Employee share schemes: an introduction

This note provides an overview of the various employee share option schemes and share incentive plans available to companies and a description of the tax treatment of each.

This overview note is available to all Practical Law subscribers but contains links to more detailed Practical Law Share Schemes & Incentives content.

Contents

Introduction to employee share schemes

Almost all UK-listed companies offer some form of equity (share) incentives to their executive directors and employees (see Quick guide: Share scheme issues for listed companies (www.practicallaw.com/7-381-9419). Share plans are also feasible and attractive for many private companies, although sometimes care needs to be taken with tax and other issues (see Quick guide: Share scheme issues for private companies (www.practicallaw.com/9-380-0683)).

This note gives an overview of some of the common types of employee share incentive arrangements used by UK listed and private companies, and also briefly outlines the regulatory, tax and other issues that companies and their advisers need to consider when designing, adopting and launching a share plan.

 

Why do companies use share schemes?

The main reason for using employee share incentive plans is to recruit, retain and motivate employees. They are also used to help align the interests of employees, particularly senior executives, with those of shareholders. The aim of this alignment is to encourage senior executives to consider the best interests of shareholders in their management of the business. This can be particularly important in listed companies (www.practicallaw.com/6-203-2398).

Employee share incentive plans can also reduce employment costs. Successive governments have taken the view that encouraging equity incentives can improve the general economy. Tax legislation has therefore been used to introduce specific employee share scheme structures that enjoy valuable tax reliefs.

 

2014 changes to tax-advantaged and fully taxable share schemes

Substantial changes were made to law and practice relating to share schemes by Finance Act 2014. This note has been updated to take account of those changes, but for more information about the changes made, see Practice note, Employee share schemes and Finance Bill 2014: summary of changes (www.practicallaw.com/9-551-9846).

 

What types of schemes are available?

Some employee share schemes benefit from favourable tax treatment, provided certain statutory rules are complied with (tax-favoured or tax-advantaged schemes). Tax-advantaged arrangements can be divided by the employees that can participate. Some types of tax-advantaged schemes have to be made available to all qualifying employees (all-employee schemes), whilst under others, the board of directors can select the employees to be invited to participate (discretionary schemes).

Before 6 April 2014, tax-advantaged schemes (with the exception of EMI options) were generally subject to prior approval by HM Revenue & Customs (HMRC). From 6 April 2014, companies operating CSOPs, SAYE option schemes and SIPs must self-certify that the scheme meets the requirements of the relevant legislation. For more information, see Practice note, Notification and declaration of compliance (self-certification) of CSOPs, SIPs and SAYE option schemes (www.practicallaw.com/5-557-2987).

For a quick comparison of the relative advantages of the different tax-advantaged schemes, see Practice note, CSOPs, SIPS, SAYE and EMI options: a comparison (www.practicallaw.com/2-205-7140).

There is also a range of other share incentive arrangements that do not attract any tax advantages (non tax- advantaged or fully taxable schemes), but that companies find useful for their flexibility. Whilst a company could adopt an non tax-advantaged all-employee plan, generally fully taxable plans are discretionary.

 

Company share option plans (CSOPs)

What is a CSOP?

CSOPs (www.practicallaw.com/1-107-5956) enable companies to grant share options (www.practicallaw.com/0-107-6937) to their employees. If statutory conditions are met, favourable tax treatment can result. From 6 April 2014, companies must self-certify that a CSOP meets the requirements of the CSOP legislation. For more information, see Practice note, Notification and declaration of compliance (self-certification) of CSOPs, SIPs and SAYE option schemes (www.practicallaw.com/5-557-2987).

As with any share option, a CSOP option is risk-free for the employee, in that there is no initial financial commitment or future obligation to exercise the option.

Which companies can set up a CSOP?

There are complex statutory provisions governing which companies are permitted to adopt a CSOP and the shares that can be used. If the plan does not come within these rules, the plan will be a fully taxable share option scheme.

In summary:

These rules are not normally a problem for companies listed on the London Stock Exchange (www.practicallaw.com/2-107-6795) (or any other recognised stock exchange). They are also unlikely to cause a problem for companies whose shares are traded on AIM (www.practicallaw.com/8-107-6392) (which is not a recognised stock exchange).

However, private companies or overseas companies with UK employees wishing to adopt a CSOP will have to review these rules carefully.

Who can participate in a CSOP?

Under a CSOP, the company has discretion over which employees can participate.

However, CSOP options can only be granted to employees and full-time directors. HMRC interprets "full-time" as meaning at least 25 hours per week, excluding meal breaks. Non-executive directors (www.practicallaw.com/1-107-6531) (unless they are "full-time", which would be very unusual) and consultants (www.practicallaw.com/6-200-3107) cannot participate. For more information, see Practice note, Who can join a share scheme? (www.practicallaw.com/3-205-8988).

Employees cannot participate in a CSOP if they (or their "associates") have a "material interest" in the company whose shares are used for the scheme, or in certain related companies (see Practice note, Material interest rules for tax-advantaged share incentives (www.practicallaw.com/2-338-4952)).

Setting the exercise price and valuing the shares

The price payable for shares on the exercise of a CSOP option must not be less than their market value at the time of grant.

The market value has to be agreed in advance with HMRC if the shares fall into any of these categories:

  • They are unlisted.

  • They are traded on AIM.

  • They are listed, but not on a recognised stock exchange.

This is not a statutory requirement, but is HMRC practice (see HMRC: Employee Share Schemes User Manual: ESSUM44135 - Requirements relating to options: MV to be agreed in advance of grant).

