Tax-advantaged employee share schemes

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Government-approved share schemes offer tax benefits to both employers and employees and can offer other advantages to businesses

What an employee share scheme can do for you 

Employee share schemes can help you recruit, retain and incentivise employees by giving them a direct financial interest in the success of the company. Larger companies can use employee schemes to compete for high-quality staff against quoted or known-brand companies. For smaller companies and start-ups with little immediate revenue, they can provide an alternative to salary as a way of attracting and rewarding key employees.

Companies can also link entitlements under some share schemes to individual, departmental or company performance, to help focus employees on targets such as profitability or productivity.

A scheme may be set up with a view to key, or all, employees succeeding to the business in due course - if the current owners sell their shares into a Share Incentive Plan, for example, they avoid paying capital gains tax on the sale.

Since 6 April 2014, capital gains tax relief has applied to owners who sell a majority interest in their business to an employee-owned structure, such as a trust. This scheme would suit businesses that plan to transfer ownership to key employees, for instance, but is not suitable for owners who want to maintain entire control of their firm.

Model documents for an employee-owned company are available from the GOV.UK website, including articles of association for an employee-owned company; articles of association for a trustee company; and a model trust deed. Always seek legal advice before entering into any of these arrangements.

Tax-advantaged share schemes

Schemes approved by HM Revenue and Customs (HMRC) offer tax benefits to both employers and employees. There are specific criteria for each type of tax-advantaged (often called either 'approved' or 'statutory') scheme. 

Ordinarily, employees will be taxed, and pay National Insurance Contributions (NIC), on the market value of any shares given to them by their employer, as if it was part of their earnings. (If the employee pays in part for the shares, they pay tax on the remaining gift element.)

If the employee is given an option to acquire shares at a future date, rather than the shares themselves, this liability to tax can be deferred until the option is exercised (provided it is exercised within ten years of the grant), but tax and NIC will be payable at that time.

If, however, the shares or options are acquired under a tax-advantaged scheme, participants will not pay income tax or NIC on:

  • the purchase of shares at less than their market value
  • the receipt of free shares
  • the grant of an option to buy shares
  • the exercise of an option to buy shares

For example, a Share Incentive Plan allows shares to be given to an employee free of tax, provided it meets certain conditions, and an Enterprise Management Incentive scheme allows options to be given, and exercised, free of tax, provided it meets certain conditions.

Employees may still have to pay income tax on any dividends they receive as owners of scheme shares, and capital gains tax when they sell their shares.

This article deals only with tax-advantaged schemes. However, the decision to set up a share scheme should not be tax-driven, but entered into to achieve your commercial objectives.

Key share scheme considerations

Choose a scheme that will achieve your objectives - that will attract and retain the employees you want. A main question is usually whether your scheme is to be for selected or key employees only, or for all employees.

Then consider issues such as:

  • How much of your company are you prepared to give up - the more shares you offer, the more you dilute your control of the company and the dividends on your own shareholding.
  • When are you prepared to let employees have shares - will you award shares now, or options to buy shares later?
  • Will you offer free shares to participants, or must they pay?
  • Subject to the constraints of each scheme, will employee shares have restricted rights, eg be non-voting shares? Will that unduly reduce take-up of scheme shares?
  • Will entitlement be subject to specific performance criteria for the individual, or their business unit, and what will the criteria be?
  • Must employees give up shares if they cease to be employed? Should there be a difference in treatment between 'good' and 'bad' leavers?
  • If the company is sold, merges or goes public, will that trigger the right to exercise options? If the majority of shareholders accept a takeover offer, are scheme participants obliged to accept it too?
  • What if the value of your company's shares goes down? Employees can feel cheated and, if things go very badly wrong, they may lose not just their jobs but the savings they have invested in your share scheme too.
  • What if employees want to sell their shares? If you are a private company, they may not be able to find a buyer that you approve of - will you act as a 'clearing house' for their shares?
  • How much are you prepared to spend on set-up and ongoing administration of your scheme?
  • How will you communicate with employees about the scheme - handbooks, posters, presentations, via an intranet?
  • What will happen if the tax benefits change?

As a rule of thumb, scheme shares in companies operating a scheme usually comprise between 5-15% of their share capital, but consider:

  • Whether the increased value of your shares, or other benefits that result from the scheme, will be enough to counter the reduction in value of your own shareholding.
  • Whether an alternative will achieve your objectives better - for example, lower-paid employees often prefer cash now to shares that might rise in value later, so consider a bonus scheme instead.

