Tax-qualified or registered pension plans

Statutory framework
Is there a statutory framework governing the establishment and operation of tax-qualified or registered pension plans? If so, outline the general rules and requirements regarding:

(a) Vesting of benefits

A member of an occupational pension scheme generally has no statutory rights to any benefits before accruing three months’ pensionable service.  Once a member has completed two years’ pensionable service, he is entitled to a pension on retirement (ie, the benefit vests after two years). If a member leaves after completing three months’ pensionable service, but before two years, he is entitled to transfer his benefits out of the scheme to another suitable pension arrangement, or to a refund of his contributions.  No refund is payable after two years.

(b) Funding of plan liabilities

Under the Scheme Funding regime (set out in the Pensions Act 2004), trustees of defined benefit schemes must obtain actuarial valuations from the scheme actuary, valuing the scheme’s assets and “technical provisions” (ie, the scheme’s liabilities expressed in actuarial terms), at least every three years.  The trustees must prepare - with the advice of the actuary and in agreement with the employer - a statement of funding principles which, among other things, records whether there is a shortfall in meeting the technical provisions and the period within which the trustees propose to meet the shortfall.

The trustees and the employer must agree a schedule of contributions setting out the contributions that the employer and members will pay to the scheme over a five-year period, and any contributions payable by the employer under a recovery plan.  The recovery plan sets out details of additional contributions that the employer must make to eliminate any shortfall against the technical provisions.

The Pensions Regulator, which oversees the activities of occupational and certain personal pension schemes, has wide powers of intervention in relation to scheme funding – including, in certain circumstances, the power to modify future benefits of active members and to impose a schedule of contributions.

In relation to funding defined contribution schemes, the regulator’s key role is to ensure that contributions are paid into the scheme in full and on time.  

(c) Tax consequences for employer and participants

Pension schemes can register with the UK tax authority, Her Majesty’s Revenue and Customs, which qualifies them and members for certain tax advantages.  Employers and employees can claim tax relief on their contributions to the scheme.  However, members are charged to income tax at the marginal rate when they receive their pension.  The Finance Act 2004 sets out the types of benefit (pension and lump sums) - called “authorised payments” - that a registered scheme can pay which attract certain tax advantages. Unauthorised payments can result in considerable additional tax charges for the member or the employer and the scheme administrator.

Members of registered pension schemes are subject to limits as to the tax-free annual savings they can make and the savings they can make into them during their lifetime (£50,000 until April 6 2014 and £40,000 thereafter being the annual limit, and £1.5 million until April 5 2014 and £1.4 million thereafter being the lifetime limit). If these are exceeded, members are subject to a considerable immediate tax charge on savings in excess of the limits.  

(d) Any requirement to hold plan assets in trust or in similar vehicles

There is no requirement under tax legislation for pension schemes to be set up under a trust.  However, under the Pensions Act 2004, trustees of an occupational pension scheme which has its main administration in the United Kingdom must be established under an irrevocable trust if it is to be funded (ie, if it receives contributions from the employer).  Civil penalties apply for individuals who accept funding into an occupational pension scheme that has not been set up under an irrevocable trust.

(e) Any special fiduciary rules (including any prohibited transactions) regarding the investment of pension plan assets

Pension scheme trustees have the same powers of investment as if they owned the scheme assets.  This is underpinned, however, by the requirement that they take such care as an ordinary prudent person would if investing “for the benefit of other people for whom he felt morally bound to provide”.  Trustees are also expected to act in members’ best interests (ie, their best financial interests), and so must put aside their own personal interests and views on investments.  There are also certain express prohibitions and limitations:

  • The assets of the scheme must be properly diversified so as to avoid excessive reliance on a particular asset class or issuer;
  • Trustees must not borrow or act as a guarantor;
  • Scheme assets must consist “predominantly” of investments admitted to trading on regulated markets; and
  • Trustees must not make investments of more than 5% in “employer-related investments”.

