Generally, income tax and primary (employee’s) national insurance contributions (primary NICs) are payable by an employee on the exercise of an unapproved share option. In certain circumstances, income tax and primary NICs will also be due if approved options are exercised.
Employers have a corresponding liability to pay secondary (employer’s) national insurance contributions (secondary NICs) which means an additional cost of 12.8% on top of the cost of satisfying the share option. As the liability is linked to the gain on the option it cannot be quantified at grant and so an employer is potentially exposing itself to an uncapped liability.
Although an employer is generally prohibited from asking an employee to pay its secondary NICs, there is an exception for secondary NICs arising in connection with gains on exercise of options. (The exception also covers charges arising on the lifting of restrictions on restricted securities or the conversion of convertible securities.) This exception (paragraph 3A of schedule 1 of the Social Security Contributions and Benefits Act 1992), allows employers to transfer the secondary NICs to the employee.
There are two ways an employer can transfer secondary NICs to an employee:
- by a simple agreement by which the employee agrees to pay the secondary NICs;
- by a joint election by which the liability for the secondary NICs is transferred to the employee.
Under the agreement route the formal liability for secondary NICs remains with the employer (and so HMRC will look to the employer if the employee fails to pay).
There is no set format of the agreement and HMRC do not need to be involved. However, HMRC guidance states that any agreement should show it was entered into voluntarily by the employee. This should be evidenced in writing.
Under the joint election route, the employee and employer must enter into a joint election prior to the secondary NICs liability arising. The form of the joint election requires prior approval by HMRC. The approval process takes ten working days (fast track) or four weeks (standard timescale). Employers may use one of the two templates set out on the HMRC web site or prepare their own draft. Amongst other things, HMRC will want to be satisfied that there are appropriate arrangements in place to ensure that the secondary NICs are paid (generally by the employee authorising the sale of sufficient shares). The joint election allows the liability for the secondary NICs to be transferred to the employee (so that HMRC will not pursue the employer if it is not paid). If in the course of an enquiry it becomes apparent that the form of election used has not been HMRC-approved, it may invalidate the election (although this will depend on the facts of the case).
Irrespective of which route is followed, the employee will be entitled to income tax relief on the amount of the secondary NICs payable. Following the relief, a higher rate taxpayer will have a combined NICs and income tax liability of 48.68% (at current rates) on share option gains. This is higher than the 41% the employee would pay without the secondary NICs liability, but less than the aggregate 53.8% which would be payable by the employer and employee if the secondary NICs were not transferred.
Both routes are popular with companies wishing to reduce employment costs and plan for future NICs liabilities. From a practical perspective:
- It is sensible for grants of share options to be conditional upon the employee entering into an agreement or joint election (as appropriate) (many scheme rules specifically allow for this);
- If a company wishes to transfer the legal liability for secondary NICs, they will need to engage with HMRC on the form of the joint election in advance of entering into it;
- If options are being satisfied out of an employee benefit trust, it will be necessary to check the terms of the trust to ensure the trustee can withhold any amount due as secondary NICs. There might be cases where this is possible provided there has been a joint election but not where there is only a simple agreement;
- Communications with employees should be clear about the obligation to pay secondary NICs; failure to communicate this properly may give rise to disappointment later and risks negating the good effects that properly managed share schemes produce.