For more information on share valuation issues for share schemes, see Practice note, Valuing employee shares (www.practicallaw.com/8-371-6958).

Other CSOP terms

From 6 April 2014, , further requirements relating to the terms of CSOP options were introduced. For more information, see Practice note, Employee share schemes and Finance Bill 2014: summary of changes: Company share option plans (CSOPs) (www.practicallaw.com/9-551-9846).

Limits on holding CSOP options

The maximum value of shares (valued at the date of grant of each option) that any one person can hold under unexercised CSOP options is £30,000.

When can a CSOP option be exercised?

Generally, a CSOP can specify that exercise can take place at any time. The only statutory requirement regarding the time of exercise is that options must not be capable of exercise more than 12 months after the death of the option holder. However, in order to obtain beneficial tax treatment for the option holder, options must generally not be exercised before the third anniversary of grant (except on leaving for a "good leaver" reason), and so it has become standard market practice for this to be the normal earliest exercise date.

CSOP options are generally exercisable before the third anniversary of grant by good leavers (death, or leaving employment due to injury, disability, redundancy, retirement, a TUPE (www.practicallaw.com/8-107-7424) transfer or the employer company ceasing to be an associated company). Options must be exercised in these circumstances within six months (or 12 months, for death). CSOP options are often also exercisable early on a takeover of the scheme company or a court-sanctioned scheme of arrangement. CSOP rules can permit exercise within 20 days before or after a change of control (see Practice note, Employee share schemes and Finance Bill 2014: summary of changes: Company share option plans (CSOPs) (www.practicallaw.com/9-551-9846)). For more on the tax treatment of CSOPs, see Tax treatment for the employee: On exercise.

When do CSOP options lapse?

The rules of the CSOP should specify exactly when options will lapse, particularly at the end of a window period for exercise. Generally, the rules will provide that options lapse on leaving employment, although early exercise may be permitted:

  • In certain defined "good leaver" circumstances.

  • In the event of a takeover, reconstruction or winding up of the company.

Options will generally also lapse if the option holder becomes bankrupt, tries to assign the options or use them as security.

Tax treatment for the company

A corporation tax (www.practicallaw.com/1-107-5999) deduction may be available when CSOPs are exercised (under Part 12 of the Corporation Tax Act 2009). Relief is given in the accounting year in which the options are exercised and should be claimed by the option holder's employer company (not the company whose shares are acquired, if different). For more information, see Practice note, Corporation tax deductions for employee share schemes (www.practicallaw.com/8-524-4838).

Issues can arise on a change of control where the acquiring company is AIM listed or is a private company if options are not exercised within 90 days of the change of control (see Practice note, Corporation tax relief for share schemes: loss of relief on takeover by unlisted company (www.practicallaw.com/6-379-0459)).

Tax treatment for the employee

The tax treatment for an employee holding a CSOP option is as follows.

On grant

There is no income tax liability on the grant of the option.

On exercise

There is no income tax liability on exercise (assuming that the CSOP still retains its tax-advantaged status) if the date of exercise is at least three years (and no more than 10 years) after the date of grant.

There is no income tax liability on exercise within three years of grant because the option holder has died or has left employment by reason of disability, injury, redundancy, retirement, a TUPE transfer or the option holder's employer company ceasing to be an associated company. In these cases, the option must be exercised within six months of leaving (12 months, in the case of death). There is also no liability to income tax if options are exercised within 6 months of a court-sanctioned scheme of arrangement, a change of control by way of general offer or as a result of the operation of the minority squeeze out (www.practicallaw.com/7-107-7561) provisions, provided certain conditions are met. From 6 April 2014, tax-free exercise is permitted within 20 days before or after a change of control that causes the option to no longer meet the requirements of the CSOP legislation, and following a "non-UK company reorganisation" (see Practice note, Employee share schemes and Finance Bill 2014: summary of changes: Company share option plans (CSOPs) (www.practicallaw.com/9-551-9846)). If there is a liability to income tax, the option holder will be chargeable to income tax on the difference between the market value of the shares acquired and the option price paid for them.

On disposal

On a sale of the option shares, capital gains tax (CGT) may be payable on any gain over the amount paid for the shares (or any gain over the value of the shares at the date of exercise where an income tax charge on exercise applies). For more information, see Practice note, Capital gains tax and employment-related securities: Tax-advantaged securities options (www.practicallaw.com/6-571-2845).

Entrepreneurs' relief (www.practicallaw.com/4-383-5915) may be available for employees disposing of shares who own at least five percent of the company's ordinary share capital (and are able to exercise at least five percent of the votes). An employee must have held the shares for at least one year. The effective rate of capital gains tax will be 10% on the first £10 million of gains of this type that an employee makes in a lifetime. For more information, see Practice note, Entrepreneurs' relief: an overview (www.practicallaw.com/2-382-4258).

PAYE

If income tax is due, it will need to be withheld by the employer under PAYE (www.practicallaw.com/4-200-3405) and class 1 employee and employer National insurance contributions (www.practicallaw.com/8-201-8297) (NICs) will also be due, if the shares are readily convertible assets (www.practicallaw.com/5-107-7109) (RCAs) at the time of exercise. If they are not, only income tax under self-assessment applies. (See also Operating PAYE.)

National insurance contributions

Broadly, the NICs treatment of CSOP options follows the income tax treatment:

  • There will be no NICs if no income tax is due.

  • Class 1 NICs will be due if income tax is payable and the shares are RCAs.

