Allowing employees to participate in the equity of the company can be a tax efficient way to align the interest of the employee with that of the business owner.
The tax implications of granting employees’ shares will need to be considered and is often forgotten as a very important factor which can affect both the employee and employer:
- Typically, where shares are gifted as a reward this will be taxable on the employee at market value, triggering income tax and sometimes National
- The shares can instead be purchased by the employee. This will incur tax only to the extent that the purchase price is at a discount to market However, this can result in a significant cost to the employee.
- As an alternative, a number of tax advantaged “share schemes” are available – alongside other well-established tax planning in this area – which can allow employees the ability to participate in equity tax The costs of implementing the scheme and the value of shares granted are also usually deductible for corporation tax purposes.
The below provides a simple overview of some of the opportunities and their key features and advantages. Given the complex nature of this area, a tax specialist will be required to identify and design a share scheme to the company’s specific requirements.
Approved Share Schemes
Enterprise Management Incentives (“EMI”) schemes
EMI is often the most advantageous share scheme. Selected employees can benefit tax efficiently from the company’s growth, whilst being protected from risk if the company does not perform as expected. A well implemented EMI scheme can have a significant and beneficial impact on employee retention and motivation.
Employees enter into an agreement, known as an “option”, to purchase shares at an agreed date and price. Any increase in share value between the date of the option, and the date of the share purchase, can be received completely tax free. Plus, the onward sale of shares will also often qualify for Business Asset Disposal Relief (previously known as Entrepreneur’s Relief) resulting in a tax charge as low as 10%.
Consider a company that wants to incentivise management by offering them the opportunity to purchase 10,000 shares at today’s value (£2 per share, total value £20,000), if performance targets are met over the next five years.
When the options are exercised (purchased), the company’s value has increased by 150% (£5 per share), so they are now worth £50,000 (increase of £30,000)
- Unapproved Option: total cost to the employee is £32,000 (1)
- EMI Scheme: total cost to the employee is £20,000 (2)
In this example, the employee saves £12,000 on the share acquisition, making the advantages of share incentivisation much more pronounced.
- Payable to company: £20,000 plus the employee will pay income tax of £12,000 on the value increase of £30,000 (assumed 40% taxpayer)
- Payable to company: £20,000; no income tax payable on value increase of £30,000 as qualifying
EMI schemes are highly flexible:
- Options can be granted at a discount against their market value, although the discounted element will become taxable on
- Where dilution of shareholding may be a concern, options can be exercisable only on an “exit” event (such as a future sale of the company). Alternatively, a separate class of EMI shares can be created with restricted voting and/or economic
From April 2023, there is no longer a requirement for the company to set out within the EMI option agreement any restrictions on the shares to be acquired under the option.
A number of restrictions apply to EMI schemes:
- Options are subject to limits of £3million total and £250,000 per
- Employees that have a material interest in the company (30% or more) cannot
- Where the company is part of a group, options must be granted over the group’s ultimate parent (holding) company. This restriction is often an issue for employers who do not want to issue share options in the holding
- EMI is unavailable where the company or group engages in “excluded activities” to a substantial extent (defined as more than 20% of their overall trading activities). Details on the types of activities that are excluded can be found in HMRC’s manual ETASSUM52100, at the following link: https://www.gov.uk/hmrc-internal-manuals/employee-tax-advantaged- share-scheme-user-manual/etassum52100
Company Share Option Plans (“CSOPs”)
Similar to EMI, a CSOP enables an employer company to grant share options to selected directors and employees, which can be subject to conditions such as a period of employment with the company and/or sales targets. The increase in share value can be tax-free for the option holder, as set out under the above example for EMI.
Where dilution is a concern, the options can be exercisable only on an exit event (such as a future sale of the company).
