Employee Incentives Guide Kemp Little
Contents Contents... 2 Introduction... 1 1 Employee Share Plans... 2 2 Other Incentives... 8 Growth share plan... 8 Phantom Share Plan... 9 Pension contributions... 9 Bonus payments... 10 3 Conclusion... 11 Our team... 12
Introduction Attracting, motivating and retaining key talent is vital to the success of any business. Structuring a competitive remuneration and incentives package is an important tool for employers to achieve this objective but any remuneration and incentives package must be structured to align the rewards given to employees with the interests of the shareholders of the company. Historically, it is has been difficult for employers to incentivise staff in a tax-efficient manner. HMRC have, to some extent, addressed this issue by introducing various taxadvantaged share plans. However, the more traditional forms of incentive also remain and are still useful. This note sets out an outline of the main types of employee incentives, and the tax implications, for the employer and the employee, of each. 1
1 Employee Share Plans The most tax advantageous and commonly used form of incentive is to establish an employee share plan. Employee share plans are popular as they can be structured to provide employees with favourable tax treatment, whilst at the same time enabling employers to provide an incentive without incurring any significant cash outlay. The use of shares to incentivise employees can take various forms: An employee is given shares for free or for a price which is less than their market value In its simplest form, an employee can be given shares in his employer company (or if he works for a subsidiary, the parent company in the group). You rarely see this form of incentive used, as it has a number of disadvantages for both the employee and the employer. The disadvantage for an employee is that he will be subject to an immediate income tax and possibly a national insurance contributions ( NIC ) charge calculated by reference to the difference between the market value of the shares and any price paid by the employee. This is expensive for the employee, and the tax liability may arise at a time when the employee might not have any cash to pay the tax liability. From an employer s perspective, it may prefer that the employee does not become a shareholder with voting rights and it may be inconvenient and expensive to deal with the situation where the employment is terminated. Usually, when the employment of an employee who holds shares is terminated either the existing shareholders or the company would want to buy back the employee s shares this will involve significant drafting in the articles and in addition the existing shareholders/company will be required to find the cash to fund the purchase of the shares. Share option plans In order to avoid the disadvantages that may arise from giving shares to an employee, an alternative may be for the employer to grant an option, giving the employee the right to obtain shares at a later date. Options can be structured to avoid an immediate income tax charge arising for an employee whilst avoiding the potential employer issues which can arise with immediate share ownership. Options can be split into two types. Firstly, there are tax advantaged options which, provided that certain requirements are satisfied, offer significant tax advantages to 2
employees. There are also unapproved options, which offer greater flexibility but without the tax advantages. I. Tax Advantaged Options The two types of tax advantaged share plans which are most frequently encountered are enterprise management incentive ( EMI ) plans and company share option plans ( CSOP ). Each of these plans has distinct characteristics and requirements. Within the parameters of the rules of the relevant scheme, tax advantaged options can, broadly, be tailored to suit the needs of the employer. For example, the option agreement can include: Performance thresholds Requirements as to length of service Leaver provisions, so that the option lapses if the option holder ceases employment other than in certain circumstances A vesting schedule, so that the option vests over a percentage of the shares at intervals over a period of time Enterprise Management Incentives Looking firstly at EMI options, the EMI regime was introduced to help small independent companies by easing some of the tax burden associated with incentivising staff whilst allowing significant flexibility in structuring the option. For example, an option can include performance criteria/thresholds to be met before the option can be exercised, or it could permit exercise only after an employee has remained with the company for a certain length of time. A common feature of many EMI options is to restrict exercise to correspond with the occurrence of certain exit events for example a share sale, with the shares issued on exercise being sold as part of the sale of the company. This has the benefit of only providing an employee with share ownership at the time of the exit event, thereby avoiding the issues described above if an employee receives shares at an earlier date. If an employee terminates his employment, the option can lapse. It is not necessary to obtain approval from her Majesty s Revenue & Customs ( HMRC ) for an EMI plan, although it is possible to apply for advance clearance that a company is eligible to grant EMI options. Tax Treatment of EMI Options No tax is payable by an employee when an EMI option is granted, provided exercise takes place within 10 years from grant. There is also no tax charge when an EMI option 3