The employer and the employee may enter into arrangements under which the employer NICs liability is transferred to the employee (see Practice note, Class 1 National Insurance Contributions (NICs) liabilities and share incentives: an overview: Transfer of employer NICs (www.practicallaw.com/9-204-9057)).

Other CSOP resources

For links to practice notes, standard documents and updates on CSOPs, see Practice note, CSOPs (Company Share Option Plans): guide to CSOP content and resources on Practical Law Share Schemes & Incentives (www.practicallaw.com/6-379-0360).

 

SAYE, Save as you earn, sharesave, or savings-related option schemes (SAYE)

What is an SAYE option scheme?

An SAYE option scheme (www.practicallaw.com/4-107-7195) has two elements:

  • A savings arrangement.

  • A share option.

The employee can choose whether to use the proceeds of the savings arrangement to fund the exercise price of the option (although he cannot exercise the option using his own funds). If statutory conditions are met, favourable tax treatment can result. From 6 April 2014, companies must self-certify that an SAYE option scheme meets the requirements of the SAYE legislation. For more information, Practice note, Notification and declaration of compliance (self-certification) of CSOPs, SIPs and SAYE option schemes (www.practicallaw.com/5-557-2987).

The savings arrangement element

The grant of the option is conditional on the employee entering into an HMRC-approved savings arrangement. This will require the employee to save between £5 and £500 per month for three or five years generally by deduction from pay (after tax). (Compare this with partnership shares under a SIP that are purchased with pre-tax income.) The maximum savings amount was increased with effect from 6 April 2014 from £250.

A number of the large banks and financial institutions have specialist teams that set up and operate these savings arrangements on behalf of employers.

At the end of the savings period, the accumulated savings can be withdrawn (together with a tax-free bonus equal to a guaranteed number of monthly contributions, if applicable).

The current SAYE scheme bonus rates that apply to SAYE savings arrangements, and the rate-setting methodology, are set out in Practice note, SAYE option scheme bonus rates (www.practicallaw.com/6-200-8647). Employees who sign up to an SAYE scheme will receive the bonus rate for the relevant savings period in force at the time they apply. Existing savings contracts are not affected by bonus rate changes during the savings term.

The maximum values of savings under the different types of savings arrangements can be found in Practice note, SAYE options: maximum savings, exercise price and share value (www.practicallaw.com/9-381-2681).

The share option element

When employees agree to enter into a savings arrangement, they are granted SAYE options to acquire shares. The number of shares is calculated by reference to the expected proceeds of the savings arrangement (normally including any bonus) at the end of the three or five year savings period chosen at the outset.

If the employee chooses at any time not to exercise the option, savings will be paid back to the employee along with any bonus or interest payable. A savings-related share option scheme is therefore risk-free for the employee until shares are acquired.

Which companies can set up an SAYE option scheme?

As with CSOPs, there are complex statutory provisions governing which companies are permitted to adopt an SAYE option scheme, and the shares that can be used.

As with CSOPs, the shares under option must be ordinary shares. The company granting the options must be either listed on a recognised stock exchange or free from the control of another company unless that other company is listed on a recognised stock exchange. Options can be granted either by the employer or a parent company.

Who can participate in an SAYE scheme?

SAYE schemes are all-employee schemes, meaning that all eligible UK-resident employees and full-time directors must be invited to participate in an offer made under an SAYE scheme. A qualifying period of service may be imposed, but this cannot be more than five years (see Practice note, Age discrimination and employee share schemes (www.practicallaw.com/8-203-8766)).

Invitations to join a scheme are often made on an annual basis, although this is not a legislative requirement. The rules of an SAYE option scheme may be drafted to allow the following additional employees to take part in the scheme:

  • Non-resident employees and full-time directors.

  • Employees and full-time directors with a qualifying period of service that is less than the period specified in the scheme.

For more information, see Practice note, Who can join a share scheme? (www.practicallaw.com/3-205-8988).

Setting the exercise price and valuing the shares

The exercise price must be fixed when the option is granted and may not be less than 80% of the market value of the shares at or shortly before the date of invitation to participate.

As with CSOPs, if the shares are not quoted on a recognised stock exchange, the market value of the shares must be agreed in advance with HMRC. Again, this is based on HMRC practice, rather than the SAYE legislation (see HMRC: Employee Share Schemes User Manual: ESSUM35135 - Requirements relating to share options - exercise price: MV to be agreed in advance of grant). The option price may be adjusted if there are certain variations to the company's share capital.

The maximum exercise price and value of shares under option (at grant) for different savings periods can be found in Practice note, SAYE options: maximum savings, exercise price and share value (www.practicallaw.com/9-381-2681).

When can an SAYE option be exercised?

An SAYE option cannot normally be exercised before the relevant savings arrangement matures. After the maturity date, the employee has six months to decide whether or not to exercise the option.

The attraction of an SAYE scheme is that the participant can, but is not required to, use the accumulated savings (and any tax-free bonus) to fund the exercise of the option. Alternatively, the employee can simply elect to have the savings and any bonus paid out in cash.

When does an SAYE option lapse?

The rules of the SAYE scheme should specify exactly when options will lapse, particularly at the end of a window period for exercise. Generally, the rules will provide that options lapse:

  • On leaving employment, although early exercise may be permitted:

    • in certain defined "good leaver" circumstances (similar to those for CSOP options - see When can a CSOP option be exercised?); or

    • in the event of a takeover, reconstruction or winding up of the company.

  • If the employee, before becoming entitled to exercise the option, withdraws the savings or misses more than six monthly savings payments.

