From 1 September 2013, pursuant to the Growth and Infrastructure Act 2013, a new form of employee status is available – the employee shareholder.
Broadly speaking, employees can receive shares in their employing company or parent worth at least £2,000 ("employee shareholder shares") in return for giving up certain employment rights, such as unfair dismissal. The upside for such employees is certain tax benefits. The intention behind the new regime is to encourage employees to invest in their employers in order to drive growth, whilst at the same time giving employers more flexibility in managing their workforce.
Where an employee is granted shares in consideration of entering into an employee shareholder agreement the first £2,000 worth of shares will be free from income tax and NICs as the shareholder will be treated as having made a payment of £2,000 for the shares. Normal rules apply to the value of any shares received in excess of £2,000.
An exemption from capital gains tax will be available on any gain realised by the disposal of employee shareholder shares. The exemption applies to the disposal of the first £50,000 worth of shares (valued at the day the shares were acquired).
For example, assume an employee is granted employee shareholder shares worth £60,000. After 3 years the shares are sold for £300,000. The realised gain is £240,000, and assuming all conditions are satisfied of this gain £200,000 would be exempt (i.e.: the proportion of the gain which is referable to the first £50,000 of shares originally awarded), and £40,000 will be subject to CGT. This is in addition to an income tax charge at the time of grant on £58,000 (i.e. the value of the award less the first £2,000 which is exempt).
In practice, in many MBOs deals, the shares issued to management (including ratchet shares) may have a much lower value on issue which could potentially realise a very significant gain on exit which could potentially be entirely exempt under this regime.
An employee will not be able to benefit from the tax exemptions if they or a person connected with them has (or in the immediately preceding 12 months had) a 'material interest' in the employer company or parent (being at least 25% of the voting rights in the company).
This new regime has already attracted significant interest from private equity firms as it may facilitate management being able to benefit from exemption from capital gains tax in respect of their shareholdings including ratchet shares (which is, of course, better than the 10% entrepreneurs relief rate and the full CGT rate of 28%).
The key to making this work is being able to structure shares with a valuation of at least £2000 on issue. It is possible to seek advance agreement on valuation from HMRC Share and Assets Valuation team.
Private equity firms will need to consider the reputational impact of using this scheme in the current environment given certain adverse press coverage already seen by some firms that have allowed senior executives to make use of this regime.