Update. Share Plans. Contents

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1 Update February 2009 Share Plans A periodic update designed to provide a summary of important developments affecting share plans, including legal, tax and accounting issues, as well as comments on market practice and practical tips. If you would like further information on any of the areas covered, please judith.greaves@pinsentmasons.com or speak to your usual Pinsent Masons adviser. Contents Short summaries of each article are shown below. If you would like to view the full article, click on the underlined links. To return to the start, click on the "Go back" link. Bank Remuneration: Proposed constraints "This House believes all bankers should be tied in sacks filled with snakes and thrown into the River Thames." Proposals currently being made around the world to rein in remuneration at banks are moderate compared with the above resolution proposed in the House of Commons after the "South Sea Bubble" burst in the early eighteenth century. Read more Beneficial loans: The official rate of interest The official rate of interest will be reduced to 4.75% from 1 March Read more EU Prospectus Directive: New "light touch" approach New guidance intended to reduce the burden on companies required to issue a prospectus purely as a result of offering share incentives has now been issued. Read more PAYE: Deductions on basis of informal HMRC demand only not unlawful In Marquette Partners (UK) Limited v Patel, the Employment Appeal Tribunal held that deductions made from an employee's wages subsequent to informal directions only from HMRC to account for PAYE were not unlawful under the Employment Rights Act 1996 ("ERA 1996"). Read more PAYE: Further tax charge for failure to reimburse The recent case of Chilcott, Griffiths and Evolution Group Services Ltd v Revenue and Customs Commissioners serves as a reminder of the additional tax charge that arises where PAYE income tax due on the exercise of an option, or in respect of other employment related securities income, is not reimbursed by the employee to the employer within the appropriate time frame. Read more Income Tax: Shares disposed of for more than market value The recent decision in Gray's Timber Products Limited v Commissioners of Revenue & Customs emphasises the importance when structuring share incentives of not falling foul of the securities disposed of for more than market value provisions, which can bring some of the disposal proceeds into charge to income tax. Read more Tax Law Rewrite Corporation tax bill As part of the ongoing Tax Law Rewrite Project a new Corporation Tax Bill was introduced in December Read more EMI options and arrangements Change in HMRC Shares Valuation practice to refer more cases to the Small Company Enterprise Centre (SCEC) for a ruling as to whether there are arrangements whereby the company ceases to qualify for EMI. Read more

2 FULL ARTICLES Bank Remuneration: Proposed constraints Across the world, banks are being compelled to restructure executive remuneration. In October 2008, the UK Government said there should be no cash bonuses for board members of banks in which it had taken shares. More recently, HM Treasury's statement on the Government's Asset Protection Scheme, published on 19 January 2009, provided that "a number of further conditions will apply to the Scheme, including in relation to remuneration policies." Details of the Scheme are expected in the last week of February. However, as part of the response to a question to the Chancellor of the Exchequer by MP Gordon Prentice in the House of Commons on 12 February 2009 regarding the Government's proposals on remuneration policy for banks in which the Government has a majority stake, Angela Eagle, Exchequer Secretary to the Treasury, noted that incentive schemes will be reviewed for linkage "to long-term value creation, taking proper account of risk. In the future, remuneration packages should reflect long-term sustainable success and not simply short-term gains." On 9 February this year, the UK Government announced the "Walker Review", which will look at the banking sector's salaries and bonuses as part of a wider study of banks' corporate governance and risk management. Sir David Walker has been ordered to leave "no stone unturned" and to consider new controls over City bonuses, including caps on payments and claw-backs on cash paid in previous years. However, preliminary conclusions of the Review will only be published in the Autumn and the final report at the end of 2009, by which time some banks will have already started paying out 2009 bonuses. On 18 February 2009, the Financial Times reported the UK Government's approval of bonus arrangements for 2008 at The Royal Bank of Scotland. These companies vastly reduced cash bonuses (90% less than for 2007), with the majority of the cash bonuses - 160m out of 175m - being paid to non-managerial staff. The remainder of the bonus payments will be in the form of "deferred awards", paid in subordinated debt, in the form of bonds rather than shares. The deferred awards will be made by way of staggered payments