Share based incentives: partly paid shares, growth shares and joint ownership arrangements

Whilst EMI is one of the most popular equity incentives for UK employees, it is not always the right option for employers.  The business or participant may not meet the relevant eligibility criteria, or the cost of acquiring equity may be too high to provide an effective incentive. There are viable alternatives that can offer significant tax efficiencies, which 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 some flexibility in how these incentives can be designed and structured. The key objectives will usually be to align  incentives with business goals, which may include an exit, while providing an attractive reward and suitable ‘lock-in’ for employees.

Where companies may struggle is deciding which type of equity incentives is the most appropriate.  Key considerations will be whether the incentive remains effective over time and whether it is sufficiently motivational to reward participants in line with their performance and contribution. Equally, companies should avoid overly complex structures. Clear terms, straightforward performance conditions and an understandable structure 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 provide significant UK tax advantages. 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. They can provide an alternative where tax-advantaged share options, such as EMI or CSOP, are unavailable or unsuitable because the relevant qualifying conditions are not met.

Companies may want to review their existing incentives and consider whether one or more of the above arrangements may be appropriate. For example, companies may not be (or may no longer be) eligible for HMRC tax-advantaged arrangements, such as EMI options or CSOP, but still want to offer tax-efficient incentives. The above three share-based incentives may also be attractive to companies that have recently grown in value, but where the upfront 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 when the shares are acquired. Instead, payment for the shares is deferred to a future date or milestone event, such as an exit, at which time the employee would be expected to pay the outstanding amount.

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 may benefit from capital gains tax (CGT) treatment on gains realised on sale, rather than income tax and potentially NICs, provided the relevant conditions are satisfied. This can allow employees to benefit tax efficiently from the increase in value of their shares after acquisition.

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 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, may be due annually on the outstanding amount until it is paid. If some or all of the unpaid subscription price is released by the company or written off, that amount may be taxed as employment income.

The BIK charge will not apply if the notional loan amount, aggregated with any other relevant employer loans 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 type of share arrangement and to establish whether the shares carry dividend and voting rights. One potential drawback concerns the implications if the company were to become insolvent. In that event, the liquidator may require the shareholder to pay any unpaid amount outstanding on the shares.

Growth shares

Growth shares involve creating 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 upfront 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 rights 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 may be subject to CGT rather than income tax and potentially NICs.

Valuation of growth shares, including setting the amount of the hurdle, is critical to establishing the appropriate tax treatment for both the company and employees. HMRC will not generally provide tax valuations for growth shares, except where 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 (JSOPs) are structured and implemented to provide similar tax efficiencies to growth shares, with the aim of minimising employees’ exposure to income tax and potentially NICs on acquiring their interests, so that future growth may 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 the shares entitles them to benefit from 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 when and how employees may be able to realise their interests in the shares, 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, the market value of its shares is too high, making it 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.

Similar to growth shares, if JSOPs are structured and implemented correctly, any gains realised on employees’ sale of their interests may be subject to CGT rather than income tax and potentially NICs.

Employees will either pay the market value for their interests or may be subject to income tax and potentially NICs on the difference between the amount paid and the market value of the interest. On vesting of the employees’ shares, which could be on an exit event or other agreed realisation date, the employee, together with the EBT where appropriate, would sell their interests. The growth on sale may then be subject to CGT.

A key part of establishing JSOPs will be the valuation of the employee’s interests in the shares on the acquisition date. For the same reasons as outlined above in relation to growth share valuations, it is advisable that the company obtains a documented valuation from a share valuer of the co-owners’ interests in the shares before employees acquire their interests.

In summary, these arrangements can provide tax-efficient alternatives where EMI is not a viable option. However, they require specialist input to ensure that potential exposure to income tax and NICs is properly considered and, where possible, minimised. As the relevant valuations and tax treatment cannot generally be agreed with HMRC in advance, specialist advice is important to minimise tax risk for both employers and participants.