If an SAYE option lapses, the employee can simply withdraw the savings.

An option will also generally lapse if the option holder becomes bankrupt, attempts to assign the option, or use it as security.

Tax treatment for the company

Corporation tax

The rules for obtaining a corporation tax deduction in relation to SAYE options are the same as those for CSOPs (see CSOPs: Tax treatment for the company).

Tax treatment for the employee

The tax treatment for an employee holding an SAYE option is as follows.

On grant

There is no tax liability on the grant of an SAYE option.

At the end of the savings period

Any savings bonus or, if the savings arrangement is terminated early, any interest payable, is not subject to tax.

On exercise

There is no tax liability on the exercise of an SAYE option if it is exercised more than three years after the date of grant. There is no tax liability if an SAYE option is exercised within three years of grant because the option holder has died, or has left employment by reason of injury, disability, redundancy, retirement, a TUPE transfer or his employer company ceasing to be an associated company. No tax liability will arise on exercise following a court-sanctioned scheme of arrangement, a change of control by way of a general offer or the operation of the minority squeeze out provisions. From 6 April 2014, SAYE schemes can permit tax-free exercise within 20 days before a change of control , and following a "non-UK company reorganisation". Exercise can also be permitted 20 days after a change of control if the change of control causes the shares to no longer meet the requirerements of the SAYE legislation (see Practice note, Employee share schemes and Finance Bill 2014: summary of changes: SAYE option schemes (www.practicallaw.com/9-551-9846)).

CGT on disposal

On a sale of the option shares, CGT may be payable on any gain over the amount paid for the shares (or any gain over the value of the shares at the date of exercise where an income tax charge on exercise applies).

In fact, very few individual participants in SAYE schemes make gains that are sufficiently large to bring them into the CGT net (often gains are well within the capital gains tax annual exempt amount (www.practicallaw.com/1-382-5588)). For more information, see Practice note, Capital gains tax and employment-related securities: Tax-advantaged securities options (www.practicallaw.com/6-571-2845).

National insurance contributions

NICs are not payable, provided that the SAYE option scheme retains its tax-advantaged status (see Class 1 National Insurance Contributions (NICs) liabilities and share incentives: an overview (www.practicallaw.com/9-204-9057)).

PAYE

HMRC takes the view that PAYE does not have to be operated on grant or exercise of SAYE options in any circumstances, provided that the SAYE option scheme retains its tax-advantaged status.

Accounting treatment

The accounting treatment of SAYE schemes is considered to be unattractive by many practitioners. In brief, this is because the company cannot adjust the expense it records in its profit and loss account (www.practicallaw.com/6-107-7062) on the grant of an SAYE option if an employee who has started saving under an SAYE savings contract later withdraws from participating. (see Practice note, Accounting for share schemes: an overview: Unattractive accounting treatment of SAYE plans (www.practicallaw.com/9-207-5980)). Despite this potential disadvantage, SAYE option schemes remain popular with both companies and employees, and are used by many listed companies.

Other SAYE option plan resources

For links to standard documents, practice notes, updates and other resources on SAYE option schemes, see Practice note, SAYE options: guide to SAYE content and resources on PLC Share Schemes & Incentives (www.practicallaw.com/0-379-0377).

 

Share incentive plans (SIPs)

What is a SIP?

SIPs (www.practicallaw.com/3-107-7252) are all-employee share plans that provide employees with the opportunity to acquire shares (as opposed to share options). If statutory conditions are met, favourable tax treatment can result. From 6 April 2014 companies are required to self-certify that a SIP meets the requirements of the SIP legislation. For more information, see Practice note, Employee share schemes and Finance Bill 2014: summary of changes: Share incentive plans (SIPs) (www.practicallaw.com/9-551-9846).

A SIP can have four distinct features:

  • Free shares.

  • Partnership shares.

  • Matching shares.

  • Dividend shares.

Companies can choose to offer free shares and/or partnership shares. In respect of awards of partnership shares, the company can decide whether to offer matching shares. Any dividends payable on the shares in the SIP can also be reinvested in further shares, known as dividend shares. The shares are acquired upfront (this is different to all other tax-advantaged share plans, as the participant is a shareholder from the outset), and are held on the participant's behalf in a trust.

Awards are free of income tax and NICs if they are held in the SIP for 3 to 5 years (depending on the type of shares) or if they are withdrawn from the plan early because the employee ceases employment for a "good leaver" reason.

For more information on SIPs, see Practice note, Share incentive plans: an overview (www.practicallaw.com/4-501-1614).

 

Enterprise management incentives (EMI) options

What are EMI options?

EMI options (www.practicallaw.com/2-107-6210) enjoy favourable tax treatment and are specifically targeted at small, higher-risk trading companies. For detailed information on the statutory requirements for, and tax benefits of, EMI options, see Practice note, EMI (enterprise management incentives) options (www.practicallaw.com/0-205-7141). EMI options may be granted under a set of plan rules, or by way of stand-alone EMI option agreements. The EMI legislation requires that the EMI option terms take the form of a written agreement between the option holder and the grantor which states the main terms of the option, including how and when it may be exercised.

Which companies can grant EMI options?

To qualify to grant EMI options, a company must be an independent trading company with:

  • Gross assets of no more than £30 million.

  • Fewer than the equivalent of 250 full-time employees.

Certain trading activities will not qualify and there are detailed rules relating to the independence requirement, the trading requirement and the shares that can be used for EMI options.

Who can be granted EMI options?

