With careful planning and execution, the new employer shareholder arrangements could provide a flexible, tax efficient way to incentivise management.

OVERVIEW

On 1 September 2013 the new “employee shareholder” regime came into effect in the UK.

Under an employee shareholder arrangement, an employee will relinquish certain statutory employment rights including the right to not be unfairly dismissed and the right to a redundancy payment. In return, the employee must receive at least £2,000 worth of shares in his employer (or a parent company). The employer can grant £2000 worth of these shares income tax-free, whilst up to £50,000 worth of shares can be granted free of capital gains tax (CGT) upon sale. The employee must obtain independent legal advice on the terms and effect of the employee shareholder agreement that documents the arrangements before entering into it.

PRACTICAL ISSUES

On first reading, the new employee shareholder regime seems like a straightforward exchange of shares for employment rights. However, on further consideration a number of practical issues emerge which employers will have to address in order to successfully implement an employee shareholder arrangement. This Client Alert considers these practical issues and possible solutions.

Valuation of the shares

The valuation of the shares issued to the employee shareholder is critical to the success of any employee shareholder arrangement. The employer must grant at least £2,000 worth of shares to the employee for the arrangement to be effective. For the purpose of this £2000 threshold, the company must consider the shares’ actual market value on the date of issue, i.e. the value should take into account any restrictions applicable to the shares. We think employers likely will want to impose restrictions on these employee shares, for example preventing the employee from selling or transferring the shares in many circumstances and perhaps restricting the voting rights attaching to the shares.

Notably, for the purposes of calculating the number of shares that can be issued to an employee and that will be exempt from CGT upon sale, the unrestricted value is used (i.e. the value ignoring any contractual restrictions on the shares).

If the restricted value of the shares is any lower than £2000, the employee shareholder scheme will not be effectively implemented (meaning that the grant of shares will become taxable and the employee will not have relinquished any employment rights). Conversely, if the value is over £2,000, income tax (and potentially National Insurance contributions) will be payable on the excess.

In addition, the employee shareholder must receive £2000 worth of shares on day one, in a single allocation. The issue of shares cannot be staggered, nor can an initial grant of shares be “topped-up” with a further grant if the initial grant is later determined to be worth less than £2000.

Therefore, any private company wishing to implement an employee shareholder arrangement, likely will incur costs at the outset as the employer will have to pay for an independent valuation of the shares. The employer can then submit the valuation to the UK tax authority (HMRC) for their approval. Although the company need not agree the valuation with HMRC, the authority’s approval will be prudent, providing the company reassurance that the shares are worth at least £2000 and therefore satisfy the requirements of the scheme. HMRC has indicated that it will take 10 working days to respond in the case of an approval, however the period could be longer if the valuation is rejected or is of a complex nature. An approved valuation will remain valid for 60 days.

Dilution

The requirement that the shares granted to the employee shareholder are worth at least £2000 also causes a potential dilution headache. Typically, when granting shares to employees (for example under “sweet equity” arrangements) the lower the value of the share the better, as a lower value enables employers to issue shares to managers at little or no cost and for any subsequent increase in value to be subject to capital gains tax treatment rather than income tax treatment. However, under an employee shareholder arrangement, the lower the value of the shares, the more shares an employer will need to issue to meet the £2000 threshold. Increased shares could lead to material dilution of the company’s other shareholders’ value. Companies adopting employee shareholder arrangements will therefore have to balance this dilution risk against ensuring a realistic valuation.

One solution might be to create a new class of shares for the £2000 worth of employee shareholder shares. These shares would have greater rights and fewer restrictions than the sweet equity, thereby increasing their value when compared to the sweet equity.

Newly issued shares

The shares granted to an employee shareholder under this new scheme must be newly issued shares. Therefore, when an employee shareholder leaves employment and is required to sell the shares back, the shares issued under the employee shareholder agreement cannot be recycled for use under another employee shareholder agreement. An employee benefit trust (EBT) can be used to buy back the shares and warehouse them for use in other employee share incentive arrangements. However, (as with any arrangement involving an EBT) the employer must be wary of impounding the shares in the trust where they can only be used for the benefit of the “beneficiaries” i.e. employees, former employees and their dependants. If a private company chooses to use the new Companies Act provisions, which allow a private company to buy back its own shares, the buy-back should be approached with care as the employer faces potential tax hazards if this is not done correctly (in particular the buy-back must occur after termination of employment). In addition, any shares the company buys back could not be allotted again under a new employee-shareholder agreement.