(f) Governmental oversight of plan administration and/or insurance coverage for plan benefits in the event of an employer’s insolvency

An insurance lifeboat exists in the form of the Pension Protection Fund (PPF), which provides compensation for members of defined benefit schemes where the employer becomes insolvent.  The PPF is a statutory fund, which pays pensioner members their full benefits and most other members compensation of 90% of their entitlement subject to a further overall cap (currently approximately £34,000).  The PPF is funded by compulsory levy payments on schemes. 

Non-qualified pension & deferred compensation agreements

Unqualified pensions & deferred compensation
Do any special tax rules apply to these types of arrangement?

Unregistered schemes take the form of employer finance retirement benefit schemes (EFRBS), under which an employer undertakes to some or all employees to provide benefits to them on retirement.  EFRBS are commonly used to provide ‘top-up’ benefits for executives and high earners. They can be on a defined benefit or defined contribution basis, and can be unfunded, secured or funded.  The ‘disguised remuneration’ provisions of the Finance Act 2011 are designed to catch employers which are using EFRBS to sidestep the annual allowance and lifetime allowance limits in registered pension schemes, by causing immediate tax charges on the accrual of pension benefits. The effect is that funded arrangements (except where the contributions are ‘pooled’ so that they cannot be attributed to a single member) will attract a tax charge in the hands of the employee; wholly unfunded EFRBS generally fall outside the new regime.

Do these types of arrangement raise any special securities law issues?

Care must be exercised when setting up EFRBS to ensure that they are not deemed to be an employer-related transaction, to which Rule 11.1 of the Listing Rules will apply.

Equity-based compensation arrangements

Treatment of grants
Outline the general tax, securities law and regulatory treatment relating to grants of:
(a) Stock options

No charge to tax arises on the grant of an option to a UK resident employee. Neither is there a tax charge when the option becomes exercisable (ie, at vesting). When the option is exercised and the employee acquires the shares, the value of the shares acquired, less the amount of the price paid (if any), will be a taxable benefit and will be subject to income tax and National Insurance contributions (social security) liability.

Where income tax arises, this will be due at the employee’s marginal rate of income tax (for the tax year April 6 2013 to April 5 2014, the income tax rates are 20% for basic rate taxpayers, 40% for higher rate taxpayers and 45% for additional rate taxpayers). Employees’ National Insurance contributions liabilities are due at 12% on annual earnings of up to £41,450 (for the tax year April 6 2013 to April 5 2014) and at 2% thereafter. In addition, the employer will be subject to National Insurance contributions liability at 13.8% (for the tax year April 6 2013 to April 5 2014), although this can be transferred to the employee in certain circumstances.

It may be possible to structure stock option awards so that they are tax efficient if certain conditions are satisfied.

The United Kingdom is subject to the EU Prospectus Directive (2003/71/EC), which provides rules for the publication of a prospectus when securities are offered to the public. Specific and limited exemptions apply to employee share schemes; in particular, the grant of a non-transferable stock option is not subject to the UK prospectus rules.

A company which establishes an employee share scheme, and any employee benefit trust to be operated in conjunction with the scheme, will likely be regarded as carrying on a ‘regulated activity’ in the United Kingdom.  It is generally an offence for a person to carry on a regulated activity in the United Kingdom, or purport to do so, unless it is either an authorised or exempt person; although exemptions are available in connection with operating employee share schemes.

The Financial Services and Markets Act 2000 provides that a person must not, in the course of business, “communicate an invitation or inducement to engage in investment activity” unless it is an authorised person or the content of the communication is approved by an authorised person.  Again, exemptions are available for communications in connection with an employee share scheme.

(b) Stock appreciation rights

Stock appreciation rights (SARs) that can be settled only by delivering shares are securities options and will be taxed as a stock option (see above). Such SARs will generally have the same securities laws and regulatory treatment as stock options (see section 3.1(a)).

