The recent Finance Bill has introduced draft legislation for a welcome new tax incentive scheme to assist small and medium-sized enterprises (SMEs) to attract and retain talent through the use of share options. The new scheme is called the ‘Key Employee Engagement Programme’ or ‘KEEP’. It offers two key benefits for eligible option holders in SMEs when compared to existing share option awards:
- a lower tax bill, and
- a later tax payment date.
How can KEEP reduce an option holder’s tax bill?
Under KEEP, employees are only subject to capital gains tax (CGT) on the sale of the shares. A charge to income tax, universal social charge (USC) and pay related social insurance (PRSI) will not arise on the exercise of the share option. When compared to how gains are currently treated, this means option holders may benefit from a potential tax saving of up to 19% on the discount received when exercising a share option.
How can KEEP ‘defer’ the tax payment?
Currently, an employee is potentially liable to tax when the employee exercises the share option and when the employee ultimately sells the shares. Under KEEP, the employee will only be liable to tax on the date when the employee sells the shares.
What are some key features of KEEP?
The SME must carry on a qualifying trade.
Certain categories of SME cannot qualify for KEEP. For example, SMEs dealing in or developing land, carrying on financial activities or professional services companies do not qualify.
There is an overall limit of €3 million on the total issued, but unexercised, qualifying options of the SME. In addition, the total market value of all shares over which qualifying options are granted to any employee or director may not exceed:
- €100,000 in one tax year,
- €250,000 in three consecutive tax years, or
- 50% of that employee’s or director’s annual pay in the year in which the share option is granted.
How an SME should determine the market value of its shares is uncertain. Determining and then monitoring these limits may prove onerous and costly.
SMEs are required to make certain annual filings under KEEP. If the SME fails to make the relevant filings on a timely basis, it will no longer qualify for KEEP. In the event this happens, the current share option rules would apply and income tax, USC and PRSI would arise on the exercise of the share option.
An employee or director will not qualify for the scheme if they and any connected persons, including family members, directly or indirectly own more than 15% of the ordinary share capital of the SME. This threshold is quite low and it will need to be monitored to ensure that employees and directors do not fall outside the scheme.
Can existing option schemes be converted to KEEP schemes?
It appears that it may be possible for some existing employee share option plans to be converted into “KEEP-compliant” plans.
The proposed implementation date for the scheme is 1 January 2018, provided EU state aid approval is given. Any share options granted before the implementation date will not be eligible for KEEP.
As a result, SMEs and prospective option holders should carefully consider whether to postpone any new share option awards until KEEP comes into effect.
Why is KEEP needed?
Share option schemes can be a useful tool to attract and incentivise key employees. However, the current Irish tax treatment of share options is not competitive with other jurisdictions from an employee perspective, particularly for SMEs. For example, under current Irish share option scheme provisions, employees are liable to:
- income tax, USC and employee PRSI at a top rate of up to 52% on:
- any gain realised on the exercise of the share options,
- the gain being calculated on the difference between the market value of the shares at the time of acquisition,
- and the aggregate amount or value of consideration, if any, paid by the employee to acquire the shares, and
- CGT at a rate of 33% on any appreciation in the share price when the shares are sold as compared to the market value on the date of exercise.
The tax arising on exercise often results in a cash-flow issue for employees who must deal with an upfront tax liability on the exercise of their share options. This is particularly the case in situations where there is not a readily available market for the sale of these shares to meet this initial cost on exercise.
KEEP is a step in the right direction to putting Ireland on a more competitive footing with other jurisdictions.
With reports the Irish economy is due to reach full employment by the end of 2018, SMEs will face strong competition from large corporates and international competitors when trying to attract and retain key employees, particularly in the technology sector. It is a welcome measure to provide high potential SMEs with a useful tool to address the talent problem in the face of competition.
Note: While this commentary is based on the most recent draft of the Finance Bill, it is possible that amendments could be made to KEEP before the Finance Bill is enacted.