over 3 years from 2010, subject to a potential 100% claw-back by reference to performance over the 3-year period. The agreed package of up to an aggregate 950m was praised by Alistair Darling as a symbol of a "cultural change that I think will be replicated in other banks." Mr Darling suggested RBS's approach as a model to be applied to other banks in which the taxpayer has a significant stake, saying that "the principles... are as good for Lloyds as for RBS." However, in spite of the above, other banks are likely to pay out significant bonuses in the next few weeks. Further guidance for the UK may emerge from the review currently being undertaken by the Financial Services Authority, an update on which is expected in March In the USA, on 4 February 2009, President Obama announced that senior executives of companies receiving federal bailout money would have their pay capped at $500,000 under a revised financial compensation plan. Pay in excess of $500,000 must be in restricted stock, which can only vest after the recipient of the bailout funds repays its debt to the US Government, with interest. The restrictions will most affect large companies (eg Citibank) that receive "exceptional assistance", under the Government-funded Troubled Asset Relief Programme (Tarp). The top 25 officials of an "exceptional assistance" company could have their bonuses and other incentive compensation "clawed back" by the company if they knowingly provided inaccurate information that helped bolster their pay. President Obama has pledged further reforms in the future, promising that the administration will "examine the ways in which the means and manner of executive compensation have contributed to a reckless culture and quarter-by-quarter mentality that in turn have wrought havoc in our financial system." In France, the French Banking Federation and the body representing Paris as a financial centre have drawn up a code, requiring bonuses for employees of France's investment banks, brokers and fund managers to be paid over several years, linked to the employer's longer-term profitability, and not solely the employee's own activities. The code, which will be compulsory and which must be complied with by the end of April 2009, will apply to 2009 bonuses paid out from early Compliance with the code will be policed by France's regulator, the Banking Commission. The French Government has previously said that banks wanting to access the French Government's bank support scheme will be required to abide by the code. This is an area in which further activity can be anticipated in the coming months as governments around the world seek to safeguard the assets they have put in to banks and potentially other organisations receiving state assistance. Go back

3 Beneficial loans: The official rate of interest HM Revenue & Customs has announced that from 1 March 2009 the official rate of interest will be reduced from 6.25% to 4.75%. The official rate of interest is used to determine whether income tax is due in respect of any "employment related loan". If such a loan is interest free or the amount of interest is less than the interest that would have been payable at the official rate, then, subject to certain exceptions, the difference between the interest that would have been payable at the official rate and the amount of interest (if any) actually paid is treated as earnings from employment. Where the official rate of interest changes during a tax year (as will now be the case in the tax year 2008/2009) an average official rate of interest must be calculated, after the end of the tax year. The official rate of interest is also used to determine the income tax due on the "notional loan" that arises where employmentrelated securities are acquired for less than market value. In our December 2008 Share Plans update we reported on a proposed amendment to the legislative provisions relating to "notional loans". Go back EU Prospectus Directive: New "light touch" approach Since July 2005 any company wishing to make share incentives available to employees in any EU country has had to be mindful of the provisions in the Prospectus Directive as implemented across the EU by local legislation. Unless a suitable exemption applies, a company which would not otherwise be required to do so may have to produce a detailed prospectus at the same time as offering shares to employees. For companies with a full listing on the London Stock Exchange or another EU Regulated Market all that is required is the provision of an information statement giving brief details of relevance to employees. However, if a company without such a listing wishes to make an employee offer which is caught by the Prospectus Directive, a full prospectus must be produced at considerable expense in both time and money, especially since it is not possible to rely on prospectuses drafted to comply with the requirements of other exchanges. The majority of EU states accept that employee share options are outside the scope of the Directive, as are free share awards. In relation to UK employees the most likely situation in which a prospectus might be required is where