Companies operating share plans out perform companies that do not. Why? - because employees feel like they are working for a business they own.

Companies looking to incentivise key members of staff by giving them equity have a number of options available to them. Some companies will opt to issue shares to their employees. Depending on the company’s circumstances they may qualify for the UK tax advantageous plans known as Enterprise Management Incentives (EMI) share options or alternatively Company Share Option Plan (CSOP).  

Why give shares to employees rather than options?  

Shares give the employee a percentage ownership of the company as they immediately become shareholders. In most cases the shares will entitle the employee to dividend and voting rights. This builds a stronger sense of a stake in the business than granting options.

However, awarding shares to employees carries greater financial risk than an option does if the share price does not perform.  

The provision of shares to UK employees is regarded as a taxable benefit in kind.  This means that the “taxable value” of the shares on award will be taxed as employment income at rates of up to 45% plus NI.  Providing there has been an appropriate payment of tax and an appropriate election entered into within 14 days of award UK capital gains tax then applies on the gain made after award and up to the date of sale. The current rate is 10% or 20% depending upon the circumstances. 

Legitimate tax planning is about finding ways of converting income into capital. HMRC offer some ideas.  For example, it is possible when shares are provided to employees for the employer and employee to elect that the gain on disposal will be taxed as capital. An election might increase the income tax payable by the employee on acquisition but it will allow any subsequent growth in value to be taxed as capital. Without the election, the entire gain could be subject to income tax and national insurance.

A company will also need to consider what happens to the shares when the employee is no longer part of the business. Should the employees be allowed to keep the shares or should the company be allowed to clawback the shares? Most private companies choose to clawback the shares by setting out such provisions in the articles of association or shareholders agreement. The price the company will pay for the shares is a commercial decision. Some companies chose to buy them back for fair market value whilst others buy them back for nominal value depending on whether the employee is a good or bad leaver.

Why might options be the better choice?

Options are commonly used as an incentive for staff. It is a way of telling your staff that they will have a choice of buying shares in the company at a price that is agreed today.  If the share price perform well the employees can benefit from a substantial gain.

EMI – the currency of choice

EMI options are the most tax efficient and flexible type of option plan.  Where it is available EMI is regarded as the ‘currency of choice’ for incentivising employees.  This is mainly because in most cases the rate of tax payable by the employees on gain on EMI options is 10%.

A private or a quoted company can qualify for EMI provided that it is a trading company with less than 250 employees and less than £30 million gross assets. If a company is a group company, the gross assets is the aggregate of the gross assets of the parent company and each of its subsidiaries. This includes assets of subsidiaries that are not wholly-owned. EMI options cannot be granted over shares in subsidiaries.

For an employee to qualify for EMI they must be employed with the company for at least 25 hours per week or 75% of their working time.

The company will qualify for corporation tax deduction when an employee exercises their right to purchase the shares over which the options are granted. The corporation tax deduction is the difference between the exercise price and the market value at the date of exercise. This could be a significant sum. For example if a company is sold for £50 million and it has EMI options in place over 10% of the share capital. Where the exercise price is nominal value, then the benefit to the company could be as much as £950,000 (i.e. £50m x 10% x 19% corporation tax).

Key features of EMI options:

  • The number of shares awarded under EMI option (up to an individual limit of £250,000), the price at which those shares can be exercised and when the EMI option can be exercised is entirely at the discretion of the Company.  
  • Where the EMI option price is at least equal to the “unrestricted tax market value” and providing that the qualifying conditions are met throughout the life of the EMI option there is no tax payable on grant or exercise and the proceeds received on disposal are subject to capital gains tax at 10%.  The “unrestricted tax market value” can be negotiated with HMRC in advance of grant of the EMI option to provide certainty in terms of any tax exposure on exercise. 
  • The employer is entitled to a corporation tax relief based on the income tax that would have been payable by the employee on exercise if the option was not an EMI option.
  • If an employee ceases to be employed, the option will cease to qualify for EMI tax relief 40 days after leaving (there is an exception for death).
  • EMI options do not carry any shareholder rights such as voting rights or dividend rights.
  • If the shares under EMI option go down in value before exercise, the employee can choose not to exercise the option.  However, if the shares decline in value after exercise and before sale, HMRC would not refund any tax paid.

CSOP

What if the Company does not qualify for EMI? CSOP can be an attractive alternative.

The restrictions imposed by EMI prove a hindrance for many quoted companies. They therefore opt for alternatives such as CSOP options which is the next best choice.

CSOP options can be granted over the shares of any company, including foreign companies. The Company must be independent or listed. Unlike EMI there are no qualifying subsidiaries requirements and, subject to the shares meeting the qualifying requirements and individual limit (currently £30,000), the company should qualify to grant CSOP. 

As with EMI, if a company ceases to qualify for CSOP the option is treated as unapproved for UK tax purposes.

Self employment consultants, non-executive directors and personnel engaged outside the UK

Neither EMI options nor CSOP options are suitable. The choice for them is shares or unapproved options.

Unapproved options

There are no restrictions on any company granting unapproved options.  However, unapproved options are the least UK tax efficient means of getting shares to employees. The tax payable on profits made by the employees is currently as high as 54.59%.

With unapproved options, income tax and national insurance is payable for the UK employees based on the gain made on exercise.  If gains arise after exercise and before sale then UK capital gains tax is payable. 

Granting options to UK employees over shares in foreign parent companies

Options can be granted in the UK over stock in a foreign parent company.  Subject to the documents governing the constitution of the parent in the UK there is a wide level of discretion on how awards are made.  For example:

  • There are no restrictions in the UK on the strike price set to exercise an option.  Generally speaking the strike price is a matter for the board to set in its discretion.
  • There are no restrictions on when an option vests and becomes exercisable which is a matter for the board.  Cliff edge vesting is common as are provisions which accelerate vesting upon exit events such as sale or IPO. 
  • Subject to the requirement to comply with UK discrimination laws, there is no obligation to provide the same size of award to all employees.
  • If UK tax does arise it is usually calculated on the “tax market value” which is a fiscal valuation agreed with HMRC taking into account amongst other factors discounts for minority shareholdings and risk of forfeiture if the employee leaves.

Tax withholding and reporting requirements

Quoted companies whose shares are under options or private companies who are about to be sold at the time of exercise, have an obligation to withhold tax under the PAYE system. The company needs to ensure that it has sufficient funds to cover income tax. If the company does not have sufficient funds, the employee will be liable to pay the tax.   

Regardless of whether the Company choses to give its employees shares or options the details of any grant, exercise, disposal or variation or cancellation of share rights needs to be reported to HMRC. The type of return required to HMRC depends upon the nature of the share award.  But all returns carry strict reporting time scales.  And, any event that took place in the last seven years relating to shares awarded to employees needs reporting.