By Craig Geraghty, Legal Director at Legal Futures Associate O’Connors Legal Services Limited
Nelson Mandela said that money won’t create success but the freedom to make it will. Perhaps this explains why more and more companies are using employee share schemes as a means of incentivising staff – aligning the interests of employees and shareholders whilst providing tax-efficient rewards.
Broadly speaking, employee share schemes split into two types – tax-advantaged share schemes and non-tax-advantaged share schemes. This note provides a quick overview of the most common tax-advantaged employee share schemes used by UK companies.
Save as you earn (SAYE)
A SAYE plan is a share plan that allows employees to acquire fully paid up, non-redeemable ordinary shares in the company at a fixed price at a particular time. When operating a SAYE plan, the company must invite all eligible UK-resident employees and full-time directors to participate. The company granting the options must be either listed on a recognised stock exchange or free from the control of another company, excluding companies controlled by a corporate trustee of an employee ownership trust.
Companies must register a new SAYE option scheme by 6 July following the end of the tax year in which it is established and self-certify that it meets the requirements of the SAYE code.
The scheme allows employees to save between £5 and £500 per month for three to five years. Such savings are made as deductions from the employees’ monthly salary after tax. With the employee required to enter a HMRC certified savings contract. SAYE options are rarely exercisable prior to the third or fifth anniversary of the relevant savings contract being entered into, and employees are entitled to stop deductions from their pay at any time and will be entitled to have their contributions returned to them in full.
At the end of the savings period set out in the savings contract, the employee has the option to withdraw the sums saved or acquire shares pursuant to the SAYE plan. As set out above, the price payable for the shares is fixed when the option is granted to the employee. However, it is worth noting that the exercise price may be up to 20% less than the market value of the shares at or shortly prior to the date that the employee was invited to participate.
Any interest and/or bonus earned at the end of the SAYE plan is tax free and the employee will not pay income tax, or NI contributions, on the difference between what they pay for the shares and what they are worth. There may be CGT payable if the shares are sold, however the employee has an ability to mitigate the CGT liability here if they transfer the shares to an ISA within 90 days of the scheme ending or directly to a pension upon expiry of the scheme.
SAYE schemes are popular with employees as there is no obligation to participate and the investment is seen as risk free, with the employee able to withdraw their savings if the share price goes down during the term of the savings contract.
Company share option plan (CSOP)
A CSOP is a discretionary share plan, pursuant to which a company can grant options to any employees or full-time directors to acquire fully paid up, non-redeemable ordinary shares in the company at a price that is not less than market value and with a maximum value of up to £30,000 per individual. The Company granting the options must be either listed on a recognised stock exchange or free from the control of another company, excluding companies controlled by a corporate trustee of an EOT.
CSOPs are subject to generous tax reliefs, being capable of exercise without any income tax or NI contributions provided the options are exercised within 10 years of grant and (a) at least three years after the grant date or (b) within six months of the option holder ceasing their employment for certain ‘good leaver’ reasons or (c) by the option holder’s personal representatives within 12 months of death or (d) within six months of certain cash takeovers.
The options need to be granted in accordance with a set of CSOP rules and an option agreement that should comply with CSOP legislation. If required, the company can impose a set of performance targets that need to be achieved before the options can be exercised. However, the performance conditions must be objective and not capable of arbitrary variation by the company.
Although not a statutory requirement, it is normal practice to have the market value of the shares agreed in advance with HMRC if any of the shares subject to the CSOP are (a) unlisted (b) traded on AIM or (c) listed on an unrecognised stock exchange. Companies must self-certify that a CSOP meets the requirements of the CSOP code. Companies must also file an annual return for a CSOP.
Share incentive plan (SIP)
SIPs allow companies to invite certain eligible employees to acquire fully paid, non-redeemable ordinary shares in the company. They are usually favoured by larger companies as they can be quite expensive to set up and administer.
Although there is no need to agree a market value of the shares with HMRC before they are awarded under a SIP, HMRC must be notified of the SIP by 6 July of the following tax year. Such notification will also require certification that the plan complies with applicable legislation.
The shares awarded to employees under a SIP are held in an employee benefit trust. Provided the shares are held for between three and five years, no income tax will arise on the shares, and no CGT will be payable so long as the shares remain held in the SIP trust. If the shares are released by the employee from the SIP trust on or after the five-year maturity date and the shares are subsequently sold upon release from the trust, no CGT will be payable.
A company can operate a SIP to offer the following shares:
- Free shares – where a company provides employees with up to £3,600 of free shares in any given tax year.
- Partnership shares – where a company allows employees to purchase partnership shares out of their pre-tax salary. Employees can acquire partnership shares up to a maximum of the lesser of £1,800 per year and 10% of the employee’s income in the relevant tax year.
- Matching shares – where a company offers employees shares to match pro rata the number of partnership shares acquired by that employee. Matching shares should be of the same class as the partnership shares to which they relate.
- Dividend shares – where a company allows or requires any dividends paid on SIP shares to be used to acquire dividend shares.
Enterprise management incentive (EMI) options
EMI options are a type of discretionary share option that can be offered to employees (including executive directors) that spend at least 25 hours per week or, if less, 75% of their working time working for the company to acquire fully paid up, non-redeemable ordinary shares. EMI options are targeted at smaller companies with assets of £30 million or less.
There are statutory requirements that must be met for a company to qualify to grant EMI options including, but not limited to, the following:
- The company must be independent of other companies.
