WHAT ARE THE CHANGES?
From 6 April 2010:
- 50% income tax on earnings over £150,000;
- Tapered reduction in personal allowance for earnings over £100,000.
From 6 April 2011:
- NICs (employer and employee) increase by 0.5%;
- No higher rate tax relief on pension contributions for 50% taxpayers (with anti-forestalling provisions applying from 22 April 2009).
We look here at possible approaches that might be taken in connection with share incentive arrangements to mitigate the impact of the 50% income tax rate, and related governance implications. In most cases, this will involve the acceleration of the income tax charge by permitting the vesting of a share award before 6 April 2010, and converting it into an award of forfeitable shares.
Most of the approaches outlined will require important decisions by the remuneration committee which operates the share incentive arrangements. While employees might be focussed on tax issues, remuneration committees will need to consider the governance implications of these arrangements. This is an area of emerging best practice, and there are no clear answers on some of the issues addressed here.
Some of the key issues that remuneration committees will need to address are:
- Are there reputational issues for the company?
This is a difficult question from a governance viewpoint. It depends on successfully addressing the issues and risks set out here. For banking clients it is possible that the matters could be regarded as falling foul of HMRC’s Code of Practice on Taxation for Banks (once it is finalised). It is, however, noteworthy that (in contrast to the restrictions of pension tax relief) there are no linked anti-forestalling provisions for deferred remuneration.
- Is it in the best interests of the company?
Mitigating the impact of the 50% income tax rate has an obvious benefit for high-earning employees. Remuneration committees will need to consider if there is a corporate benefit - particularly in advance of April 2011 when the increased employer NICs rate is introduced.
- What is the cost (potential or actual) to the company?
There is a strong likelihood that some of the proposed approaches would cost a company more than the original share incentive – particularly if the company vests an award early that would not have vested on its normal timescale. Companies will need to consider what approach they want to take to any potential increased cost. A more detailed discussion of this is in the section below headed “Holding the Company Harmless”.
- What rule amendments might be needed? Will shareholder approval be required?
Acceleration of unvested awards (the main category discussed below) is likely to require a rule amendment. However, in the great majority of cases, shareholder approval would not be required because most rules permit the remuneration committee to amend where the rule amendment is to “obtain or maintain favourable tax treatment for participants”.
- What are the disclosure implications of any arrangements?
For PLC directors, the Directors’ Remuneration Report regulations would require that any amendments to the terms of awards are disclosed. In practice, the reasons for doing so would also need to be explained. A stock exchange announcement would also be required where a PDMR’s award vests early, and the reasons would in practice need to be explained. For the reasons explained below, companies will need to take care to avoid blanket statements along the lines that “the company is no worse off as a result of the arrangement” - because that may well not be true.
Should any changes only apply to prospective 50% taxpayers or to all share incentive participants?
Any amendments should be on a voluntary basis (i.e. where the employee wants to accelerate). Remuneration committees need to think about whether non-50% tax payers should be offered early vesting in light of the potential additional cost to the company outlined below.
Companies will also need to consider the accounting consequences and corporation tax implications of these approaches. These are not addressed in this briefing. This briefing concentrates on share awards, but similar principles apply to deferred cash bonus arrangements.
Existing Options and Awards
This section considers potential issues for remuneration committees in relation to key categories of option/awards which employees are likely to hold.
(A) Vested Options/Awards
For options and awards that have already vested, and are within any exercise or calling period, the employee can exercise at any time prior to 6 April 2010 (subject to any dealing restrictions). Companies need to take no specific action – other than perhaps reminding employees of the potential to exercise before 6 April 2010.
If the employee would need to sell shares on exercise to meet the income tax liability, the employee would need to weigh up their income tax saving against the potential growth in value of the shares under option/award that they would be selling.
(B) Unvested Options/Awards
For options and awards that have not yet vested (i.e. service and/or performance conditions remain to be met), the income tax charge could be accelerated by restructuring the option or award.
Effectively, the option / award would vest early (and so attract tax) and become an allocation of forfeitable shares – where the employee receives the shares under the option / award but is under an obligation to return the shares if any performance conditions or service requirements which applied as vesting conditions to the original award are not met. Income tax would be payable when the employee receives the shares but the original commercial intention of the arrangement would be preserved (as the performance conditions and service requirement would remain in place).
The existence of the obligation to return the shares in certain circumstances is likely to necessitate the participant entering into a section 431 income tax election to make clear that he has elected to be taxed on the full “unrestricted market value” of the shares received. Further advice can be given on this.
As income tax would be payable on receipt of the shares by the employee, the practical result is that employees would hold an after-tax number of shares. For example, assuming for simplicity a 40% tax rate, an initial award over 100 shares would become an allocation of 60 forfeitable shares (with 40 shares being sold to pay the income tax).
However, if the 60 shares are subsequently forfeited (because the performance condition or service requirement is not met) the income tax already paid (and employee and employer NICs) is irrecoverable.
This means that the restructured award is potentially more expensive for the company. (Note that references in this briefing to expense or cost for the company do not take account of the IFRS 2 accounting charge). In circumstances where performance conditions or service requirements are not met, the company would not have had to provide any shares under the original award (i.e. the 100 shares above). Under the restructured award, even though the employee returns the 60 forfeitable shares, the company has still had to provide 40 shares (as these were sold to raise the income tax on the acceleration). See below regarding employer NICs.