is exercised, provided the exercise price is not less than the market value of the relevant shares at the time the EMI option was granted. As a practical matter, this will permit an employee to benefit from any increase in the value of the option shares during the EMI option holding period, without suffering income tax and NICs on that increase. However, there will be a capital gains tax ( CGT ) charge on any consideration received by an employee on the sale of the option shares in excess of his base cost (which will be the exercise price plus any amount on which income tax was payable on exercise). The current rate of CGT is 18% for lower rate taxpayers and 28% for higher rate taxpayers. It may also be possible for employees who sell their shares to benefit from entrepreneurs relief and the resulting CGT rate of 10%. An employee can usually benefit from entrepreneurs relief provided that during the 12 month period ending on the date of sale, he has been a director or employee and he has held at least 5% of the voting shares in the company. Historically, it has been difficult for EMI option holders to satisfy these criteria, as generally the shares are only acquired just before the sale. However, recent changes make it easier for an EMI option holder to benefit from entrepreneurs relief in particular the holding period will start to run from the date on which the option was granted and in addition the 5% holding requirement has been abolished for EMI options. This relaxation of the entrepreneurs relief rules, coupled with the 250,000 maximum value of shares that can be granted to a single individual, makes EMI options extremely attractive. Requirements of the EMI Regime In order to benefit from the favourable tax treatment under the EMI rules, certain requirements relating to the employee, the employer company and the options themselves, must be satisfied. Employee requirements Employees and Directors can benefit from the tax treatment available for EMI options provided they: are employees of the Company or a qualifying subsidiary work at least 25 hours per week for the Company (or, if less, 75% of their working time, being time spent on remunerative work for the Company or otherwise) have no material interest in the Company most importantly this means holding less than 30% of the ordinary share capital in the Company Company requirements The company granting the EMI options must: 4
have gross assets of no more than 30 million have fewer than 250 full time employees be independent only have subsidiaries in which it owns 51% or more of the shares The company must also be a trading company and for these purposes certain trading activities will not qualify. For example, if a company trades in shares, securities or other financial instruments, or provides services to those who do, that company may not be able to grant EMI options. Option requirements The options must: be over ordinary, fully paid up and non-redeemable shares (although it is possible to set up a special class of employee shares carrying, for example, different voting rights) be capable of exercise within 10 years, and not more than a year after the death of an option holder be in writing, with the terms clearly set out, including any conditions of exercise not be assignable be notified to HMRC within 92 days of grant In addition, there is a limit (currently 3million) on the value of the shares in a company that can be subject to unexercised EMI options and a 250,000 limit on the value of shares over which an individual employee can hold EMI options. All of the requirements set out above need to be met for the entire time the options are held and so this will need to be monitored on an on-going basis. If the requirements cease to be satisfied then a disqualifying event will occur and unless the options are exercised within 40 days following a disqualifying event the favourable tax treatment will no longer apply. CSOP A CSOP is also a tax advantaged share plan. However, unlike EMI plans, in order to issue options under a CSOP, a company must seek HMRC approval for the plan. Whilst a CSOP offers a tax efficient and flexible way to reward employees, if a company qualifies for EMI then this is generally the preferable plan to use. This is because the individual limit on the value of shares over which options can be granted is significantly lower for CSOPs as compared with EMI plans and the requirements of the EMI rules are less onerous. However, CSOPs are a good alternative (perhaps in combination with an unapproved share plan) for a company which does not satisfy the EMI requirements. This may arise 5
where a company is too large to qualify for EMI or it does not carry on a qualifying trade. Tax Treatment of CSOP options The taxation of options granted under a CSOP is broadly similar to the taxation implications for EMI options but with one important difference. There is no tax payable by an employee on the grant of an option, but to avoid income tax or NICs on the exercise of the option, a CSOP option must not be exercised within 3 years of the date of grant. As was the case for EMI options, there will be a CGT charge on any consideration received by an employee on the sale of the option shares in excess of his base cost (which will be the exercise price plus any amount on which income tax was payable on exercise). The current rate of CGT is 18% for lower rate taxpayers and 28% for higher rate taxpayers. A 10% rate of CGT will be available if an employee otherwise satisfies the requirements for entrepreneurs relief. Employer Requirements The employer company must either be listed on a recognised stock exchange or free from the control of another company. It must be the employer company, or a parent of the employer, who grants the options and the shares under option must be ordinary, unrestricted shares. Employee Requirements The employer company has discretion over which employees can participate in a CSOP plan. CSOP options can, however, only be granted to: Full-time employees or directors (full time for these purposes means at least 25 hours per week, excluding meal breaks) Cannot be granted to