- The company must not have gross assets more than £30 million at the time that the option is granted.
- The company (or group of companies) must have fewer than the equivalent of 250 full-time employees at the time of grant.
- The company must carry on a qualifying trade as defined by HMRC or be prepared to do so.
- The company (or if the company is a parent company of a group, a group member with a qualifying trade) must have a UK permanent establishment.
The EMI option must take the form of a written agreement that sets out the terms on which the option has been granted. In particular, the option must be exercisable within 10 years of the grant.
The company can grant options over shares worth up to £250,000 to each individual. However, there is a limit on the total value of options that can be granted by the company of £3 million.
From a tax perspective, EMI tax treatment is very generous, with no income tax or NI contributions payable on the grant of the option. Business asset disposal relief is also potentially available on a disposal of shares acquired pursuant to an EMI scheme.
Although not required, it is advisable that the company establish the market value of the shares under option prior to the EMI options being granted. Obtaining a valuation will help to ensure that the company does not exceed the individual and company limits on granting the options.
Employee Ownership Trust (EOT)
Another way in which a company, through its shareholders, can look to incentivise employees is by selling a controlling interest in the company’s share capital to an EOT. An EOT is a specific type of employee benefit trust established for the benefit of all employees of the company. Once established, the shareholders of the company look to sell a controlling interest in the company to the EOT, and the EOT will then hold the shares on trust for the benefit of the company’s employees.
EOTs were introduced by the UK government as part of the Finance Act 2014 to encourage employee ownership (a drive towards the John Lewis model) and help drive business growth. EOTs were seen as a way of allowing business owners to directly incentivise staff by giving them an interest in the future growth and the direction of the business while also providing business owners with a more tax advantageous way to dispose of their interests.
EOTs are often used as a tax efficient succession planning tool in addition to an employee incentivisation tool. Selling to an EOT has the following tax advantages:
- Individuals selling their shares to an EOT may do so free of any capital gains tax (subject to the qualifying conditions set out below); and
- Once controlled by the EOT, the company will be able to issue tax free bonuses of up to £3,600 per employee per annum.
A seller being able to dispose of his shares free of CGT is clearly attractive, particularly given the changes to business asset disposal relief referred to above. Furthermore, having an ability to issue tax free bonuses of up to £3,600 per annum will go a long way to ensure employees are incentivised to help grow the business.
For an employee benefit trust to qualify as an EOT, the following conditions must be met:
- The company must be a trading company.
- The EOT must acquire a controlling interest in the company and must continue to hold that controlling interest at all times. A controlling interest means that the EOT must hold more than 50% of the company’s share capital, a majority of the voting rights and be entitled to more than 50% of the company’s distributable profits.
- The EOT must be established to benefit all employees and they must be treated equally. Shareholders who hold or have previously held 5% or more of the company’s shares are not classed as eligible employees.
- Any continuing shareholders who are directors and employees must not exceed 40% of the total number of employees of the company.
Once an EOT is established, the trustees and shareholders of the company will need to agree a valuation of the shares that are to be acquired. The price payable for the shares must be market value, as determined by an independent expert. We would advise that the valuation be undertaken by a completely independent party with no prior connection to the selling shareholders, or the company, to ensure that valuation stands up to any scrutiny from HMRC. Once a valuation has been agreed, you should seek advance approval from HMRC in respect of the sale valuation so that you can have a degree of certainty in respect of the tax treatment of sale proceeds.
Some advantages of selling a controlling interest in the company to an EOT are:
- There is no requirement to go to market and seek a buyer.
- It is usually a quicker, simplified and more collaborative transaction process.
- It allows sellers to obtain a fair price with shares sold at market value.
- Any element of deferred consideration can take the form of vendor loan notes attracting commercial rates of interest.
- It allows employees to acquire the company without having to directly fund the cost.
- Former owners are able to maintain an interest in the company up to 49%.
- There is no capital gains tax on the sale.
- The company can issue tax free bonuses to employees’ post-acquisition.
- Giving employees an indirect interest in the company, a greater say in how it is conducted and a share in its success, should create higher engagement, incentive, productivity and innovation with lower absenteeism and staff turnover.
There are some downsides when selling to an EOT. It is common for a large part of the consideration payable to be on deferred terms, which means taking a risk on the future success and profitability of the company. Also, as the sale price is fixed at the date of closing, in the absence of HMRC approved anti-embarrassment provisions, the sellers may not benefit fully from unforeseen growth and success.
As mentioned, the EOT must acquire a controlling interest in the company to qualify for the reliefs available. Any seller must not have any ongoing control over the company, whether at shareholder or board level. This means that the seller is reliant on the incoming directors to distribute funds to the EOT and for the trustees to apply the funds received to discharge the EOT’s obligation to pay any deferred consideration.
A positive next step?
Employee share schemes provide a useful way to incentivise and reward employees in a tax efficient manner, while at the same time helping drive business growth. In some circumstances, they can also help facilitate a tax efficient exit.
If you are looking to incentivise your employees and/or looking at succession planning, then considering employee share schemes may be a positive next step for you and your business.
DISCLAIMER: The information and opinions contained in this article are for general information purposes only, are not intended to constitute specific legal or other professional advice. It should not be relied on or treated as a substitute for specific advice relevant to particular circumstances. O’Connors does not accept any responsibility for any loss which may arise from reliance on information or materials published in this article. The article reflects our understanding of the position as of August 2022 and deals only with matters of law in England and Wales.