As widely reported, the Government is consulting on plans for a new "owner-employee" employment status under which employees will have restricted employment rights but benefit from capital gains tax exemption on their shares. The main aim of the reform is to reduce the financial risk for employers taking on new staff. While this is intended to help start-ups and other small businesses, it is possible that it may become a more general feature of private equity financed companies.
Under these "owner-employee" contracts, companies will be able to issue to each employee between £2,000 and £50,000 worth of shares in the company in exchange for the employee giving up certain statutory employment rights, namely rights to compensation for unfair dismissal and redundancy and certain rights to request flexible working or time to train. In addition, owner-employees will have to give 16 weeks' notice of their intention to return early from maternity or adoption leave rather than the standard eight weeks' notice. However, owner-employees will still have the right to claim unfair dismissal for circumstances where dismissal is automatically unfair (including whistle-blowers, trades union membership and maternity) and to claim for discrimination. As these tend to be the claims which are most problematic for employers, because compensation is generally uncapped, it is questionable whether this reform will give employers as much reassurance as might have first appeared.
The shares will be exempt from CGT on eventual disposal, but in other respects the consultation indicates they will be treated in the same way as other shares acquired by reason of employment. In broad terms, this means income tax and NICs will be payable if the shares are worth more at the time of acquisition than the consideration given by the employee. The consultation document does not state whether the consideration given by the employee will be treated as including the value of the employment rights given up; however, this seems unlikely given the valuation difficulty and uncertainty this would cause.
Under these normal rules for employee share acquisitions, where the shares acquired are subject to any 'restrictions' (which will almost certainly be the case for owner-employee shares) then, unless an election is made, their value on acquisition will be calculated taking into account the effect of the restrictions. Income tax and NICs will be payable on the difference between this 'restricted value' and the consideration given by the employee for the shares. In addition, when restrictions are lifted or on disposal if earlier, part of the increase in value will also be subject to income tax and NICs and not capital gains tax.
If however a joint election is made by the employer and employee, the shares will be valued at the time of acquisition as if the restrictions did not apply - their 'unrestricted value'. This has two consequences. Firstly, it means that any future increase in the value of the shares will be subject to capital gains tax (not income tax and NICs). For this reason, in practice owner-employees are very likely to make such elections as there would be little point in a capital gains tax exemption if much of the increase in value of the shares was subject to income tax instead. However, the second consequence is that this may increase the initial income tax and NIC charge on acquisition.
The consultation document states that unrestricted market value is to be used for the purpose of calculating the £2,000 to £50,000 limits. The document recognises that the valuation of shares in small unquoted companies is not straightforward and seeks views on how best to deal with valuation practicalities.
Employers who qualify for corporation tax relief when shares are issued to employees at less than market value will also be entitled to this relief on acquisitions by owner-employees. In addition, although the shares will not be eligible for Enterprise Investment Scheme reliefs, nor for inclusion in any tax advantaged employee share scheme, employers will be able to operate these in addition and employee owners will be eligible to join such share schemes.
It is intended that all types of shares will be eligible for owner-employee arrangements, so employers will have flexibility to restrict voting and other rights if they think appropriate. It is likely that most employers will want to impose a compulsory transfer requirement on termination of employment to avoid a disaffected former employee becoming a hostile minority shareholder. This will be possible provided the employer pays a "reasonable price". The Government is consulting on whether this should be full market value or a lesser amount, perhaps a stipulated fraction of market value. It remains to be seen whether employers will be able to distinguish between good and bad leavers, paying good leavers more than bad ones and permitting good leavers to keep some or all of their shares depending on length of service. As mentioned above, restricted securities elections will presumably be necessary on acquisition to avoid income tax on vesting, the lifting of other restrictions and disposal. We also assume that there will be no prohibition on shares being subject to 'drag' and 'tag' and 'lock-in' provisions.
The Government assumes that employers will usually have existing employee share schemes and will be able to use these to facilitate the issue and buy back of owner-employee shares, in particular the share scheme exemptions from the company law requirements on issue and repurchase of shares. However, the smallest businesses and start-ups generally do not have share schemes in place and may well be deterred from taking up the proposals by the additional valuation and compliance burden imposed by owner-employee arrangements.
Employers will be able to require new joiners to have owner-employee status, but they will not be able to impose this on existing employees. Existing employees can however change their status by agreement with their employer. Such share awards towards the upper end of the scale might be a more attractive option for those who have faith in the company's future and are confident that they can perform well enough not to need employment protection. Employers and private equity investors like to see employees with these characteristics and, whilst it will not be permissible to require existing employees to switch status, it is easy to imagine that employees may be encouraged to show their commitment in this way. There will be anti-avoidance provisions in the legislation to prevent abuse of the new status and the Government has been consulting on how these might be formulated.
Click here for the consultation document.