"Ask the Team": should we grant performance shares or nil cost options under our performance share plan?

Practical Law UK Legal Update 0-500-1235 (Approx. 7 pages)

"Ask the Team": should we grant performance shares or nil cost options under our performance share plan?

by PLC Share Schemes & Incentives

High earners' tax (and pensions tax relief) reforms and employee incentives

This "Ask the Team" looks at the implications of the 2009 - 2011 reforms of higher earners' taxation for employee share schemes and incentives.

For more on the reforms to higher earner's taxation, see PLC Tax, Practice note, Tax changes for higher earners.

Question

I am the share plans manager of a listed manufacturing company. We moved away from executive share options in 2006, when we adopted a performance share plan (PSP). The plan allows us to grant conditional share awards or nil/nominal cost share options. So far we have granted only conditional share awards under this plan, although we do use it quite heavily, making awards to a range of executives at different levels of pay and seniority. However, I've heard that with the new 50% rate of income tax from 6 April 2010, it may be better to switch to nil cost options. Is this right, and if so, why?

Answer

It may be better for the tax position of some participants in a PSP to receive:

A nil cost option (a share option with no exercise price to pay); rather than
A conditional share award (a promise to transfer a certain number of shares to the employee on a certain date, if performance conditions are met).

This is because the participant can choose when to exercise a vested nil cost option, during a (usually) quite extensive exercise period, but cannot choose when to receive shares under a conditional share award with a fixed vesting date. If an employee has widely varying taxable income from year to year, perhaps because of variable annual bonuses, he may be able to reduce his tax bill by exercising an option in a year when his total taxable income is below the £150,000 threshold for the 50% tax rate.

However, there are reasons why companies may choose to continue with conditional share awards rather than options, and companies should consider the issues carefully before deciding to change their grant policies. At the very least, a possible tax benefit to a small number of executives is not a reason for a company to change the way its makes PSP awards to all PSP participants.

The company should also consider whether just to review the grant policy for new awards, or also to look at whether it may be possible to amend existing awards which will vest after 6 April 2010, to change them from conditional share awards into nil cost options.

Obviously, your company's PSP definitely allows the company to grant nil cost options, but if other companies are considering this, they will need to check the terms of their PSPs to see whether they are able to grant nil cost options. If not, they may need to amend the plan to permit this. We would also recommend checking the summary of the plan provided to shareholders when the plan was originally approved by shareholders, to ensure that there is nothing in the summary which would prevent the company from taking this action without further shareholder approval.

Conditional share awards

Under a conditional share award, once the award has vested (normally after a performance condition has been satisfied), shares are transferred to the participant automatically within a relatively short period. The shares will be delivered to the participant without the participant having to do anything to trigger the transfer. The vesting of a conditional award gives rise to a tax charge on the value of the shares transferred.

Many companies have usually chosen to grant conditional share awards under a PSP rather than nil or nominal cost options because the company has certainty over when the shares will be delivered if awards vest. This is preferred because:

It is administratively easier for the company, which does not have to keep track of all vested awards and award holders until they are individually exercised.
It caps the company's exposure to employer National Insurance contributions (NICs) to the amount due on the value of the shares on the vesting date. With options which can be exercised, the liability may increase (as share values increase, and possibly as NICs rates also increase) after the performance conditions are met right up to the point when they are exercised, which might be several years later. Although the company is likely to enjoy corporation tax relief associated with the exercise of options, there may still be cashflow concerns about meeting large employer NICs liabilities at a time not set by the company itself.
This is especially important if the company cannot, or does not wish to, make the employee bear the employer NICs liability arising on the award. Companies will not be able recover employer NICs arising on conditional share awards from (or transfer them to) employees, if the conditional share awards are not "rights to acquire shares". Transfer/recovery is only permitted in very limited circumstances, including for gains arising in connection with rights to acquire shares (section 4(4)(a), paragraph 3B(1A)(c), Schedule 1, Social Security Contributions and Benefits Act 1992 and sections 420(8) and 479, Income Tax (Earnings and Pensions) Act 2003).
Although conditional shares awards often clearly are rights to acquire shares, in some cases they will not be. Reasons for this may include:
- The conditional share award is less than a right. For example, the award may simply be a statement that the company will consider the executive eligible to be considered for an award of shares on a certain date if performance conditions are met (these arrangements are sometimes referred to as "fuzzy" awards).
- The award is a right to receive a certain amount, based on the value of a number of shares on the vesting date, but the company can decide whether to pay it in shares or cash.
For more information on transfer of employer NICs, see Practice note, National insurance contributions liabilities and share incentives: an overview: Transfer of employer (secondary class 1) NICs.)
The share plans of listed companies always include dilution limits (as do the plans of many companies which are not listed). Companies can still make awards despite being close to, or at, their dilution limits by making use of market-purchased shares held by an employee benefit trust (EBT). However, to manage dilution limits effectively, a company which makes substantial use of its employee share schemes needs fairly accurate estimates of how many shares will be needed to satisfy awards and when. Budgeting for the delivery of newly issued or EBT shares is much easier with conditional share awards than with nil cost options. It may also be quite difficult for a company to make a sudden change from conditional share awards to nil cost options if it has little scope for manoeuvre within its share scheme dilution budget.