To be eligible to be granted an EMI option, an employee must work for the company for at least 25 hours per week, or if less, 75% of his working time.

Employees cannot be granted EMI options if they (or their "associates") have a "material interest" in the company whose shares are used for the scheme, or in certain related companies (see Practice note, Material interest rules for tax-advantaged share incentives (www.practicallaw.com/2-338-4952)).

Setting the exercise price and valuing the shares

The exercise price of EMI options can be set at less than market value (and can be nil, if option shares are not newly issued). Setting an exercise price that is less than market value at grant has consequences for the tax treatment of the EMI option.

Limits on holding EMI options

An employee can hold unexercised EMI options over shares worth up to the current EMI individual limit (www.practicallaw.com/4-518-7444).

When can an EMI option be exercised?

The EMI legislation requires that EMI options must be capable of being exercised within 10 years of the date of grant, and options can only be exercised within a period of 12 months after the option holder's death. Otherwise, there are no restrictions on the exercise provisions that can apply to EMI options, and this flexibility means that they can be used for exit-only arrangements, as well as for options exercisable at the end of a performance or vesting period.

When do EMI options lapse?

Apart from the legislative requirements for the exercise of EMI options referred to above (see When can an EMI option be exercised?), there are no restrictions on when EMI options can be exercised or will lapse. However, it is best practice for EMI option agreements to specify exactly when options will lapse, particularly at the end of a window period for exercise. Often, the EMI option agreement will provide that options will lapse on leaving employment, although early exercise may be permitted in certain circumstances.

The EMI option agreement will generally also provide that options lapse if the option holder becomes bankrupt, tries to assign the options or use them as security.

Tax treatment for the company

The rules for obtaining a corporation tax deduction for EMI options are the same as for CSOPs (see CSOPs: Tax treatment for the company).

Tax treatment for the employee

In order for an EMI option to qualify for favourable tax treatment, the grant of the option must be notified to HMRC within 92 days of the date of grant, using the form prescribed by HMRC. The grant of EMI options must be made online. If the option remains a qualifying option (no disqualifying event has taken place before exercise), the tax treatment for an employee holding an EMI option is as follows.

On grant

There is no income tax liability on the grant of the option.

On exercise

There is no income tax liability on exercise if the exercise price was at least equal to the market value at grant.

If the exercise price was less than the market value at grant, then income tax is due of the difference between the exercise price and the market value at grant.

On disposal

On a sale of the option shares, CGT may be payable on any gain over the market value at grant.

Shares acquired on the exercise of EMI options on or after 6 April 2012 and disposed of on or after 6 April 2013 qualify for entrepreneurs' relief, with the holding period of the option counting towards the 12 month holding period for the shares required for the relief to apply. For more information, see Practice note, EMI (enterprise management incentives) options: Entrepreneurs' relief (www.practicallaw.com/0-205-7141).

Disqualifying events

If a disqualifying event occurs, the tax treatment of an EMI option will be affected, but the tax position will depend on when the option is exercised and whether the option was granted at a discount to market value. For more information, see Practice note, EMI (enterprise management incentives) options: Losing favourable tax treatment (www.practicallaw.com/0-205-7141).

National insurance contributions

Broadly, the NICs treatment of EMI options follows the income tax treatment:

  • There will be no NICs if no income tax is due.

  • There will be NICs if income tax is payable and the shares are RCAs.

The employer and the employee may enter into arrangements under which the employer NICs liability is transferred to the employee (see Practice note, Class 1 National Insurance Contributions (NICs) liabilities and share incentives: an overview: Transfer of employer NICs (www.practicallaw.com/9-204-9057)).

Other EMI resources

For a list of standard EMI option rules and agreements, practice notes, checklists and flowcharts, see, Practice note, EMI (Enterprise Management Incentive) share options: quick guide to EMI content and resources on PLC Share Schemes & Incentives (www.practicallaw.com/6-369-8111).

 

Fully taxable (non tax-advantaged) share schemes

There are numerous types of fully taxable share incentive schemes. These schemes provide share incentives but do not attract favourable tax treatment. They are frequently used as share incentives for senior executives when tax-advantaged schemes may not provide the flexibility or the value of share awards the company requires.

It is rare for executives in listed companies to be able to benefit from a fully taxable share incentive arrangement without meeting a performance condition. For more on performance conditions, see Practice note, What is a performance condition?: an overview (www.practicallaw.com/8-205-5483).

 

Fully taxable (non tax-advantaged) share option schemes

These discretionary share option schemes are similar to CSOPs, but do not have any statutory requirements regarding the company, the shares, the employee or the limits on participation. They are therefore much more flexible than CSOPs, and are used by many companies in addition to a CSOP (to grant options above the limits on participation in a CSOP) or as an alternative, where the company or the individual does not qualify for CSOPs.

Many private companies which do not qualify to grant CSOPs use fully taxable share options to incentivise employees to work towards an exit (such as a sale or listing) and private company non tax-advantaged options are often only exercisable on an exit. In listed companies, fully taxable option exercise terms often mirror those for CSOPs, and are generally exercisable after the third anniversary of the date of grant, unless there is a corporate transaction or the option holder leaves the company for a "good leaver" reason. For more on the drafting of non tax-advantaged share option plans, see Standard document, Non tax-advantaged share option plan rules (www.practicallaw.com/7-374-9049).

Tax treatment of a non tax-advantaged share option

On grant

There is no liability to income tax.