Additionally, employers must ensure the shares are issued to the employee shareholder fully paid-up. However, the first £2000 worth of shares must not be paid for by the employee. For the shares to be issued fully paid-up the company must have distributable reserves or receive money or money’s worth for the shares equal to the amount to be paid-up. This contradiction between the new employee shareholder rules and established company law appears to be a legislative oversight and we anticipate that the government will issue new guidance on this point. Employers could possibly argue that the employee’s agreement to give up their employment rights comprises “money’s worth”. However this argument is untested.

S.431 election

For the purpose of the £2000 threshold, the company must consider the shares’ actual market value, taking into account any restrictions on the shares, such as vesting or forfeiture provisions. Employees will likely want to make a s.431 election (which is broadly equivalent to a s.86(b) election in the U.S.) electing for income tax purposes to ignore any restrictions on the shares and to pay any income tax (calculated on the difference between the restricted and unrestricted market value of the shares) at the time of acquisition. Making this election and paying the income tax on acquisition avoids a potentially greater income tax charge when those restrictions are lifted. However, this election also means that the employee will need to find a means of funding the income tax charge on acquisition of the shares, which could be expensive if the restricted and unrestricted value differs greatly.

This problem can be avoided by using unrestricted shares in the employee shareholder scheme. However, in practice, most private company employers are likely to want to impose restrictions on the shares. Listed companies (that would be more likely to grant unrestricted shares) are more likely to use other tax approved employee share schemes that allow greater income tax savings.

Independent legal advice

The employee must obtain independent legal advice on the terms and effect of the employee shareholder agreement before entering into it. The employee must follow a specific process; taking seven calendar days to consider the advice before the employee can enter into the shareholder agreement. This process is likely to be time consuming and potentially expensive for the employer who must meet the reasonable cost of the advice being provided. The employer should be vigilant to pay only for advice to the employee on: the terms and effect of the employee shareholder agreement and general advice explaining how employee shareholder arrangements are taxed as only this advice can be paid for by the employer on a tax-free basis. In particular, if an advisor began negotiating the terms of an employee shareholder agreement (for example the good leaver/bad leaver provisions relating to the shares) or providing detailed tax advice, the employer could not pay for this advice on a tax-free basis.

Will Anyone Adopt the Employee Shareholder Regime?

Time will tell whether the employee shareholder arrangements will be adopted by many employees and employers as well as how easily the practical issues discussed above can be successfully navigated.

Although the UK government likely did not intend this outcome, we anticipate that employee shareholder schemes will appeal primarily to senior managers in a private equity buy-out scenario who are familiar with the concept of share-based remuneration and will appreciate the associated tax advantages. In particular, the CGT exemption on employee shares valued at up to £50,000 on date of issue will be extremely attractive to senior managers. The employee shareholder regime allows employers to impose restrictions on the shares issued to the employee shareholder and the employer is free to agree to any contractual terms around forfeiture of the shares, including when the employee shareholder becomes a “leaver”. This flexibility will appeal to investors.

Employee shareholder agreements will be less attractive to junior employees who will want to retain their employment rights and are less motivated by potential tax savings. Employee shareholder agreements are also unlikely to be attractive to listed or independent companies that have the option of other HMRC approved share schemes that afford greater tax savings (for example, CSOPs, SIPs, EMI and SAYE schemes).

We anticipate that in a private equity backed, buy-out scenario, the employee shareholder regime could be used to maximise tax efficiencies as part of any management incentive arrangements. For example, if companies create a separate class of shares for the purpose of granting the initial £2000 worth of employee shareholder shares, provisions pertinent to valuation can be “baked in” to the shares’ rights so that the provisions are applicable to both the restricted and unrestricted value of the shares. This approach will minimise the difference between the restricted and unrestricted values, which in turn reduces the income tax charge when making a s.431 election. Companies may also consider issuing unrestricted “institutional strip” shares worth £2000 in order to ensure that the managers qualify as employee shareholders. Thus, companies could eliminate the need for a separate valuation process, and if the shares are unrestricted, eliminate the need for a s.431 election, which would trigger a tax charge on acquisition of the shares. Such arrangements would not preclude companies using a separate class of shares in standard “sweet equity” arrangements alongside the employee shareholder arrangements and, if properly structured, managers could benefit from the £50,000 CGT exemption in respect of these additional shares as well.
 
Conclusion
 
Integrating the employee shareholder regime into management incentive arrangements will, of course, require careful consideration of the company’s existing share structure and documentation to ensure that the new arrangements do not cut across existing pre-emption rights or other shareholder protections. However, with careful planning and execution, we anticipate that the employee shareholder regime could offer a new means of incentivising key employees in a tax efficient way.