(c) Restricted shares

No tax charge arises where a UK resident employee acquires shares which are subject to a forfeiture provision which lasts for no longer than five years. When the forfeiture provision is lifted (or falls away), the value of the shares received will be subject to income tax and National Insurance contributions liability (see section 3.1(a)). Shares will be subject to forfeiture provisions if the terms on which they are acquired provide that they must be cancelled or transferred for less than market value if certain conditions have not been met within a specified period.

The offer of restricted securities will be subject to the prospectus and securities laws requirements set out in section 3.1(a) and the company will need to comply with the requirements of the Prospectus Directive and/or the applicable securities laws; although if shares are offered without payment, they will not be subject to the UK prospectus rules. 

(d) Restricted share units

Restricted share units will generally be taxed, for UK resident employees, in the same way as stock options (see section 3.1(a)) on the value of the shares received.

The offer of restricted share units will be subject to the prospectus and securities laws requirements set out in section 3.1(a); although if the shares are offered without payment, they will not be subject to the UK prospectus rules. 

(e) Phantom (ie, cash-settled) units

There is no charge to tax at the time that the phantom units are granted to a UK resident employee, as the employee has only an unsecured promise to the cash. When the cash is paid to the employee, the cash received will be a taxable benefit and will be subject to income tax and National Insurance liabilities (see section 3.1(a)).

The offer of phantom units, where the value is based on the share price, will be subject to certain UK securities laws requirements as set out in section 3.1(a), and such requirements will need to be complied with unless an exemption is available.

Pros and cons
Compare and contrast the pros and cons of granting different types of equity award from a general tax, securities and regulatory standpoint.

In relation to stock options (including market value, discounted and nil-cost options), the employee will acquire all of the shares subject to the option on payment of the exercise price (if any). SARs are incentive arrangements which are similar to stock options. However, SARs differ from stock options as they only deliver the value equivalent to the gain made on the exercise of a fully taxable stock option without a need for the employee to fund an option exercise price. Therefore, the company will use fewer shares than under an equivalent stock option.

Phantom units are essentially cash bonus schemes which replicate the key features of stock-based schemes, with the amount of the cash bonus mirroring the gain which would have been made on a true stock-based award. They are usually used where a share scheme is not possible, but where the company wishes to link part of an employee’s remuneration to the share price as an incentive.

It may be possible to amend the terms of stock option plans when options are granted at market value so that new option grants qualify for beneficial tax treatment. This is not possible on the grant of SARs or cash-based phantom units.

Companies may be able to rely on the employee share scheme exemptions in respect of the prospectus and securities laws requirements associated with the grant of stock options and SARs to employees. In respect of other types of award, companies should confirm whether an exemption is available should the employee share scheme exemption be unavailable.

Payment of exec comp generally

Tax and regulatory limitations
Do any tax or regulatory limitations apply to amounts that may be paid to executives, or deducted by employers, with respect to executive compensation generally?

Where the director is an employee, income tax and National Insurance contributions should be deducted through the pay as you earn system on salary and bonus payments.

In relation to listed companies, the salary level should be set by the remuneration committee in accordance with:

  • the principles contained in the Corporate Governance Code;
  • the Association of British Insurers (ABI) Guidelines on Executive Remuneration; and
  • other best practice guidance.

Where the organisation is regulated by the Financial Conduct Authority (FCA), which replaced the Financial Services Authority with effect from April 2013, remuneration should be set in accordance with the revised Remuneration Code of Practice applicable to FCA-regulated firms. This sets out principles against which the FCA will assess the quality of firms’ remuneration policies and any linkage between these policies and excessive risk taking by staff. Key objectives of the code include making boards focus more closely on ensuring that the total amount of remuneration paid by a firm is consistent with good risk management, and that individual compensation practices provide the right incentives.

Remuneration arrangements for directors of UK incorporated quoted companies must be consistent with the company’s remuneration policy.

Do any special limitations apply to severance benefits?

The amount of severance payable on termination of employment will primarily depend on the terms of the contract.  The employer is obliged to give an employee notice of termination in accordance with the terms of the contract and may, in some circumstances, make a payment in lieu of notice.  A dismissal without notice could give rise to a wrongful dismissal claim.  In addition, the severance payment will be determined by reference to statutory rights, such as the right to minimum statutory notice and holiday pay.

