The current economic climate creates both challenges and opportunities for employee share incentives. In the quoted sector, executive remuneration is under scrutiny from regulators (in the process of implementing changes to the regulatory framework), shareholders (many still nursing losses and all facing uncertain prospects) and government (with the recent bankers' bonus tax). In the unquoted sector, cash is tight which makes equity incentives attractive to use but the prospects of realising value from an equity incentive at an exit event are thinner than usual. For all companies, finding a balance between motivating performance, managing risk and promoting long-term success is a key priority.

If this is the overall context, a specific issue in the forefront of many minds is tax efficiency. From 6 April 2010, the rate of income tax for high earners for taxable income over £150,000 will be 50 per cent and NIC increases are on their way too. Meanwhile, despite suggestions that the Chancellor might increase capital gains tax (CGT) rates, these remain at 18 per cent. Many companies and executives are considering how best to respond to this tax landscape.

1. Utilising the 40 per cent tax band while you can

High earners with "in the money" unapproved share options available to exercise should consider whether to do so before 6 April 2010. While this will accelerate a tax event and has financing implications (unless cashless exercise is available), it will limit income tax exposure to 40 per cent. Needless to say, such a decision will be influenced by an assessment of future prospects for share prices as well as tax considerations.

In the unquoted sector, companies may wish to explore whether unapproved options which only become exercisable after 6 April 2010 could appropriately have their exercise dates brought forward. In the case of HMRC approved or Enterprise Management Incentives (EMI) options, caution is needed as such acceleration would generally be regarded as the grant of a brand new right to exercise and if so, would not attract tax privileges.

2. Tax-privileged schemes - now 25 per cent better!

Tax favoured share options, such as EMI options and HMRC approved Company Share Option Plans (CSOPs), are set to become more attractive to those high earners facing a 25 per cent increase in their marginal rate of tax from 6 April 2010.

  • EMI options For companies eligible to grant EMI options, these remain immensely attractive. Indeed, one leading adviser once described them as the "best tax shelter in the UK tax system". EMI options are tax privileged share options available to independent companies carrying on a qualifying trade with less than 250 employees and with gross assets of no more than £30 million.

An employee can be granted EMI options over shares with a maximum value of £120,000 at the date of grant (including the value of CSOP options also held). So long as the exercise price is no lower than the market value of the shares at the date of grant, and no disqualifying event occurs, employees can exercise options free of income tax and NICs. On the eventual disposal of the shares, normally only a CGT charge (currently at 18 per cent) will arise. For smaller trading companies, the simplicity and flexibility of EMI options, together with the individual limit of £120,000, makes them preferable to the use of CSOPs.

If the value of your company's shares has slumped, and you are looking to replace existing EMI options with new options at a lower exercise price, take care! There are a number of pitfalls and, in certain circumstances, replacement options may not be eligible for EMI status.

  • Company Share Option Plans (CSOPs)

CSOPs are HMRC approved discretionary share option plans. For some unquoted companies, jumping through all the hoops to secure HMRC approval can be unappealing. For all companies, their impact is limited by the fact that an employee can only be granted CSOP options over shares worth up to £30,000 at the date of grant. However, CSOPs do offer an opportunity to pass value to employees free of income tax and NICs on exercise. In the right circumstances, a CSOP option granted subject to suitable performance conditions could be part of the remuneration mix for senior executives.

3. Capital vs income

There is considerable interest at present in methods to enable executives to benefit from growth in value of a company's shares and be taxed on that growth in value as a capital gain rather than income. There are a number of different ways to achieve this with minimal initial outlay of cash by the executive. Examples include:

  • Nil-paid shares: Here the executive buys ordinary shares but on deferred payment terms;
  • Flowering shares: Here the executive buys a special class of shares whose rights are carefully designed to minimise their current value but to grow in value as the company grows in value;
  • Joint share ownership plans: Here the executive and an employee benefit trust (EBT) buy ordinary shares jointly but their respective interests are different. Typically, the EBT buys almost all the current value and the right to, say, the first 5 per cent pa of future growth; meanwhile the executive buys little current value and the right to all future growth in excess of the first 5 per cent pa.

The technical details of these arrangements can be complicated, and each has its own advantages and disadvantages. All have in common the fact that, unusually, the company does not benefit from any corporation tax deduction. In effect, under these awards tax costs are passed from the executive to the company. However, in certain circumstances, that will be little disadvantage (eg if the company has substantial carried forward losses) or a price worth paying (eg to recruit a key individual or really motivate an executive team to pursue performance which will underpin share price growth). One area of uncertainty is the risk that HMRC might introduce anti-avoidance legislation to target one or more of these incentive structures.

In the quoted sector, the tax treatment is only one consideration, and the Association of British Insurers (ABI) has produced guidance saying "Remuneration structures that seek to increase tax efficiency should not result in additional costs to the company or an increase in its own tax bill. Remuneration Committees should be aware of the potential damage to the company's and shareholders' reputations from implementing such schemes." Any quoted company considering introducing such a tax structured scheme will need thorough consultation with its shareholders to ensure the proposal will attract shareholder support.