employees with a material interest in the company over whose shares the options are granted (material interest currently means beneficial ownership of, or ability to control, 30% of the ordinary share capital of a company, or beneficial entitlement to 30% of the assets available for distribution or on a winding up). Option Requirements The exercise price must not be less than the market value of the shares at the time the options are granted and for unlisted companies the value of the shares must be agreed with HMRC before the option is granted. Discounted options cannot be granted under a CSOP. The position here as regards CSOP options can be contrasted with the position for EMI options above. Whereas an option can still be an EMI option if the exercise price is less than the market value on grant (albeit with adverse tax implications), a CSOP option must be issued with an exercise price equal to the market value of the shares if it is not, the option will be treated as unapproved option. 6
There is a limitation on the value of shares over which a CSOP can be granted. An individual may only be granted an option over shares with a maximum value of 30,000 (measured by reference to the value of shares at the date of grant). As mentioned above, to benefit from the favourable tax treatment offered by the CSOP regime, an option should generally not be exercised less than three years from the date of grant. II. Unapproved Options An unapproved share option is an option which does not benefit from any tax advantaged regime however, they are very flexible and simple to administer. If a company can grant EMI options, this would be the most advantageous plan to use. However, if a company is unable to grant EMI options, then the use of unapproved options (perhaps in conjunction with a CSOP) should be considered. There will generally be no tax liability when the option is granted, but the employee will be liable to income tax (and potentially NICs) when the option is exercised. The income tax charge will be calculated on the difference between the market value of the shares at the date of exercise and the exercise price of the option. This treatment can be contrasted with an EMI option, where income tax and NICs arise only where the exercise price for the options is less than the market value of the shares at the time of grant. A CGT charge will arise on any consideration received by an employee on the sale of the option shares in excess of his base cost (which will be the exercise price plus any amount on which income tax was payable on exercise). The current rate of CGT is 18% for lower rate taxpayers and 28% for higher rate taxpayers. A 10% rate of CGT will be available if an employee otherwise satisfies the requirements for entrepreneurs relief. As mentioned above, unapproved options are useful for companies that are unable to issue CSOP or EMI options and are often used as a top up in situations where the individual CSOP and EMI limits are too low. This is because, although unapproved options carry no tax advantage, they are often seen as preferable to an immediate issue of shares to employees. Corporation Tax Deduction A company will normally be entitled to a corporation tax deduction upon the exercise of an option by an employee. This is generally equal to the employee s gain, regardless of whether the employee pays income tax on this gain. 7
2 Other Incentives Growth share plan A growth share arrangement is another tax efficient form of employee share incentive. Growth shares are designed to permit an employee to benefit from the future growth in the company, whilst acquiring shares for a small upfront cost (and avoiding an immediate income tax charge when the shares are acquired). The aim of growth shares is to secure capital gains tax treatment for the relevant employees on any gain on the sale of the growth shares i.e. the same tax treatment as would be achieved by establishing a tax advantaged option plan. This objective is achieved by limiting the rights of the growth shares in particular, a growth share is only entitled to share in the exit proceeds on a sale of the company, to the extent that the exit proceeds exceed the market value of the company at the date of issue. For example, if the growth shares are issued when the company s other shares are worth 10p and the company is sold when the shares are worth 1, the growth shares would only receive 90p. From the perspective of the employee, growth shares are appealing because: There is little upfront cost provided the employee pays market value for the shares, there will be no tax when the shares are issued, and the market value should be very low There is little risk if the share price falls the most an employee will have lost is the price paid for the shares on issue. From a company s perspective, growth shares are only likely to be appealing if it is not possible to make use of a tax advantageous share option plan. There are a number of reasons for this. Firstly, it is necessary to create a new class of shares each time a company issues a new round of growth shares. In addition, the articles will need to deal with leavers this will generally require either the company or the other shareholders to purchase the shares from an ex-employee (although the use of an employee benefit trust could be considered). One of the main disadvantages for a company is that the issue of growth shares does not permit the company to benefit from a corporation tax deduction either on the issue of the growth shares or when the shares are sold and the employee makes a gain. Tax treatment of Employees As mentioned above, provided the employee pays market value for the shares when they are issued, there will be no tax for the employee when the shares are acquired. HMRC will not provide advance assurance on the value of the growth shares, although it will agree the value after the shares have been acquired if any income tax is payable through PAYE. Capital gains tax will arise when the employee sells the shares. The rate of capital gains tax could be as low as 10% if the employee qualifies for entrepreneurs relief. 8