Types of approved share scheme

There are four main types of approved scheme:

1. Share Incentive Plans (SIPs)

These offer generous tax and NIC advantages. HMRC says SIPs are designed for smaller companies that might not otherwise have offered a share scheme to employees. However, creating the trust needed to hold the shares (see below) can mean set up and administration costs for a full SIP scheme can be high, making them more suitable for businesses with 50 or more employees, rather than the majority of small businesses.

SIPs are all-employee schemes, in which every member of the workforce, including part-timers, is entitled to participate. Participants are awarded shares now (rather than granted options that entitle them to acquire shares in the future). Companies can give up to £3,600 worth of 'free' shares a year to each participant.

In addition (or alternatively), the scheme can allow participants to buy a limited number of 'partnership' shares each year; it can pay for additional shares to 'match' those bought by an employee; and employees can buy scheme 'dividend' shares from dividends received from existing scheme shares. Partnership shares can be bought from pre-tax salary and are limited to £1,800 or 10% of your annual income (whichever is lower).

Free, matching and partnership shares are held in an employee benefit trust (funded by the company) for participating employees until they either leave the company or withdraw all or some of their shares from the SIP, although employees receive dividends directly.

The shares (other than partnership shares - see below) must usually be held in the trust for at least three years, although some schemes require them to be held for five years. Income Tax and National Insurance is not payable on the value of the shares providing they are held for at least five years.

Read about SIPs on the GOV.UK website.

2. Enterprise Management Incentive (EMI) schemes

EMI schemes are designed to help small, higher risk companies recruit and retain employees by offering them tax-beneficial share options - perhaps to make up in part for the higher salaries they could expect to earn in larger companies. They are usually used to benefit key employees, or key groups of employees. Each option entitles the employee to acquire shares in the company in the future, at a price agreed at the date of the grant. If the value of the shares rises between the option and exercise dates, the employee benefits.

A qualifying company, that does not carry on excluded activities, can grant EMI options over fully paid shares with a market value of up to £250,000 to each qualifying employee, provided the total value of the options granted to all employees does not exceed £3 million. Each grant can be made subject to individual performance targets. The company’s gross assets must not exceed £30 million.

Read about EMIs on the GOV.UK website.

3. Savings Related Share Option Schemes (SAYE or Save as You Earn schemes)

These tend to be set up by large, often listed, companies, because of the large number of shares required to satisfy potential employee demand, and because private companies often find the restrictions on the rights that can be attached to scheme shares unattractive.

Employees are granted options over ordinary shares in the company's share capital, to be exercised after three, five or seven years, dependent on the scheme rules. A market value is agreed for the shares with the Shares Valuation Division of HMRC. All full- and part-time employees and full-time directors must be offered the opportunity to take part, provided they are Case 1 Schedule E taxpayers and are employed by the company at the date of grant of the option.

Participants save up to £500 per month, to be used to acquire shares at the end of the savings contract (three or five years), by entering into a SAYE contract with a bank or building society. The sum is deducted at source each month. At the end of the period they also receive a tax-free bonus and then have six months to decide whether to:

  • Use the money (plus any accrued interest) to exercise the options, and buy shares at the value agreed at the time of the grant, or at a discount of up to 20% on that value.
  • Take the money (including the tax-free bonus).

Read about SAYE schemes on the GOV.UK website.

4. Company Share Option Plans (CSOPs)

CSOPs can be set up by any independent company, irrespective of size, and can provide benefits to all employees, or selected employees only. In practice, they are usually for the benefit of selected, senior staff, although there are some all-employee CSOPs.

CSOPs allow up to £30,000 worth of options to acquire shares to be granted to each participating employee. There is no limit to the total overall value of the options that can be granted.

However, CSOPs are often passed over in favour of Enterprise Management Incentive ('EMI') schemes. EMI participants can be granted options to a value of £250,000 shares (but the company is subject to an overall limit of £3m worth of options), and the tax advantages are more generous. But where a company is not eligible to introduce an EMI (for example, because it carries on a non-qualifying activity), a CSOP offers an alternative.

Read about CSOPs on the GOV.UK website.

When a share scheme is not suitable

Companies that are controlled by another, ie subsidiaries, are not eligible to set up schemes unless the parent is a listed company (in which case, they can set up any scheme except an Enterprise Management Incentive scheme). Partnerships and companies limited by guarantee (such as charities, clubs or associations) may not, by definition, offer employee share schemes as they do not have share capital.

Companies that plan to sell out or float within a few years will find that an employee share scheme can complicate the sale or flotation.

Always take advice on the suitability of each type of scheme for your business.

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