An employee with two years’ service also has the right not to be unfairly dismissed. Potentially fair reasons for dismissal include redundancy, misconduct and performance.  If the employer dismisses an employee without a fair reason or without following a fair procedure, the individual can claim unfair dismissal, which has a maximum compensation limit of £74,200 or 12 months’ pay, whichever is the lower.

The terms of any bonus or share awards may be subject to ‘claw-back’. Where claw-back provisions apply, they are usually triggered in circumstances such as:

  • a material misstatement of the financial accounts of the group which resulted in vesting at a higher level than would have been the case had there not been such an error or misstatement; or
  • misconduct on the part of the employee which, had the company been aware of the misconduct prior to the payment or vesting of the award, would have resulted in forfeiture of the award. 

The Companies Act 2006 sets out requirements to obtain shareholder approval in relation to payments for loss of office in certain circumstances.

Do any special limitations apply to amounts payable under a change in control agreement?

No. A payment made in accordance with a clearly drafted change of control provision should not require shareholder approval under the Companies Act 2006, as it should fall within the exemption for payments made in discharge of an existing legal obligation.

Special issues applicable to public companies

Regulatory disclosure
Does executive compensation raise any special regulatory disclosure issues?

The directors of a quoted company must prepare a directors’ remuneration report for each financial year (Section 420(1) of the Companies Act 2006).  All other companies must provide details of directors’ remuneration in the notes to the financial statements, but the disclosure is far simpler than for a directors’ remuneration report. The remuneration report must be approved by the board of directors and signed on behalf of the board by a director or the company secretary (Section 439).

The remuneration report forms part of the annual report and accounts. It must be sent to the quoted company’s shareholders with notice of the annual general meeting (AGM), laid before the meeting and a copy sent to Companies House.

The Companies Act 2006 and Schedule 8 of the Accounts Regulations have been amended to introduce new requirements in relation to directors’ remuneration reports for quoted companies, which came into force on October 1 2013.  The changes require a restructure of the form and content of the directors’ remuneration report. There are new standardised methodologies for the disclosure and presentation of remuneration information, which should be clear and prepared consistently from year to year.   The directors’ remuneration report must contain the following:

  • Annual statement – this statement by the chair of the remuneration committee summarises the major decisions on directors’ remuneration, any substantial changes relating to directors’ remuneration made during the year and the context in which these occurred.
  • Directors’ remuneration policy - this sets out the company’s forward-looking policy on remuneration and potential payments (including its approach to exit payments), and is subject to a binding shareholder vote at least every three years.
  • Annual report on remuneration – this discloses how the remuneration policy was implemented in the financial year being reported on, setting out the actual payments made to directors in the last financial year, including new disclosure requirements such as the single total figure for remuneration, and is put to an annual advisory shareholder vote. 

The new measures apply to remuneration payments to directors of UK incorporated quoted companies, whether they are executive or non-executive directors.   A ‘quoted company’ is defined in the Companies Act 2006 for this purpose as a company whose shares are listed on the Official List, officially listed in an EEA state or admitted to dealing on the New York Stock Exchange or Nasdaq.

Once the remuneration policy takes effect, the new regime will apply in relation to all remuneration and loss of office payments to directors; such payments must be consistent with the company’s approved remuneration policy or else separately approved by shareholders’ resolution, unless the payment is made as part of an agreement entered into before June 27 2012 which has not since been amended or renewed.  A payment which is inconsistent with the remuneration policy will be void (and there are potential personal liabilities for any director who approves a payment in contravention of an approved remuneration policy). 

Remuneration payments to directors of all other types of UK incorporated company will continue to be subject to the existing regime in the Companies Act 2006.

Employee transactions
Do any special rules apply to employee transactions involving employer securities?

