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Share incentives: comparison of alternative employee share incentive structures for SMEs INTRODUCTION The following provides a brief overview of the main features and tax treatment of various equity incentive arrangements available to small and medium sized enterprises. In particular, we compare enterprise management incentives (EMI), employee shareholder status shares (ESS) and unapproved share options. Please note it does not comment on the accounting treatment of any of the alternatives or issues of valuation. It is based on the laws and judicial interpretation in force at the date of writing and is therefore subject to any changes in applicable tax laws and HMRC interpretations occurring after the date of this document. If, having considered this guide, you would like to know more or to discuss you own circumstances in greater detail, please speak to your usual contact at Stevens & Bolton or a contact listed at the end of this guide. Definitions: CGT EBT HMRC Capital Gains Tax Employee Benefit Trust H M Revenue & Customs NICs PAYE National Insurance Contributions Pay As You Earn ENTERPRISE MANAGEMENT INCENTIVES (“EMI”) Key Features Overview of Tax Treatment Pros and Cons Employer Pros Tax favoured statutory option Employees may obtain up to £250,000 of shares (based on unrestricted value at date of grant) Overall scheme limit of £3 million Option term of 10 years Bespoke exercise trigger e.g. exit based (i.e. sale or listing) or performance related Issuing company must be qualifying at date of grant and vigilance required that option remains qualifying throughout the term: o Independent (not under the control of another corporate) If the exercise price is equal to the market value at the date of grant, employer NICs ought not to be due in respect of the award of shares If the options are granted at less than the market value or if a ‘disqualifying event’ occurs during the option term, employer NICs liability may be passed to the employee with employee agreement Employer is required to notify the grant of an option to HMRC within 92 days Employer is required to make annual returns Employer should (subject to statutory requirements) obtain a corporation tax deduction based on the option profit (market value of a share at date of exercise less exercise price of option) when the options are exercised 1 Potentially no income tax/NICs on increase in value of a share HMRC will agree a market value of a share prior to grant Potential valuable corporation tax deduction on exercise of option for employer company Bespoke option which may be closely aligned with desired employee behaviours (e.g. exit) Entrepreneurs’ Relief potentially available to EMI option holders on the o Gross assets of £30 million or less o No more than 250 full time employees (or part time equivalents) o All subsidiaries are at least 50%+1 owned o Less than 20% of the business activities are non-qualifying Employees are eligible if: o they work at least 25 hours per week or 75% of their working time on the business of the grantor company o hold 30% or less of the ordinary share capital Employee If the exercise price is equal to the market value at the date of grant and no ‘disqualifying event’ occurs during the option term, no income tax/NIC will be due on exercise If there is a ‘disqualifying event’ (e.g. employee leaves employment or a change in the company/share structure) and the option is exercised more than 90 days after that disqualifying event, an income tax charge (and potentially NICs) will arise on the increase in value of a share between the disqualifying event and exercise On disposal of the resulting shares, if there is longer than 12 months between grant and disposal and the option holder remains in employment with the company, a reduced rate of CGT at 10% applies, otherwise normal CGT rates apply (10% or 20%) disposal of shares irrespective of size of shareholding Well understood by employees and potential purchasers Cons EMI must operate within legislative parameters i.e. qualifying issuing company, working commitment of employee Possibility of post-grant disqualifying event EMPLOYEE SHAREHOLDER STATUS (“ESS) SHARES Key Features Overview of Tax Treatment Pros and Cons Employer Pros Employee receives ESS shares in employer company (or top company in the employer group) for no payment (paid from reserves) Employee gives up/adapts rights to the following: o Unfair dismissal o Right to statutory redundancy pay o Right to request flexible working o Right to request time off for training o Notice period for return from maternity/paternity/adoption leave ESS shares must have a tax market value of at least £2,000 but CGT benefits do not attach to shares with a value of more than £50,000 ESS shares do not need to be voting shares nor carry dividends Employee and employer enter into a written statement setting out the terms of the share grant and any restrictions over the shares Employee must obtain independent legal advice on accepting ESS status (paid for by the employer) 7 day cooling off period between receiving the independent advice and entering into the ESS agreement ESS shares must have a value of not less than £2,000 but not more than £50,000, employer should pay for a valuation to be agreed with HMRC Employer will be liable for employer’s NICs on any amounts in excess of £2,000 Employer will be required to pay for independent legal advice for employees, which is deductible for corporation tax purposes Employer should obtain a corporation tax deduction equal to the value of the ESS shares provided Acquisition of ESS shares reported on Form 42 at the end of the relevant tax year Employee Employee is deemed to have made a payment of £2,000 for the ESS shares; income tax (and potentially NICs) is payable on any value in excess of £2,000 No benefit in kind in relation to the employer paying for the reasonable costs of independent advice No capital gains tax on the disposal of ESS shares with an initial value of up to £50,000, capped at £100,000 of gains Potential exemption from CGT on disposal of ESS shares