partnership shares are being offered under an HMRC approved share incentive plan by a substantial private company or by a company listed on AIM, (which is not classed as an EU Regulated Market), or outside the EU. The cost of producing a prospectus purely for this purpose is disproportionate, such that many US, Canadian and AIM listed companies have been discouraged from using share incentive plans, or at least the partnership shares elements of such arrangements, at all. To address this issue, the Committee of European Securities Regulators ("CESR"), have updated their document "Frequently asked questions regarding Prospectuses: Common positions agreed by CESR Members." The new section 71 Employee Share Scheme Prospectuses:Short-form disclosure regime for offers to the employees in those cases where a prospectus is required (application of Article 23.4 of the Prospectus Regulations) applies when the only reason a prospectus is required is that employee offers are being made. The intention is to restrict the information to those areas of interest to employees, and to accept that employees are not in the same position as external investors since they already have information about the company or group for which they work, and can always choose to purchase shares direct from the market instead. Perhaps for this reason, only companies whose securities are admitted to trading on a market can take advantage of this regime. In January 2009 the EU Commission launched a consultation on its review of the application of the Prospectus Directive. This will review the scope of the employee share schemes exemption with a view possibly to extending it to share offers to EU employees of companies listed on third country exchanges or in EU exchange-regulated markets and to non listed companies. This is a useful relaxation of a burdensome provision, but still leaves those companies without a listing on an EU regulated market having either to structure their share plans to fall outside full prospectus requirements or to produce a separate prospectus, albeit on a reduced scale. The cost of compliance will be reduced, but given that the information must still be provided in a specific format which differs from that required by e.g. the US or Canadian listing authorities, whether the reduction will be sufficient to bring the overall cost down to a manageable level will vary in each case. It is to be hoped that the EU Commission will amend the Prospectus Directive as suggested in its consultation so that the short form disclosure régime will simply form a temporary solution to the problem. Go back

4 PAYE: Deductions on basis of informal HMRC demand only not unlawful. Mr Patel received substantial payments from Marquette that were structured not as cash bonuses but as dividends paid on shares awarded to him by an employee benefit trust which HM Revenue & Customs ("HMRC") considered part of a tax avoidance scheme. However, having received a letter from HMRC warning that they would bring formal proceedings to recover amounts of unpaid PAYE income tax and NICs in respect of the dividends (on the basis that they were earnings from employment), Marquette deducted 65,000 from Mr Patel's next bonus. Mr Patel subsequently filed a grievance and resigned, claiming that the deduction for tax due on the earlier bonuses was unlawful under the Employment Rights Act ("ERA 1996"). Marquette's defence was that the normal provisions restricting deductions from employees' wages did not apply as the deduction was within a specific exemption for payments made: "in pursuance of a requirement imposed.by a statutory provision to deduct and pay over to a public authority amounts determined by that authority as being due to it from the worker if the deduction is made in accordance with the relevant determination of that authority" (section 14(3) ERA 1996) [emphasis added] Mr Patel however argued that for the exemption to apply, mere letters from HMRC stating (in the relevant officer's opinion) that the dividend bonus constituted earnings and that therefore a PAYE liability had arisen, was not sufficient to amount to a "determination" by them since "determination" meant a formal determination under PAYE regulation 80. The Employment Appeals Tribunal did not agree with Mr Patel and held that a "determination" for the purposes of section 14(3) is not confined to a formal determination by HMRC under PAYE regulation 80. The purpose of the section 14 exclusions in ERA 1996, the tribunal decided, was to ensure that claims were brought in the appropriate forum; under the tax appeal system if the claim related to tax, and under ERA 1996 if the claim related to a breach of statutory employment protections. The case is of interest as it shows that, for employment law purposes, companies setting up incentive schemes for their employees do not need to wait for formal determinations to be made by HMRC before they can settle amounts stated in correspondence as owing. This case is a little unusual in that Marqutte was expressly directed by HMRC to deduct the amounts by PAYE deductions, whereas we would normally only expect HMRC to demand that