On exercise

Income tax is payable on the difference between the market value of the shares on the date of exercise and the option exercise price. If the shares are RCAs, income tax will be payable through PAYE and NICs will also be payable (see Class 1 National Insurance Contributions (NICs) liabilities and share incentives: an overview: Non tax-advantaged schemes (www.practicallaw.com/9-204-9057) and Operating PAYE).

On disposal

On a sale of the option shares, CGT may be payable on any gain over the value of the shares at the date of exercise. For more information, see Practice note, Capital gains tax and employment-related securities: Non tax-advantaged securities options (www.practicallaw.com/6-571-2845).

Entrepreneurs' relief may be available for employees disposing of shares who own at least five percent of the company's ordinary share capital (and are able to exercise at least five percent of the votes). An employee must have held the shares for at least one year. The effective rate of capital gains tax will be 10% on the first £10 million of gains of this type an employee makes in a lifetime. For more information on entrepreneurs' relief, see Practice note, Entrepreneurs' relief: an overview (www.practicallaw.com/2-382-4258).

 

Long term incentive plans/performance share plans

A long term incentive plan (www.practicallaw.com/0-107-6796) (LTIP) is a discretionary share incentive arrangement generally operated by listed companies. LTIPs are also sometimes known as performance share plans (PSPs).

Under an LTIP, shares are awarded to senior executives at nil or nominal cost, usually subject to the satisfaction of a performance condition. Awards can be made in a number of forms, including conditional share awards and nil (or nominal) cost share options (which can be awarded as EMI options if the company and the individual qualify - see Enterprise management incentives (EMI) options).

LTIP awards are sometimes structured so that the executive acquires forfeitable or restricted shares. The executive forfeits the shares if certain conditions are not met or certain events occur. Although these are not as common as share awards or nil-cost options, the complex tax treatment of restricted securities can be attractive in some circumstances (see Practice note, Restricted securities (www.practicallaw.com/3-364-2007)).

Sourcing shares for LTIPs

As shares are offered to executives under an LTIP at nil or nominal cost, the source of the shares is a particular issue. UK companies are not permitted to issue new shares at less than nominal value, so a nil-cost LTIP award will generally be satisfied using existing shares that are:

For more on sourcing shares for share schemes and the relative merits of the different approaches, see Practice note, Sourcing shares for share plans: an overview (www.practicallaw.com/8-205-0145).

Using an EBT to satisfy awards has become more complex following the introduction of Part 7A of the Income Tax (Earnings and Pensions) Act 2003. Whilst it is still possible to use an EBT to satisfy awards under a mainstream share plan such as an LTIP, companies and their advisers should check carefully that either the proposed actions fall within either HMRC's guidance on using EBTs to "hedge" awards, or within an exemption from Part 7A. For more information, see Practice note, Disguised remuneration tax legislation (Part 7A of ITEPA 2003): issues for share plans and other employee benefits: Relevant steps: Earmarking (www.practicallaw.com/4-504-5317).

Tax treatment of an LTIP award

On grant

There is no liability to income tax.

On exercise/vesting

Income tax is payable on the market value of the shares on the date of exercise/vesting. If the shares are RCAs, income tax will be payable through PAYE and NICs will also be payable (see Class 1 National Insurance Contributions (NICs) liabilities and share incentives: an overview: Fully taxable schemes (www.practicallaw.com/9-204-9057) and Operating PAYE).

On disposal

On a sale of the LTIP award shares, CGT may be payable on any gain over the value of the shares at the date of exercise/vesting. For more information, see Practice note, Capital gains tax and employment-related securities (www.practicallaw.com/6-571-2845).

Entrepreneurs' relief may be available for employees disposing of shares who own at least five percent of the company's ordinary share capital (and are able to exercise at least five percent of the votes). An employee must have held the shares for at least one year. The effective rate of capital gains tax will be 10% on the first £10 million of gains of this type an employee makes in a lifetime. For more information on entrepreneurs' relief, see PLC Tax, Practice note, Entrepreneurs' relief: an overview (www.practicallaw.com/2-382-4258).

 

Deferred bonus/share matching plans

Deferred bonus plans are discretionary share schemes that are normally only operated by listed companies. They generally involve the voluntary or compulsory deferral of an executive's annual bonus into shares that are held in an EBT.

The company may then award the executive a matching award of additional shares or nil-cost share options if performance and service conditions are met. Because of this matching element, some deferred bonus plans are called share matching plans.

Tax treatment of a deferred bonus/matching share award

The deferred bonus element

The tax treatment of the bonus element depends on whether the bonus is deferred on a pre or post tax basis. To be deferred on a pre-tax basis, the right to the bonus must be given up by the executive before it is deemed earned for PAYE purposes (the rules for a successful bonus deferral are broadly the same as those for salary sacrifice - see Practice note, Salary sacrifice arrangements (www.practicallaw.com/6-287-9952)).

If the bonus is deferred on a pre-tax basis, income tax will arise on the value of the bonus shares when they are released from the plan. If the shares are then RCAs, the tax will be due through PAYE and NICs will also be payable.

If the bonus is deferred on a post-tax basis, income tax and NICs will have been paid on the bonus amount before it was used to acquire bonus shares. Therefore, no income tax or NICs are due when the bonus shares are released from the plan.

The matching shares element

There is no liability to income tax on grant.

On the exercise or vesting of a matching share award, income tax is payable on the market value of the shares on the date of vesting/exercise. If the shares are RCAs, income tax will be payable through PAYE and NICs will also be payable.

On disposal of plan shares

On a disposal of bonus shares, CGT may be payable on any gain over the value of the shares at the date of purchase (if the bonus was deferred after tax) or the date they were released from the plan (if the bonus was deferred before tax).

On a disposal of matching shares, CGT may be payable on any gain over the value of the shares at the date of vesting/exercise.

Entrepreneurs' relief may be available for employees disposing of shares who own at least five percent of the company's ordinary share capital (and are able to exercise at least five percent of the votes). An employee must have held the shares for at least one year. The effective rate of capital gains tax will be 10% on the first £10 million of gains of this type an employee makes in a lifetime. For more information on entrepreneurs' relief, see Practice note, Entrepreneurs' relief: an overview (www.practicallaw.com/2-382-4258).

 

Phantom option plans

Phantom share options (www.practicallaw.com/3-376-5197) are cash awards the value of which is linked to the value of the company's shares. They are often used by private or overseas companies to grant awards to employees that mirror share options, in circumstances where actual share options are not appropriate or possible. They are generally discretionary plans and are used by public and private companies.

For more information, see Ask the team: Using phantom share options (www.practicallaw.com/1-503-9087).

Tax treatment of a phantom option

On grant

There is no liability to income tax.

On exercise

Income tax is payable on the cash amount paid out under the phantom option at the date of exercise. Income tax will be payable through PAYE and NICs will also be payable.

On disposal

Under a phantom option, the employee is awarded cash rather than shares or other securities, so CGT is not an issue.

 

Joint ownership arrangements/shared growth plans

Under a joint ownership arrangement (JOA) or shared growth plan, the employee acquires an interest in shares upfront, jointly with another shareholder (usually the trustee of an EBT). Their interests are drawn up so that the employee only benefits to the extent that the shares increase in value above their acquisition value (plus, usually, a carrying charge).

The purpose of a JOA is for the employee to acquire a CGT asset upfront, so that any growth in value of the shares is charged as a capital gain rather than as employment income. As a result, the value of the employee's interest at the outset is critical, and valuation is an important part of adopting and running a JOA.

For more information, see Practice note, Joint ownership arrangements: an overview (www.practicallaw.com/5-520-2316).

 

Employee benefit trusts (EBTs)

An employee benefit trust (www.practicallaw.com/6-205-8072) (EBT) is a special type of discretionary trust (www.practicallaw.com/6-107-6128) that is used to benefit employees and former employees (and their dependants) of the settlor company and its subsidiaries. EBTs are used for many reasons, including to provide shares for mainstream employee share plans and to buy shares from departing employees in a private company.

A major reason for using an EBT to satisfy share options and awards is to overcome the company law prohibition against a company issuing new shares at less than nominal value. Another reason particularly relevant to listed companies is that they may not be able to dilute their share capital by issuing new shares for share plans. Shares bought in the market by an EBT to satisfy awards under share plans do not dilute a company's share capital.

For more information on EBTs, see Practice note, Setting up an employee benefit trust: an overview (www.practicallaw.com/3-504-8302).

EBTs may be caught by Part 7A of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). This is anti-avoidance legislation that was introduced to prevent the use of trusts (and other third parties) to benefit employees and their family members in a way that avoids or defers income tax or NICs. Part 7A of ITEPA 2003 applies from 6 April 2011, although some provisions (mostly relating to loans) apply from 9 December 2010. The legislation imposes an immediate tax charge when a trustee, or other third party, takes certain steps under arrangements that are designed to benefit employees.

Using an EBT to satisfy options and awards has become more complex following the introduction of Part 7A of ITEPA 2003. Whilst it is still possible to use an EBT to satisfy awards under a mainstream share plan, companies and their advisers should check carefully that either the proposed actions fall within either HMRC's guidance on using EBTs to "hedge" options and awards, or within an exemption from Part 7A. For more information, see Practice note, Disguised remuneration tax legislation (Part 7A of ITEPA 2003): issues for share plans and other employee benefits: Relevant steps: Earmarking (www.practicallaw.com/4-504-5317).

For disposals on or after 6 April 2014, there is a new CGT relief for qualifying disposals of a controlling interest in a company to a qualifying "employee ownership trust" and a new income tax relief for qualifying bonus payments to employees by such a trust (see Practice note, Companies owned by employee-ownership trusts (www.practicallaw.com/8-563-0127)).

EBT resources

For a list of Ask the team resources on EBTs, see PLC Share Schemes & Incentives Ask the team archive: Employee benefit trusts (www.practicallaw.com/3-301-2980).

For a list of documents and drafting notes relating to the establishment and operation of EBTs, see PLC Share Schemes & Incentives Standard documents and drafting notes: Employee benefit trusts (www.practicallaw.com/1-205-8994).

 

Employee shareholder employment status

Although not strictly a type of employee share incentive arrangement, the employee shareholder (www.practicallaw.com/1-539-8565) employment status involves an employee agreeing to give up certain employment rights in exchange for shares in his employer company. If various qualifying criteria are met, the shares attract certain tax advantages. For more information, see Practice note, Employee shareholders (www.practicallaw.com/7-537-2807).

 

Operating PAYE

The employer company has responsibility for operating PAYE and for making payments of income tax and NICs due through PAYE over to HMRC. The employer's responsibility is independent of any arrangements it may have with the employee to recover the tax and employee NICs (and employer NICs, if these have been lawfully transferred to the employee (see Practice note, Class 1 National Insurance Contributions (NICs) liabilities and share incentives: an overview: Transfer of employer NICs (www.practicallaw.com/9-204-9057)). As a result, it is very important to ensure that all employee share schemes contain appropriate indemnities for tax and NICs and provisions for recovery of tax and NICs from employees. For more information, see Ask the team: Employees' indemnities for PAYE arising on share incentives (www.practicallaw.com/7-385-0297).

PAYE withholding should be made on the best reasonable estimate of the market value of the shares at the date of vesting of a share award or exercise of a share option (see Ask the team: Best estimates of PAYE liability in relation to employee shares (www.practicallaw.com/4-500-1219)).

Separately from the obligation to withhold, if the employee has not reimbursed the income tax due to the employer within 90 days of the taxable event, this amount is treated as additional remuneration liable to income tax and NICs (see Practice note, Pay as you earn (PAYE): Notional payments (www.practicallaw.com/7-520-4442)). From 6 April 2014, the deadline for the employee to reimburse tax due on notional payments was extended to 90 days after the end of the tax year in which the payment arises (see Practice note, Employee share schemes and Finance Bill 2014: summary of changes: Non tax-advantaged arrangements and amendments affecting all share schemes (www.practicallaw.com/9-551-9846)).

For more information on PAYE and share plans, see Ask the team: Payroll management of PAYE and NICs on share options and other notional payments (www.practicallaw.com/6-385-3480).

 

Other issues to consider when establishing and running an employee share plan

Part 7A of ITEPA 2003

Part 7A of ITEPA 2003 is anti-avoidance legislation affecting certain steps taken by EBTs and other third parties. If an action is caught by Part 7A, and income tax charge applies on the value of the step at the date it is taken, then the tax is due through PAYE and NICs are also due.

Part 7A was introduced to stop EBTs and similar structures, such as family benefit trusts (FBTs), from providing benefits to employees and their families in a form which avoided or deferred income tax and NICs. The legislation is very widely drawn, and although there are exemptions for certain types of share plans, such as CSOPs, EMIs, SAYE schemes, SIPs and fully taxable options and awards, the exemptions are complex and narrowly drawn.

Companies using an EBT in conjunction with an employee share plan of any type should seek specialist advice as to whether the arrangements fall within in an exemption from Part 7A. Companies using an EBT or an FBT to provide other benefits to employees or their families should seek specialist advice before taking any further steps in relation to the EBT or FBT.

For more information on Part 7A, see Employee benefit trusts (EBTs) and Practice note, Disguised remuneration tax legislation (Part 7A of ITEPA 2003): issues for share plans and other employee benefits (www.practicallaw.com/4-504-5317).

Company law

Most share plans are set up as employees' share schemes (www.practicallaw.com/6-107-6213) for company law purposes, as this gives exemptions from some important company law requirements (see Practice note, Benefits of being an employees' share scheme (under Companies Act 2006) (www.practicallaw.com/6-559-2447)).

For public companies, financial assistance (www.practicallaw.com/6-107-5751) is also an issue when funding an EBT to buy shares for share plans. For more information, see Practice note, Funding employee benefit trusts: financial assistance, UITF Abstract 38 and international accounting standards (www.practicallaw.com/4-205-2981).

Financial services law

The Financial Services and Markets Act 2000 (FSMA 2000) prohibits an unauthorised person from carrying out regulated activities and making financial promotions. Activities in relation to employee share plans may fall within the scope of one or both prohibitions, but there are exemptions from the prohibitions that may assist. If an exemption does not apply, activities and communications must be signed off by an authorised person, and failure to comply is a criminal offence, so it is important to ensure that a particular share plan falls within an exemption from the FSMA 2000 prohibitions. For more information, see Practice note, Financial services (FSMA 2000) regulation and the operation of share plans (www.practicallaw.com/0-382-2057).

In some circumstances, a company may need to issue a prospectus if it proposes to offer shares to employees under an employee share plan. There is an exemption from the requirement to issue a prospectus for certain offers to employees made by EEA registered companies and non-EEA companies listed on an "equivalent" market. For more information, see Practice note, When is a prospectus needed for an offer to employees? (www.practicallaw.com/4-212-0956).

Listing Rules, Model Code and ABI remuneration principles

Companies listed on the London Stock Exchange must comply with the Listing Rules (www.practicallaw.com/7-107-6774) and the Model Code (www.practicallaw.com/7-107-6854), and certain sections have an impact on the adoption and operation of share plans. For more information, see Quick guide: Share scheme issues for listed companies (www.practicallaw.com/7-381-9419) and Practice note, Listing Rules: employee share schemes aspects (www.practicallaw.com/4-382-0184).

The ABI remuneration principles (www.practicallaw.com/2-205-8149) are also generally adhered to by fully listed companies (and by many AIM listed companies). For more information, see ABI remuneration principles: new version published (www.practicallaw.com/5-522-6384).

Internationally mobile employees

The tax position of employees who benefit from share plans who are internationally mobile is complex.

For more information, see Practice note, Not ordinarily resident employees: UK taxation of share incentives (www.practicallaw.com/7-380-8717).

The effect of corporate transactions

Dealing with the effect of a corporate transaction on the holders of option and awards under employee share plans can be complex and time consuming, particularly if there are a large number of employees involved.

The company will need to identify how the proposed transaction affects employees participating in different share plans, communicate with the employees about the proposals, follow the employees' instructions in relation to the transaction and withhold and account for any tax and NICs due on the transaction under PAYE.

Thorough due diligence is essential, to understand exactly who is affected by the transaction, and the tax and other consequences that may arise. The exact issues, process and tax liabilities will depend on the type of transaction and the type of share plan involved. For more information on specific types of transactions, see:

 
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