Phantom Share Plan A phantom share plan is possibly the easiest type of plan to create. Essentially, a phantom share plan is simply a cash bonus plan where the amount of the bonus is calculated by reference to the increase in value of the company s shares or options. Phantom share plans have no tax advantages the bonuses are subject to income tax and NICs. They are, however, simple in that they do not involve the shareholders giving up any of their control and the employees get a guaranteed reward which does not, for example, rely on them finding a buyer for their shares. In addition, the employer will be able to claim a corporation tax deduction for the amount of the bonuses. The employer s costs in setting up the phantom share plan should also be deductible for corporation tax purposes. Pension contributions Pension contributions are a standard and expected feature of most employment arrangements (and are, therefore, perhaps not the most obvious example of an employee incentive). However, an employer can set itself apart by offering generous contributions into its employees pensions. Furthermore, as registered pension plans offer significant tax benefits, they are a means of incentivising staff which is beneficial to both the employer and the employee. A detailed review of the tax treatment of contributions into a pension plan is beyond the scope of this note. Broadly, however, authorised contributions into registered pension plans have the tax benefits set out below. Tax treatment employee An employee can claim tax relief on authorised contributions into a registered pension. Broadly, this means that the employee is not liable to income tax and NICs on the earnings which form the contribution. Contributions made by the employer are not taxable as a benefit in kind. Income from investment returns is exempt from income tax Gains on realising investments are exempt from capital gains tax Tax treatment employer An employer can claim a corporation tax deduction on authorised contributions into a registered pension. In addition, the employer will not be liable for employer NICs on those contributions. Authorised contributions for these purposes means contributions within the relevant allowances. Generally contributions are permitted over and above those limits, but such contributions will not attract the favourable tax treatment referred to above. The relevant current registered pension allowances are as follows: 9
A lifetime allowance (i.e. the maximum amount of saving that a member can make in a registered pension plan) of 1.5million, which is due to be reduced to 1.25million for the 2014/15 tax year An annual allowance (which acts as an annual limit on the increase in value of an employee s pension savings in any registered pension plan of which the employee is a member) of 50,000, which is set to be reduced to 40,000 for the 2014/15 tax year Personal allowance (i.e. the amount of employee contributions which will qualify for tax relief) equal to the higher of 3,600 or 100% of the member s earnings Employer allowance of 500,000 per year (i.e. the amount of relief an employer can claim in respect of its contributions into the registered pension plans of its employees) Bonus payments Bonus payments represent a convenient, flexible means for an employer to incentivise and/or reward its employees. From a tax perspective it is not particularly efficient for the employee, who will be taxed on the payment as if it is additional salary (i.e. the bonus will be subject to income tax as the top slice of an employee s earnings. It will also be subject to employer s and employee s NICs). However, as the bonus constitutes extra (perhaps unexpected) cash, the tax charge may not be a concern for the employee. From an employer s perspective, bonus payments are attractive because they are easy and cheap to administer and they are entirely discretionary (although from an employment law perspective issues may arise if an employer deviates from the parameters of a bonus plan that are enshrined in an employee s contract, for example, or if an employer s approach to bonus payments could be shown to be discriminatory). In addition, the employer should be entitled to a corporation tax deduction equal to the bonus payment. Finally, unlike share based incentive arrangements, an employer can reward its employees without diluting its current shareholding or relinquishing any control to its employees. 10
3 Conclusion In developing an effective employee incentives package, a combination of the various types of incentive discussed above would usually be appropriate. The package would reflect the precise circumstances of both the employee and the employer. 11
Our team For further information, please contact a member of our Employment or Tax teams: David Williams Head of Employment Michael Cashman Head of Tax ddi +44 (0) 20 7710 1641 david.williams@kemplittle.com ddi +44 (0) 20 7710 1619 michael.cashman@kemplittle.com Christopher Middleton Employment Partner Kathryn Dooks Employment Partner ddi +44 (0) 20 7710 1622 chris.middleton@kemplittle.com ddi +44 (0) 20 7710 1660 Kathryn.dooks@kemplittle.com Virginia Allen Senior Associate Sally McGuire Tax Associate ddi +44 (0) 20 7710 1654 Virginia.allen@kemplittle.com ddi +44 (0) 20 7710 1611 sally.mcguire@kemplittle.com Nicola Whelan Employment Associate Emma Morrison Employment Associate ddi +44 (0) 20 7710 1631 nicola.whelan@kemplittle.com ddi +44 (0) 20 7710 1659 emma.morrison@kemplittle.com Elizabeth Kirk Employment Associate ddi +44 (0) 20 7710 1616 Elizabeth.kirk@kemplittle.com 12
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