Yes. Under the UK Listing Rules, a company that has a premium listing of equity shares in the United Kingdom must require all persons discharging managerial responsibilities (PDMRs) to comply with the Model Code and take all proper and reasonable steps to secure compliance. Such companies may impose more rigorous dealing obligations than those required by the Model Code.

The Model Code prevents “restricted persons” (ie, PDMRs) from dealing in securities during “prohibited periods”. Non-PDMRs are not caught by the Model Code, although some may be caught by the company’s share dealing code if the company extends the application of the Model Code to non-PDMRs who are insiders.

No employee should deal in shares while in possession of inside information, as insider dealing is a criminal offence under the UK Criminal Justice Act. The law also prohibits such information being passed onto others. The Financial Services and Markets Act 2000 market abuse regime is similar to the insider dealing provisions, but also applies to the company and not just the employee. Breach of this regime is a civil offence. 

Activist investors
Outline any general issues relating to the impact of proxy advisory firms such as ISS.

Representative bodies of institutional shareholders, such as the ABI and the National Association of Pension Funds (NAPF), have issued guidelines with which they expect companies proposing stock-based arrangements to comply.

The sanction for non-compliance is that members may vote against such any scheme. It is now common for institutional shareholders to produce papers highlighting proposals that do not conform to particular guidelines, and often to recommend that members vote against the proposal. In addition, the Institutional Voting Information Service reviews the remuneration reports and AGM proposals of FTSE-All Share companies and produces a report that is available to subscribers. There is also a separate monitoring service - Research Recommendations Electronic Voting, a wholly owned subsidiary of ISS - and many NAPF members follow its recommendations as regards voting on remuneration practices.

M&A issues

Pension plans treatment
Outline the treatment of pension plans in an M&A transaction. Do such transactions raise any special funding or regulatory issues (eg, required consents from governmental agencies or independent trustees)?

Employer debt: Material issues can arise on a commercial transaction as a result of legislation which requires companies leaving defined benefit plans (eg, on the acquisition of a subsidiary) to pay an immediate ‘exit debt’. The amount of this debt is calculated by reference to the full buy-out deficit (ie, the amount needed to secure all pension entitlements by buying annuities with an insurance company), and will be the cessation employer’s share of the buy-out deficit.   Alternative means of dealing with such debts (other than payment) may be available, but these will require negotiation with the plan trustees and may not be appropriate in all cases.  A leaving employer will want to pay its Section 75 debt (or otherwise deal with it in a permitted way); otherwise, it will remain on the hook for the scheme liabilities going forward.  Where that is the case, the requirement to pay such a debt may render a transaction commercially unviable.

Trustees: Pension plan trustees will scrutinise a transaction to analyse its effect on the employer covenant.  The employer covenant is the employer’s willingness and ability to fund the scheme. If the employer covenant will be materially weakened by the transaction, trustees will likely require some form of mitigation, such as additional funding, security over assets or other financial support.

Pensions Regulator: The Pensions Regulator has powers (known as ‘moral hazard’ or ‘anti-avoidance’ powers) to impose certain sanctions where the employer covenant is materially weakened and mitigation is not provided. Broadly, the regulator may issue a ‘contribution notice’ where there has been an act, or failure to act:

  • one of the main purposes of which was to reduce the amount of any Section 75 debt or prevent such a debt from becoming due; or
  • which has had a materially detrimental impact on the likelihood of accrued scheme benefits being received

A contribution notice can be issued to anyone ‘connected’ or ‘associated’ with the employer (including directors) who was a party to the relevant act and, broadly, can be for up to the full amount of the Section 75 debt in the scheme.

A financial support direction may be issued where the employer in relation to a plan is a service company or is insufficiently resourced.  An employer will be insufficiently resourced if it has insufficient net assets to meet 50% of the estimated buy-out deficit in the scheme and there is another connected or associated entity or entities whose assets are sufficient to meet the difference. A financial support direction may be issued to an employer and anyone connected or associated with the employer (but generally not to individuals).  There is no immediate requirement to make a cash payment to the plan; the direction is to ‘support’ the plan (eg, through a guarantee).  In either case, the exercise of the regulator’s powers is subject to a reasonableness requirement.