A number of restrictions apply to CSOPs:
- Employees that have a material interest in the company (30% or more) cannot participate
- Options cannot be exercisable within the first three years, nor can they be granted at a discount against market
- Options are subject to a £30,000 per employee limit (as valued at the date of grant). However, there is no “total limit” over the value of options that can be
- The company over which options are granted must either be “independent” – i.e. where the company is part of a group, options must be granted over the group’s ultimate parent company, or alternatively, the shares must be listed on a recognised stock
Unapproved Share Schemes
Nil Paid Shares
Using nil paid shares offers the advantages of immediate share ownership (including access to dividends), without requiring an upfront payment from the employee. It offers a simple, low cost way to grant equity to key employees.
The shares are treated as purchased at market value, which is owed to the company from the employee. Where the value of the shares is below the £10,000 benefit in kind limit, and the employee has no other loans to the employer company, the shares can essentially be granted free from tax implications (see below).
Ordinarily an interest free loan to an employee would be taxable as a benefit in kind for the employee using HMRC’s approved interest rate (currently 2.25% for 23/24 tax year). The employee would then pay tax on the interest element each year it is outstanding, and the employer would pay national insurance at 13.80%.
This benefit in kind would not be due in the following circumstances however:
- If the loan is less than £10,000 (assuming the employee has no other loans) , i.e., the value of the loan when the shares are issued is less than £10,000.
- The employee repays the company interest at the same rate as the official HMRC
- If the nil paid shares are issued by a close trading company, provided that the employee work for the greater part of their time in the actual management or conduct of the company, tax relief would be available that would mean that the annual interest benefit would negate the benefit of the interest free The individual does need to own more than 5% of the issued share capital. Care needs to be taken to determine whether the participants qualify for this relief.
Consider an employee receiving a salary of £50,000, who will acquire shares worth £10,000:
- The tax cost for the company of providing the shares outright would be well over £5,000.
- In comparison, if the shares are granted as “nil paid”, the tax cost to both the employee and company is nil.
In this example, using the “nil paid” share method has saved over 50% of the value of the shares.
Where shares are granted as “nil paid” the resulting loan can be repaid on a future sale. This provides a reduced cost to the employee in comparison to income treatment (as it will be repaid from the capital proceeds of the sale).
There are few “qualifying criteria” for nil paid shares, making this route particularly attractive for companies that do not meet the qualifying conditions for tax advantaged share schemes.
However, in comparison to an option scheme, there is an element of genuine economic risk for the employee: if the shares decline in value, they will still have an obligation to pay the outstanding consideration.
For example if the company were to fail and enter into liquidation, it is likely that the appointed liquidator would look to pursue the employee for the unpaid loan despite the failure of the company.
Gift of Shares
If the amount paid for the shares is not treated as a loan and the shares are effectively gifted by the company or the existing shareholder, the market value of the shares is taxable on the employee at their marginal rate of tax. There is also a possibility that national insurance could be due for the employee and employer.
Growth shares involve the creation of a new class of shares that allow employees to participate only in the increased value of the company after the date of grant. This may be particularly attractive to companies that are currently small, but who expect to increase in size significantly over a period of time.
Although these shares are not usually tax advantaged like HMRC approved schemes, as the value of these new shares will typically be very low, employees can often be granted a significant stake in the future of the business with few tax implications.
Alongside the tax advantages, growth shares incentivise the recipients by directly linking the value that they will receive to the growth of the company (for which they are responsible).
Consider an employer who wishes to grant share equity – of around 10% – in a valuable company (c.£1million) to incentivise employees:-
- If the shares are granted outright, the total value of shares (up to £100,000) will be immediately taxable to PAYE/NIC at the employees’ marginal rates of
- In comparison, if the shares that are granted only have rights to future capital growth (and none of the existing value), the value of that 10% stake in the business will be reduced significantly (for example, to 5% e. £5,000).
As seen in this example, using Growth shares can significantly reduce the tax cost on share grant.
Growth shares are highly flexible. And can also be partnered with other tax planning to further increase their efficiency – for example, as Nil Paid Shares, or alongside an EMI scheme.