Companies with US employees may also prefer conditional share awards to nil cost options to avoid additional penal tax charges for their US employees under section 409A of the US Internal Revenue Code - see Practice note, US Internal Revenue Code section 409A: impact on UK share incentives: Other common UK share and bonus plans may be caught. Nil cost options are likely to give rise to a section 409A charge at least if they are exercised more than two and a half months after the end of the year in which they first become capable of exercise (which is of course likely where an option has been granted to allow the employee to choose a tax-efficient tax year in which to exercise the option). Only share options with an exercise price at least equal to the fair market value of the shares under option on the date of grant can fall outside section 409A.

Nil cost share options

Under a nil cost share option, once the option has vested (again, normally after a performance condition has been satisfied) the option holder can usually choose when to exercise the option. The option holder will normally have a relatively long exercise period (often up to seven years after the vesting date).

Companies normally have little control over when nil cost options are exercised (except for personal dealing restricitions to comply with the Model Code or similar obligations). Sometimes a PSP contains a very limited window for exercising nil cost options - for example, exercise may only be permitted within 6 months of the vesting date, after which options lapse. But obviously, a short exercise period would be of little use for tax planning, as the whole point of using a nil cost option to manage an employee's exposure to 50% marginal income tax is to allow the employee to choose to exercise the option in a year when income falls below £150,000.

Companies also have no control over how much employer NICs will be due on the exercise of a nil cost option under a PSP. However, companies should be able to recover employer NICs arising on nil cost options from (or transfer it to) option holders, as nil cost options are normally very clearly "rights to acquire shares" (see the discussion about NICs in Conditional share awards).

Granting new awards

Switching from granting conditional share awards, to granting nil cost options, to all executives under your PSP is unlikely to be particularly attractive to the company, because of the additional administrative burden of nil cost awards (and because of other reasons for preferring conditional share awards - such as the section 409A tax issues for US participants). However, the company may decide to determine the type of award based on the individual circumstances of each proposed recipient of a PSP award. Obviously, this could be both more costly and time consuming, so the company will probably only want to take this course of action if there are sufficient executives who may benefit.

Which executives may benefit from a nil cost option?

An executive who is expected to have taxable income of more than £150,000 every year is not going to benefit from receiving a PSP award in the form of a nil cost option. Similarly, nil cost options will not be a useful tax planning tool for an executive who will probably never have income of more than £150,000 in any year.

Depending on the amounts earned by your company's PSP participants, these rules of thumb may make it relatively easy to work out whether this is something you need to seriously consider.

However, you need to remember that it is not just income from the company that is relevant. You may have a colleague who earns less than £150,000 from your company, but has private income taking him over that limit in terms of total taxable income in at least some years.

Another scenario to consider is whether some PSP participants may be approaching retirement, or about to start a career break, and will be allowed to retain PSP awards after that event. In those circumstances, their income may be about to fall sharply, in which case a PSP award in the form of a nil cost option may be worthwhile.

Amending/replacing existing conditional share awards

A matter you did not mention in your question was whether it may be possible to amend/replace existing conditional share awards, so that executives hold nil cost options instead. To achieve this, the amendment or replacement must take place before income tax arises - which normally happens on the vesting of a conditional share award.