Clearance: The Pensions Regulator operates a clearance procedure, whereby parties to corporate activity can seek assurance in advance that the transaction will not give rise to a moral hazard sanction. The procedure is voluntary. However, clearance has its limits and comes at a price, usually in the form of additional or accelerated scheme funding. Many parties to transactions thus decide against seeking clearance.  However, some directors and lending banks may take a conservative view and insist that clearance be sought. If the transaction needs shareholder approval, shareholders may also expect to see confirmation in the shareholder circular that clearance has been obtained.

In some cases, the transaction may also need to be notified to the Pensions Regulator under specific legislative requirements.

The Pensions Regulator has posted guidance on the clearance procedure on its website.  

Equity compensation arrangements
Outline the treatment of equity compensation arrangements in an M&A transaction

Takeovers and mergers of UK companies are principally regulated by the City Code on Takeovers and Mergers. The code is designed to ensure that target shareholders are treated fairly and not denied the opportunity to decide on the merits of a bid, and are afforded equivalent treatment by a bidder.  The code is issued and enforced by the Panel on Takeovers and Mergers.

The code regulates the takeover of companies whose shares are admitted to trading on a UK regulated market, which includes the main market, but excludes the Alternative Investment Market. It also applies to offers for unlisted public companies considered by the UK Takeover Panel to be resident in the United Kingdom, the Channel Islands or the Isle of Man, and to certain private companies considered to be so resident.

The Takeover Code covers both takeovers by contractual offer from the bidder to purchase the target shareholders’ shares and schemes of arrangement sanctioned by the court under the UK Companies Act 2006. Where an offer is made for equity share capital and the offeree has any options or other rights over shares, the offeror must make an appropriate offer or proposal to the holders of options to ensure that their interests are safeguarded.

There are three main ways in which the rights of participants can be dealt with on a takeover (although references below are to options, the same provisions may apply to share schemes where the participant has a conditional right to receive shares):

  • exercise of the option so that the option holder can accept the takeover offer;
  • rollover of the option (ie, release of the existing option in consideration of the grant of a replacement option of equivalent value over shares of the offeror); and
  • release of the option for cash consideration.

Where participants hold restricted shares, any takeover offer will extend to those shares and participants (or the trustee holding those shares, if appropriate) will be able to accept the offer subject to any terms set out in the governing plan rules or agreement.

Tax and regulatory issues
Does the treatment of executive compensation in an M&A context raise any special tax or other regulatory issues?

During any M&A transaction, a variety of complex tax and legal issues often arise which need to be covered on a case-by-case basis. The beneficial tax treatment normally associated with UK-approved awards over a company’s share capital may be lost if the awards are subject to accelerated vesting and/or the conditions required to receive beneficial tax treatment are lost pursuant to the M&A transaction. 

Health insurance

Provision of insurance
Outline the extent to which health insurance coverage is provided by the government, through private insurers or through self-funded arrangements provided by employers.

Health insurance coverage is not provided by the government. Healthcare in the United Kingdom is free, provided through the National Health Service.  However, some individual employers do provide private healthcare as an employee benefit.

Coverage levels
Do any special laws mandate minimum coverage levels that must be provided by an employer?


Can employers opt to provide different levels of health benefit coverage to different employees within the organisation?

Yes - this is lawful, provided that there is no disparity of treatment because of “protected characteristics” under the Equality Act 2010 (eg, gender, race, age, sexual orientation).

Post-termination coverage
Are there any requirements that oblige employers to continue providing health insurance coverage after an employee’s termination of employment?

Dismissing an employee while he is in receipt of private health insurance benefits could entitle the employee to claim damages for breach of contract for being wrongfully deprived of benefits under the policy. Employers should consider the wording of the employee’s contract, the rules of the policy and whether their actions could be construed as wrongfully depriving the individual of the possibility of cover under the scheme.