Unapproved share options have limited advantages for tax purposes but do have greater flexibility than statutory share schemes, such as CSOP or EMI. There is no restriction over the type of companies, employees, or shares that can use this route.
The grant of the option will typically be tax-free for the employee in the right circumstances and a corporation tax deduction is given when the shares are received by the employee.
The employee will be taxed on exercise. If full market value is paid for the shares no tax will be due, but if less than market value is paid income tax (and typically NICs) will be due to the extent of the discount.
Consideration should always be given to the possible use of tax advantaged share schemes.
Share Options or Issued Shares
In the above summary we refer to share options (EMI/CSOP/Unapproved options), whereby an employee receives an option to acquire shares at a later date and an issue/transfer of shares (Growth Shares/Gifted Shares/Nil paid shares) whereby the employee is issued/transferred shares immediately.
We have listed below the advantages and disadvantages of both mechanisms.
Share Options Advantages
Can set targets/criteria before an employee can exercise their options, this should help the business develop further from its current position by incentivising the employees and aligns an employees interests with the company’s success.
Tax approved options offer great tax benefits for employee and employer.
Can offer a competitive edge in attracting and retaining top talent if the company has an existing share option scheme in place.
You need to ensure you are setting realistic targets to ensure the employee maintains motivation prior to exercising their options.
Employee is not formally a shareholder until the options are exercised and this may not guarantee employee retention
Complexity & Administration– regular HMRC returns are required
Miscommunication or unclear expectations regarding the potential value of the share options can lead to dissatisfaction among employees. If the company’s performance doesn’t meet the anticipated growth, employees might feel they didn’t receive the benefits they were hoping for.
Issued Shares Advantages
Directly issuing shares makes employees immediate shareholders, aligning their interests directly with the company’s success. This sense of ownership can foster a stronger commitment to the company’s goals, leading to increased motivation, engagement, and loyalty.
While share options can have complex terms and vesting schedules, direct ownership is often simpler to understand. Employees own actual shares from the start, eliminating the need to navigate option exercises, vesting periods, and other intricacies.
Issuing shares can have immediate tax implications for both the company and the employees. Employees might be required to pay taxes on the value of the shares received, even if they haven’t sold them yet. This can create financial challenges for employees, particularly if they haven’t received cash to cover the tax liability.
If an employee who owns shares directly decides to leave the company, there could be complexities in determining how the shares are handled (but see below in respect of shareholders agreement)
Long-term commitment may not be suitable for all employees.
Drafting a shareholders’ agreement when issuing shares to an employee can prove to be a strategic move that offers several significant benefits to both the employee and the company. Firstly, such an agreement helps establish clear expectations and guidelines for the employee’s role and responsibilities as a shareholder. By outlining the employees’ rights, obligations, and the extent of their involvement in decision-making processes, the agreement minimises potential misunderstandings and conflicts down the line.
Secondly, a well-structured shareholders’ agreement ensures that the employees’ interests are safeguarded, providing them with a sense of security and motivation. The agreement can detail provisions related to the employee’s exit strategy, such as the conditions under which they can sell their shares and any pre-emptive rights that they might possess. This empowers the employee to plan for their financial future and promotes a long-term commitment to the company’s growth.
Additionally, the agreement can address scenarios like changes in the company’s ownership, protecting the employee from potential adverse impacts on their investment.
Lastly, a shareholders’ agreement can contribute to the overall stability of the company by offering a mechanism to resolve disputes and disagreements amicably. The agreement can include provisions for dispute resolution, such as mediation or arbitration, before resorting to more costly and time- consuming legal actions. By formalising the relationship between the company and the employee- shareholder, the agreement demonstrates a dedication to transparency and fairness, ultimately bolstering the company’s corporate governance and enhancing its attractiveness to potential investors.
In conclusion, a well-crafted shareholders’ agreement is a valuable tool for companies when issuing shares to employees.