an employer "makes good" the underpaid tax. In this more usual situation, the employer would have to assess whether it could properly deduct from future wages under the PAYE Regulations (something which Mr Patel did not challenge). If not, the employer would have to pay the tax due and only then seek to reclaim it from the employee. The 2006 case of McCarthy v Stone lends support to the proposition that, in these circumstances, the employer may have a restitutionary right against the employee. Go back PAYE: Further tax charge for failure to reimburse Section 222 of the Income Tax (Earnings and Pensions) Act 2003 applies where there is a charge to income tax under the provisions of the tax legislation relating to employment-related securities and employment-related securities options, and the employer is required to account for tax under PAYE. If the employee does not "make good" the amount to the employer before the end of the period of 90 days beginning with the date on which the employer is treated as having made a "notional payment" for PAYE purposes, the employee is charged to income tax under section 222 on the amount of the tax due under PAYE. The recent case of Chilcott, Griffiths and Evolution Group Services Ltd v Revenue & Customs Commissioners highlights the issue and shows why processes need to be in place to recover PAYE income tax from participants in share and share option plans. Chilcott is a case in relation to section 144A of the Income and Corporation Taxes Act 1988, the legislation which was replaced by section 222. In that case, two directors exercised options to acquire shares. PAYE was not applied because the employer believed that the options were not obtained by reason of employment. Ultimately, each director included the exercise of the options on his self-assessment return for the relevant tax year. HMRC subsequently claimed that a liability arose under section 144A because the PAYE amount had not been "made good" within the required period. Various arguments were advanced on behalf of the directors as to why there should be no section 144A liability, including that section 144A should only apply where there was a tax avoidance motive, that it amounted to double taxation and that the section was penal in nature and in the

5 absence of avoidance or evasion it could not have been the purpose of the section to impose a penalty. However, ultimately, the Special Commissioner dismissed the appeal. The case highlights the importance of employers being able to recover (and actually recovering) PAYE income tax due in respect of share or option related income. It is also important that the PAYE income tax is recovered within the applicable time frame (now 90 days under section 222) as the liability arises, even if the tax is reimbursed, where recovery is outside the time frame. The odd thing about section 222 is that the "benefit to cost ratio" of a notional payment made to an employee without deduction of PAYE, and with no recovery of the PAYE tax from the employee (so the employer pays the employee's tax liability) is the same as if the benefit had been paid net of tax, but is much less if in fact PAYE tax is recovered after the 90 day period. For this reason the Special Commissioner suggested that HMRC should review the section with a view to considering a graduated penalty according to how late the reimbursement is made. Go back Income Tax: Disposing of shares for more than market value The recent Court of Session decision in Gray's Timber Products Limited v Commissioners of Revenue & Customs emphasises the importance, when structuring share incentives, of not falling foul of the tax charges where securities are disposed of for more than market value (Chapter 3D of Part 7 of the Income Tax (Earnings and Pensions) Act 2003). In the Gray's Timber case the managing director was entitled to a specific share of consideration on a sale under the terms of a subscription agreement entered into at the time he acquired his shares. He held 5% of the shares but was entitled to 25% of the sale proceeds so he was receiving significantly more per share than the other shareholders. It was held by a 2:1 majority that the consideration he received in excess of his pro-rata share of the total consideration was subject to PAYE and NICs. The two Court of Session judges who found for HMRC considered that in ascertaining the market value of the shares for the purposes of Chapter 3D, personal circumstances of the individual and any personal rights other than rights contained in the articles of association should be ignored. In this case the fact that the rights under the subscription agreement varied depending upon when a sale took place and upon the particular circumstances of the sale and were not assignable, emphasised that they were rights that were personal to the individual, rather than being attached to and running with the shares. On the facts of this case it was difficult to see how the price differential could be justified other than as being connected with the individual's employment with the company. However it does not mean that in every circumstance where shareholders