up to £100,000 of gains ESS shares with a value of £2,000 can be delivered with no charge to income tax/NICs Added flexibility in workforce due to waiver of certain employment rights It may be possible to reinstate employment rights in the future without impacting ESS status HMRC will agree value of shares prior to subscription Cons 2 Employees may be reticent about giving up employment rights Any ESS shares in excess of £2,000 are subject to income tax (and potentially NICs) Relatively complex procedure to provide ESS shares Risk of legislative change HMRC will agree the market value of the shares prior to the issue GROWTH SHARES Key Features Overview of Tax Treatment Pros and Cons Employer No corporation tax deduction for the employer company as the employee will have paid full unrestricted market value of the shares at day 1 If the employee pays the full unrestricted market value of the shares there will be no obligation on the employer to collect tax on the acquisition of the shares via PAYE If a loan is made to fund the purchase price it may result in tax on any ‘cheap loan’ under the benefit in kind rules Employer will need to report the acquisition on Form 42 at the end of the relevant tax year Pros The existing share capital of the Company is reclassified into different classes of ordinary shares (e.g. A & B), with the A shares having the right to participate in the proceeds of any subsequent sale up to a set value of the company and the B shares only able to participate pro rata in the excess above this level Employee acquires B shares for cash at the unrestricted market value at the point of acquisition The unrestricted market value is the value of the shares if all restrictions attaching to the shares (such as forfeiture or compulsory transfer provisions on cessation of employment) are ignored Acquisition can either be of new issued shares or shares held by an EBT The company/EBT may provide a loan in order to fund the acquisition cost of the shares Employee So long as price paid represents unrestricted market value of the shares at the date of acquisition, and the appropriate tax election is entered into, there will be no income tax/NIC on the acquisition of the shares Proceeds from the disposal of the shares will ordinarily be subject to the capital gains tax regime (if market value) If a loan is made by the company (or EBT), it may give rise to a benefit in kind (as a cheap loan – please refer to “Part-paid Share Scheme” below for further details) No upfront charge to income tax/NIC on acquisition of the shares Total growth in share value will be subject to CGT Structurally simple Cons Specialist valuation advice required in order to ensure that the price paid represents the unrestricted market value Total price for the shares must be provided upfront but may be loaned to employee No corporation tax deduction for acquiring company Employee acquires shares at day 1 so all restrictions (on cessation of employment, etc.) must be included in the company articles of association UNAPPROVED SHARE OPTION SCHEME Key Features Overview of Tax Treatment Pros and Cons Employer Pros Options over either a new class of ordinary shares or exit based arrangements over a current class of ordinary shares Usually open to any employee at the discretion of the directors/shareholders; may be extended to non-employees Vesting dependant on the level of sale proceeds achieved Flexibility on lapsing criteria, vesting criteria On exercise, the employer company should (subject to statutory requirements) obtain a corporation tax deduction equal to the difference between the exercise price under the option and the market value of a share at the date of exercise Employer NICs may be due on the exercise of the option if the shares are readily convertible assets at that point Subject to certain restrictions, employer NICs may be passed to the 3 No need for prior HMRC approval Wide latitude on terms/conditions No tax on grant of option The holding of an option is risk free for an employee Subsequent growth in value of a share following exercise will be subject to and performance conditions UK market standard to grant options with a term of 10 years No limit on individual participation May be granted at less than market value but not less than nominal value if it is an option to acquire new shares May be granted at less than nominal value if it is an option over existing shares held in an EBT employee by agreement PAYE to be operated on the exercise of the option if shares are readily convertible assets Employer will need to report the acquisition of shares following exercise of the option on Form 42 at the end of the relevant tax year Employee: capital gains tax Can aid employee retention Cons Income tax (and NICs via PAYE shares are readily convertible assets) payable on the difference between the exercise price and the market value at exercise; if shares are not readily convertible assets then income tax due via self-assessment Any subsequent increase in value of the shares following exercise will be liable to CGT Tax treatment – employee charged to income tax (and possibly NICs) on the difference between the exercise price of the option and the market value of a share at exercise CONTACT US For further information about any of the issues raised in this guide, please contact: Kate Schmit Partner Jamie Crawford Senior Associate +44 (0)1483 406954 [email protected] +44 (0)1483 406436 [email protected] The information contained in this guide is intended to be a general introductory summary of the subject matters covered only. It does not purport to be exhaustive, or to provide legal advice, and should not be used as a substitute for such advice. © Stevens & Bolton LLP November 2016 Wey House, Farnham Road, Guildford, Surrey GU1 4YD Tel: 01483 302246 Fax: 01483 302254 www.stevens-bolton.com Stevens & Bolton LLP is a limited liability partnership registered in England with registered number OC306955 and is authorised and regulated by the Solicitors Regulation Authority with SRA number 401245. A list of the members may be inspected at it registered office. 4