveness over time; and if they will be sufficiently motivational to reward those participating commensurate with performance. Equally, companies should avoid overly complex structures: clarity in the design/structure of incentives with readily understandable terms and performance conditions will benefit all parties.
We focus below on three common share based incentives: partly paid shares, growth shares and joint share ownership arrangements which, if structured appropriately, can be highly UK tax efficient arrangements. They are likely to be suitable for companies expecting to grow shareholder value in the future, because employees broadly only benefit from the ‘upside’ in value created after they have acquired their shares or ownership interests. These are alternatives to share options which are only tax inefficient for employees if delivered under an EMI or CSOP option which have strict qualifying criteria (see below).
Companies may want to review their existing incentives and consider if one or more of the above incentives may be appropriate. For example, companies may not be (or are no longer) eligible for HMRC tax advantaged arrangements, such as EMI options or CSOP, but want to offer tax efficiency. The above three share based incentives may also be attractive to companies that have recently grown in value, but where the up-front cost to employees of purchasing a meaningful equity stake would otherwise prove too costly.
Partly paid shares
Employees subscribe for shares on terms where they do not pay some or all of the subscription price on the acquisition date. Instead, payment for the shares is deferred to a future date(s) or the occasion of milestone event (e.g. an exit event), at which time the employee would be expected to pay up the amount(s) outstanding.
Offering nil paid shares gives employees the benefit of immediate share ownership (as compared to a share option) and the possibility of receiving dividends. Additionally, employees should be subject to capital gains tax (CGT) on any gains realised on sale, rather than being subject to income tax and possibly NICs. This allows employees to benefit tax efficiently from the increase in value of their shares above the market value of the shares at the time they were subscribed.
The subscription price payable is determined before the employee acquires the shares. If the price payable for the shares is at least equal to the tax (fiscal) market value, there will be no upfront tax for the employee. Instead, any unpaid subscription price will be treated as a ‘notional loan’ on which a Benefit in Kind (BIK) charge (plus employer’s NICs) will be due annually on the outstanding amount (from time to time) until it is paid. If some or all of the unpaid subscription price is released by the company (or written off), that amount will be taxed as remuneration.
The BIK charge will not apply if the notional loan amount, aggregated with employer loan(s) (if any) held by the employee, does not exceed £10,000. Further, income tax relief from a BIK charge may be available if the employee subscribes for shares in a close company where certain conditions are met.
Before introducing nil paid shares, the company’s articles of association should be checked (and if necessary amended) to ensure that they provide for this; and also if the shares will be eligible for dividends and/or votes. One potential drawback concerns the implications if the company were to become insolvent. In that event, the liquidator would be expected to call for any unpaid amount outstanding on the shares from the shareholder.
Growth involve a new class of shares which have limited capital rights on subscription, but which may share in a proportion of future capital growth in the company. For this purpose, growth is linked to ‘hurdles’, which usually relate to the company’s performance or exit value.
The up-front cost to individuals of acquiring growth shares should be relatively low if the shares do not participate in the current value of the company and are only entitled to a percentage of value above the hurdle.
Acquiring growth shares gives employees the benefit of immediate share ownership, although the shares do not usually have entitlement to income dividends. One of the key reasons for using growth shares is that, if structured and implemented correctly, any gains realised on sale of the shares should be subject to CGT, rather than being subject to income tax and possibly NICs.
Valuation of growth shares (including setting the amount of the hurdle) is critical to provide tax certainty for both the company and employees. HMRC will not provide tax valuations for growth shares, except if a company is eligible for EMI and seeks a valuation for the purpose of granting EMI options over growth shares. It is strongly advised that a company obtains a documented valuation from a share valuer (with relevant experience) before growth shares are subscribed.
Joint share ownership arrangements (JSOP)
Joint share ownership arrangements (JSOP) are structured and implemented to provide similar tax efficiencies to growth shares in order to minimise employees’ exposure to income tax (and possibly NICs) on acquiring shares, so that any gains realised on a future sale should be subject to CGT.
Under a JSOP, employees acquire an interest in shares jointly with a co-owner (usually the trustee of an employee benefit trust (EBT)). An employee’s interest in shares entitles them to benefit in the value of the shares above a certain level. This is typically set at the market value of the shares on acquisition, although it may be a higher price (known as the ‘hurdle’). Details of the respective interests, held by the EBT and employee, will be set out in a joint ownership agreement (JOA). The JOA will also set out how employees may be able to sell their interests in shares (i.e. when the interests will ‘vest’), for example, on an exit event or on leaving employment.
JSOPs may be attractive to companies that want to offer tax efficient incentives but where other alternatives are not possible, either because: the company is not eligible for HMRC tax advantaged plans (such as EMI or CSOP); or the market value of its shares is too high (meaning it is too costly for employees to acquire a meaningful equity stake), or shareholders do not want to alter the company’s share capital structure to create a class of growth shares to be used to incentivise employees.
Similar to growth shares, if JSOPs are structured and implemented correctly, any gains realised on employees’ sale of their shares should be subject to CGT, rather than being subject to income tax and possibly NICs.
Employees will either pay the market value for their shares, or income tax (and possibly NICs) on the difference between the amount that they pay and the market value of that interest. On vesting of the employees’ shares, which could be on an exit event or other agreed realisation date, the employee (or jointly with the EBT) would sell their shares. The growth on sale of the shares should be subject to CGT.
A key part of establishing JSOPs will be the valuation of the employee’s interests in shares on the acquisition date. For the same reasons as outlined above in relation to a growth share valuation, it is advisable that the company obtains a documented valuation from a share valuer, of the co-owners interests in shares, before employees’ acquire shares.
In summary, the above arrangements can deliver tax efficiencies where EMI is not a viable option. However, these arrangements require specialist input to ensure that any exposure to income tax and possibly NICs is as low as possible. As these values cannot be agreed with HMRC it is imperative that specialist advice is taken to minimise the tax risk for both employers and participants.
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