are receiving differential consideration the excess consideration will be subject to PAYE or NICs. If, for instance, the rights to a specific share of the consideration had been included in the articles of association, not a separate subscription agreement, the price may have been justified as the right to the excess consideration was inherent in the rights attaching to the shares. Equally there may be circumstances where shareholders are selling their shares on substantially different terms (for instance one set of sellers are giving extensive warranties and indemnities and another group of sellers are not). In these circumstances it may be possible to justify a price differential. Each case needs to be looked at on its own facts. This will be an issue for buyers as well as sellers as it will be the target company (as employer) that will be liable to account for any PAYE and NICs due (and in the Gray's Timber case it was the company which was being assessed to tax by HMRC). It is always possible to seek an indemnity from the sellers for the risk. In addition even if the buyer has an indemnity it needs to consider whether it is proper for it to pay the consideration without deducting PAYE and NICs if it believes there are no real grounds for supporting the differential. The case will be particularly relevant in the context of structuring incentives in private companies and in the private equity context. The clear distinction drawn between personal rights and rights inherent in the shares and contained in the articles is potentially helpful in the context of "growth" or "value" shares as it confirms that where the rights are in the articles of association they should not be within the scope of Chapter 3D. Go back

6 Tax Law Rewrite Corporation tax bill Schedule 4AA to ICTA 1988 and Schedules 23 and 24 to Finance Act 2003 currently contain the provisions which deal with corporation tax relief and deductions for employee share plans and employee benefit contributions. These Schedules are to be repealed. The Corporation Tax provisions they contain are being collected together into two adjacent parts in the main body of the Bill: Part 11 - Relief for particular employee share acquisition schemes; and Part 12 - Other relief for employee share acquisitions. The third reading is scheduled for 3 March and Royal Assent is expected by the end of March. The Corporation Tax Bill is the latest part of the tax law re-write project intended to redraft tax legislation to make it clearer and easier to use without actually changing the substance of the law. In line with this, although there are changes and additions to the original drafting if the bill is enacted in its current form there should be little substantive alteration to their practical operation. Go back EMI options and arrangements In order for a company to be a "qualifying company" for Enterprise Management Incentives (EMI) it needs to meet a number of requirements including an independence requirement. This independence requirement is set out in paragraph 9 ITEPA Schedule 5 and consists of two conditions:- 1. the company is not a 51% subsidiary of another company or a company which is under the control of another company AND 2. no arrangements are in existence by virtue of which the company could become such a subsidiary or fall under such control. A company can seek the agreement of HMRC as to the market value of a share as at the time the option is granted and there is an HMRC Form for such purpose - VAL 231. On this Form there are the very broadly phrased questions "Is there a prospect that there will be an opportunity for shares to be sold or exchanged? Or is there a prospect of a flotation or other marketing event?" Care is required in responding to these questions as it has recently become the practice of HMRC Shares Valuation to sometimes refer such cases to SCEC for a ruling as to whether there are "arrangements" and in the meantime the process of negotiating the share valuation may be delayed. Go back Pinsent Masons LLP 2009 This note does not constitute legal advice. Specific legal advice should be taken before acting on any of the topics covered. LONDON BIRMINGHAM BRISTOL LEEDS MANCHESTER EDINBURGH GLASGOW DUBAI BEIJING SHANGHAI HONG KONG T Pinsent Masons LLP is a limited liability partnership registered in England & Wales (registered number: OC333653) and regulated by the Solicitors Regulation Authority. The word partner, used in relation to the LLP, refers to a member of the LLP or an employee or consultant of the LLP or any affiliated firm who has equivalent standing and qualifications. A list of the members of the LLP, and of those nonmembers who are designated as partners, is displayed at the LLP s registered office: CityPoint, One Ropemaker Street, London EC2Y 9AH, United Kingdom. We use Pinsent Masons to refer to Pinsent Masons LLP and affiliated entities that practise under the name Pinsent Masons or a name that incorporates those words. Reference to Pinsent Masons is to Pinsent Masons LLP and/or one or more of those affiliated entities as the context requires. For important regulatory information please visit: