What are the options for equity incentives?
The following is an overview of some of the methods whereby employees can be provided with shares in their employing company or employing group, or granted options to acquire such shares at a later date.
Whether an employer will prefer to award shares or options over shares to an employee will depend on various commercial considerations. Granting options over shares can be more flexible for an employer company or group and can avoid complications which could arise if employees held the shares directly, for example, options do not allow the holder to vote or receive dividends on the shares. In addition, the employing company may be eligible to obtain a deduction from its profits chargeable to corporation tax on the exercise of the option equal to the option gain made by the employee.
These are a type of option which can be granted to an eligible employee up to £250,000 worth of shares (that value is taken at the date of grant). If the options are granted at market value at the date of grant and certain other conditions are satisfied, there is no income tax and NIC on the exercise of EMI options.
EMI options can be used by certain companies carrying on a trade in the UK (subject to certain exceptions including insurance, banking and property development).
The company must also be an independent company which is not under the control of another company and is not a subsidiary of another company. The company (together with any group company) must also not have gross assets of more than £30 million group-wide and the company and its subsidiaries must together have fewer than 250 employees.
EMI schemes do not need to be pre-approved by HMRC but there is a notification requirement after the grant of options. It is also advisable to obtain a valuation agreed by HMRC before options are granted.
These are options which can be granted to an eligible employee up to £30,000 worth of shares (that value is taken at the date of grant). CSOP scheme rules must be approved by HMRC before options are granted. The rules are more restrictive than under the EMI scheme and are usually used by listed companies and larger groups.
The price payable for shares on the exercise of an approved option must not be less than their market value at the time of grant and the market value has to be agreed in advance with HMRC, unless the shares are listed on a recognised stock exchange.
There is no income tax liability on exercise (assuming that the CSOP still retains its HMRC-approved status) if the date of exercise is at least three years from the date of grant. There should also be no income tax liability on exercise within three years of the date of grant if the right to exercise arises because of the option holder ceasing employment due to disability, injury, redundancy or retirement and the option is exercised within six months of leaving.
A Save As You Earn option scheme has a savings arrangement and a share option element. The employee uses the proceeds of the savings arrangement to fund the exercise price of the option. The scheme has certain tax advantages but is quite restrictive, needs prior approval from HMRC and must be available to all employees. The scheme would usually be used by larger, listed companies.
This plan also needs to be pre-approved by HMRC and must be available to all employees. It involves the establishment of an employee benefit trust. The plan enables employees to be given free shares, for them to buy shares (using pre-tax salary) or to receive matching shares. If the shares are held in the trust for 5 years then there is no income tax or capital gains tax when the shares come out of the trust. Again, the scheme would usually be used by larger, listed companies.
These options are not subject to tax at grant. There is income tax on the exercise of the option on the option gain, which is the difference between the market value of the shares at the date of exercise of the option and the option exercise price. This type of option is tax inefficient, but very flexible and simple to administer.
In certain circumstances there will be a Pay As You Earn liability and National Insurance Contribution ("NIC") liability arising in connection with the exercise of the options. The employing company may wish to pass on the cost of the employer NIC to the Optionholder as a condition of exercise. This would mean that the Optionholder has an effective rate of 50.28% for income tax and NIC (if paying tax at a rate of 40%).
If the shares are restricted shares it may be prudent to require that the Optionholder enter into a section 431 election on exercise of the option to ensure that any potential income tax is crystallised at the date of acquisition and avoid any post-acquisition tax charges that might arise under the restricted shares legislation.
If the shares are sold immediately upon being acquired there will not be any capital gains tax, but if the shares are held for a time after exercise there maybe capital gains tax on any gain.
This is an arrangement where an employee or director agrees to subscribe for shares at the current market value but there is an agreement that the employee only pays the subscription price when it is "called" by the company e.g. before an exit.
There should be no income tax on the acquisition of the shares as the shares are being acquired at market value. There would be an annual benefit in kind charge under the beneficial loan provisions on the outstanding amount. This is unless the £5,000 exemption applies or the exemption for acquiring shares in a close company and being involved in the company's management. There are various important commercial and tax issues which should be considered before such an arrangement is entered into.
If employees acquire shares, there is an income tax charge on acquisition if they are acquired for less than market value. If the shares are restricted the employee would usually be required to enter into a section 431 election within 14 days of acquisition to ensure that any potential income tax is crystallised at the date of acquisition and to avoid any post-acquisition tax charges that might arise under the restricted shares legislation.
There are various other equity arrangements which can be implemented by companies seeking to incentivise their employees using equity, for example "Hurdle Schemes" and "Joint Share Ownership Plans". If you would like to discuss any of these, or any of the above, do not hesitate to contact us.
"Enterprise Management Incentive "EMI" Options are a highly effective way to incentivise management and employees by ensuring their gains are charged at Capital Gains Tax rates and not (higher) Income Tax rates."