The main commercial drivers for a company to set up an employee share scheme are, firstly, to attract and retain the best talent available and, secondly, to incentivise that talent to grow and develop the business (often to an exit).
Because employee share schemes do not require the immediate cash outlay of salary or cash bonus payments, they can assist start-up companies, along with those businesses adversely impacted by the pandemic, where cash retention is a key current objective.
The key tax considerations with employee share schemes
The key tax considerations tend to be ensuring:
- Tax liabilities arising on the acquisition of the shares are either minimised or deferred (possibly until sale); and
- Tax liabilities on a sale are minimised.
Tax issues around the acquisition of employee shares
Any difference between the market value of the shares at the date of employee acquisition and the price paid for the shares can result in an employment tax charge. This would be akin to a non-cash bonus and therefore represents a ‘dry tax charge’, as the employee will have no cash proceeds out of which to pay the tax.
In order to mitigate this employment tax risk, some employee share schemes look to reduce the market value of the shares at the date of acquisition (for example, growth share arrangements).
Other employee shares schemes use option arrangements to defer such employment tax charges, as there will generally be no employment tax charge until the option is exercised in the future. If these options are exit-only, the employment tax charge can be deferred until, say, a future sale of the company and therefore funded by the employee out of the sale proceeds received from the subsequent sale of their shares. However, unlike holding shares from the outset, share options do not enable employees to benefit from a dividend income stream.
Tax liabilities on the sale of employee shares
The use of approved employee share schemes can have significant tax advantages for both employees and the employing company, as any growth in value tends to attract lower capital gains tax (CGT) rates (rather than income tax).
There has been recent speculation as to whether the government will look to increase CGT rates to be more in-line with higher income tax rates, and this may well happen at some stage in the future. However, irrespective of the final tax treatment, it is important that directors of companies looking to incentivise employees do not lose sight of the commercial benefits of these employee share schemes to motivate, incentivise and retain key employees. Concerns over possible increased future tax rates should not normally be a reason not to implement these arrangements.
Details of some of the different equity incentive schemes available are set out in our employee share schemes factsheet here. This factsheet includes details of probably the most common equity incentive scheme, the Enterprise Management Incentive (EMI) share option scheme, which is an approved employee share option scheme and has very generous tax breaks.
As well as the tax and commercial aspects of employee share schemes, the valuation of shares is also important. The choice of employee share scheme can be driven by the current market value of the shares, as this will tend to determine the tax risk. Lower company valuations, as a result of the pandemic for example, can therefore make employee shares schemes more attractive for both the employees and the employer.
However, the impact of the pandemic can also result in difficulties and uncertainties in preparing such share valuations, both in terms of determining appropriate multiples (with less deals having taken place, some of which being on a distressed basis, and the volatility of price in listed shares) and the associated impact of the pandemic on determining the level of sustainable earnings. Therefore, instructing a firm with extensive share valuation experience will be more important than ever.
How does an employee benefit from employee share ownership?
Often, value is intended to be returned to the employee on an exit, for example when the underlying shares are sold. But what happens if there is no exit envisaged?
One option is that it may be possible to create an artificial market for the shares acquired under an employee share scheme, possibly via the use of an Employee Benefit Trust to buy shares from the employees, but this can be complex to implement.
Alternatively, a form of cash bonus scheme or phantom share scheme could be used as an alternative to an employee share scheme, as a mechanism to return value to the employee if certain performance thresholds are met. Whilst the returns for the employee from a cash bonus scheme or phantom share scheme are unlikely to be as tax efficient as an approved employee share scheme (they would be subject to PAYE and National Insurance), it is important to reiterative the significant commercial benefits of such arrangements, such asmotivating, incentivising and, ultimately, retaining key employees.
We discussed how employee incentives can help optimise cash retention for businesses in a recent entrepreneurs webinar. You can watch this here.