Some PSP rules allow the company to grant a nil cost option to satisfy a conditional share award, but this type of replacement of an award will only be successful in giving the executive control over when the tax charge is triggered by deciding when to exercise the option if either:

The cancellation of the conditional share award and grant of replacement option takes place before the award becomes vested; or
The original award is less than a right to acquire shares (a "fuzzy" award), as the vesting of this type of award does not trigger a tax charge. Instead, income tax and NICs are due when the award is satisfied, usually by the transfer of shares.

Otherwise, the income tax and NICs charge will arise when the award vests, and cannot be postponed by the later grant of a replacement nil cost option.

Even if your rules do not permit the company to grant a nil cost option to satisfy a conditional share award, before awards vest, you could invite executives to:

Cancel conditional share awards and accept replacement nil cost options; or
Accept an amendment of the terms of their awards so that the executives control when their awards are exercised.

This should not affect the tax position of the awards, since income tax and NICs will be fall due at the time that shares are received by the executive.

You may be able to amend existing awards without needing shareholder approval if your rules allow the directors to make amendments "to obtain or maintain" favourable tax treatment for award holders. You should also be able to cancel and regrant awards without needing to go back to shareholders. Of course, you will not be able to take either action when you are in a close period.

If you decide to cancel and regrant or amend existing awards, you will have to:

For directors and other persons discharging managerial responsibilities (PDMRs), announce the changes through the regulatory news service (RNS); and
For directors, include information on the changes in the directors' remuneration report in your annual report and accounts.

Therefore, to avoid later adverse publicity, you may want to discuss your proposals with your main institutional shareholders in advance, even if shareholder approval is not strictly needed.

However, before replacing any conditional share award with a nil cost option, companies and their share scheme advisers will need to think about whether this may be tax avoidance, and the possible consequences if it is. We consider this issue further in the next section.

Is it tax avoidance to replace a conditional share award with a nil cost option?

There must be some risk that HM Revenue & Customs (HMRC) will look askance at steps to replace conditional share awards with nil cost options to manage 50% tax liabilities, and treat them as tax avoidance. If a conditional share award is replaced with a nil cost option before the original award vests, HMRC may argue that:

The replacement option is not a "securities option", because it was granted with a main purpose of tax avoidance (see Practice note, Employment-related securities: Share options are usually not employment-related securities); and
As a result, the replacement option is a restricted security (as most employee options would be, if they were not "securities options") which is taxable on its full value on grant, because it was granted with a main purpose of tax avoidance (see Practice note, Restricted securities: Immediate tax charge on UMV if securities or interests are acquired for tax avoidance).

The consequence of this would be an immediate tax charge on the grant of the replacement option, based on its "unrestricted market value" at the time. If the option was very likely to vest and become exercisable soon, this would be nearly the current value of the shares under option. So the tax charge would be very similar to the amount that would have been payable on vesting of the original conditional share award. Negative aspects of this scenario would be:

The employee might (in theory) need to meet a tax liability before receiving saleable shares to fund that liability. However, this would be unlikely to happen because the company and employee would be unlikely to realise that the tax liability had arisen; or
Much worse, the company would fail to account for a PAYE and NICs liability that HMRC considers arose on the grant of the replacement nil cost option. As a result, the company would then pursued by HMRC for those amounts (and probably also associated liabilities under section 222 of the Income Tax (Earnings and Pensions) Act 2003), plus interest and penalties. This would happen because, n these circumstances, even though the nil cost option would not be something that the employee could sell for cash, it would still be a readily convertible asset giving rise to PAYE and NICs liabilities (see Practice note, Restricted securities: PAYE and NICs). For an example of a dispute between taxpayers and HMRC about failure to account for PAYE and NICs on the exercise of options and section 222 liabilities, see Legal update, Failed appeal over tax charged on PAYE on option exercise, not made good in time (section 222/144A)).

However, if a conditional share award is replaced with a nil cost option some considerable time before the original award would vest, this avoidance argument would be potentially less rewarding to HMRC, because the value of the replacement option would be very significantly less than the amount that would be likely to be taxable on a later exercise of the option (and HMRC would find it very hard to tax both the grant and the exercise of a replacement option).

So, companies and their advisers should consider carefully the risk that the replacement of a conditional share award with a nil cost option will be treated as tax avoidance. But, this may be much more likely to be a problem if the planned replacement will happen close to the vesting date of a conditional share award that is very likely to vest.

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