For this reason, the terms of each option/award need to be considered to establish the likelihood of forfeiture; it may mean certain awards are not appropriate to be restructured in this way. The company should consider whether it should ask the employee to hold the company harmless by bearing the cost of the irrecoverable income tax (i.e. the 40) – see further under “Holding the Company Harmless”.
Outstanding Service Requirement
If there is an outstanding service requirement, whether restructuring would be appropriate will generally depend on the breadth of the “bad leaver” language in the relevant plans and the period remaining to the normal vesting date. Restructuring is likely to be most appropriate for arrangements with no, or only a narrow, bad leaver clause (for example, where an employee is only a bad leaver if they are dismissed for misconduct).
Where the bad leaver clause is wider, remuneration committees will need to consider the potential cost implications of shares being forfeited following an award being accelerated. A company may conclude that acceleration is only appropriate on a hold harmless basis. Provided the employee understands the risk, it may be reasonable to permit acceleration on this basis, given that the actions leading to forfeiture (for example, resignation or dismissal for cause) would generally follow from the employee’s own actions.
A difficult area is where a standard executive termination (i.e., on a compensated basis, where the employee is not at fault) would be a bad leaver reason (or vesting would be at the remuneration committee’s discretion and, in the circumstances, the remuneration committee would not exercise discretion in his or her favour). This is something largely outside the employee’s control, but could have the result of putting him or her in an adverse financial position as a result of having accelerated the award.
In any event the position will need to be made clear to the employee, and he or she should, in appropriate cases, be encouraged to seek personal financial advice.
Performance Condition Already Satisfied / Will Easily be Satisfied
For this category of options/ awards, there are no obvious objections to restructuring the award and accelerating the tax charge, subject to the comments above relating to continued service. However, the remuneration committee will need to assess the cost implications for the company in accelerating the award.
Performance Period Complete, or nearly Complete but Award not yet Vested
It may be appropriate to restructure these options / awards if the performance condition has been satisfied.
If accelerated testing of a performance condition is required (albeit in respect of a completed performance period), it will be important that the remuneration committee takes particular care in assessing satisfaction of the target, including in relation to independent verification. For example, if a three year EPS target is being measured on the basis of unaudited information for the final year, care will be needed to ensure that the final outcome is sufficiently certain for the committee to proceed.
For companies with a December 2009 year end, so that results would have been announced well before 6 April, difficulty should not arise in relation to prohibited periods. However, for companies with a 31 March 2010 year end, there are likely to be difficulties with acceleration where the level of vesting could be taken to give an indication (via an RNS announcement of the vesting level for a PDMR) of year end results (an example would be where management accounts are used to extrapolate EPS information, which in turn determines satisfaction of a three year target).
Performance Period not Complete
It is unlikely that acceleration would be sensible for this category because it would not be appropriate for the company to bear the cost of the performance conditions not being met. Further, it is unlikely to be appropriate to ask an employee to accept the risk of holding the company harmless if the performance condition turns out not to be satisfied.
A possible exception to this would be where there was a reasonably short period left to run on the performance period (say, 6 months), and there was a very strong likelihood of the performance condition being met in full. Then, provided the employee fully understands the risk he is taking on, acceleration on a “hold harmless” basis may be appropriate.
A variation on this theme would be to “salami slice” an award in this category, so that a portion that was reasonably certain to vest (say, half) would be accelerated, and the balance would be left to vest (or not) on its original terms. Holding the Company Harmless
As outlined above, a critical preliminary issue for remuneration committees to address is the extent to which the effect of acceleration should result in the company being “worse off” or “at risk” (financially or otherwise), comparing the objectives and terms of the award pre-acceleration to those post-acceleration.
As illustrated in various places, the effect of accelerating an award may be to expose the company to cost (notably in the case of bad leavers) and this may be unacceptable from a governance perspective. In consequence, the remuneration committee may conclude that any “risk” surrounding acceleration should be wholly that of the employee, not the company.
This could be achieved in two broad ways. The employee could be required to pay the income tax out of his own resources on the acceleration of the award – so that there are the same number of shares under the initial award as are under the allocation of forfeitable shares. Thus, an initial award over 100 shares would become an allocation of 100 forfeitable shares (with the employee funding the 40 income tax out of his own resources). If the shares are subsequently forfeited, there will be no income tax cost to the company when compared with the initial award. The employee would simply lose the 40 that had been paid to HMRC. However, see below regarding employer NICs.
Alternatively, the initial income tax liability could be funded by a sale of shares so that the initial award over 100 shares would become an allocation of 60 forfeitable shares. However, if the shares are subsequently forfeited, the employee would also be required to pay the company 40 (representing the income tax previously funded by the sale of shares).
It should be noted that the above does not address the employer NICs cost. Under both scenarios above, the employer would suffer irrecoverable 12.8% NICs when the shares are forfeited. There are difficulties from a legal perspective in seeking to recover these amounts from the employee (on which further advice can be given). However, the employer NICs cost alone probably means that the company is not in practice held harmless on the acceleration of most categories of award.
Companies may also wish to consider the structure of their future arrangements made before 6 April 2010. For awards with a service only condition, companies may wish to structure the award as forfeitable shares. Other considerations include making greater use of HMRC approved plans or structuring LTIPs as nil cost options to give participants more flexibility over the timing of their tax liability.