Employee Share Schemes

The principal reasons why a company may wish to consider share schemes for its employees are as follows:

• to encourage an employee to remain with the company until a key defined target or objective is achieved such as performance targets, a sale or Initial Public Offering (IPO). For a company in its early stages of development, or one that is fast growing, the conversion from immediate cash benefits for its employees to a reward in the form of potentially valuable shares can be extremely beneficial for both parties.
• to reward employees ahead of a potential sale for their loyalty. It is not surprising for the shareholders of a company contemplating a sale to wish to share the sale proceeds with employees who have helped contribute to the creation of the company's value.
• to permit employees to obtain and sell shares in a tax-efficient manner over a period of time in order to help increase motivation and performance.

Before entering into any share schemes, shareholders should ask themselves whether they would be content to extend share ownership and they should be fully aware of the implications of doing so, for example, the effect of granting voting and dividend rights and also the potential issues arising from minority shareholder rights.

Overview of the various employee share schemes

Employee share schemes can involve the donation of free shares to employees, granting them options to purchase shares at a pre-determined price after a fixed time period or after achieving agreed targets, or matching employee purchases of shares with those offered for free or at a discount.

Employee share schemes should be tailored to match the specific needs and goals of the company. They may, for example:

• award shares or grant options dependent on achieving a certain defined target or objective;
• permit employees to become shareholders only on the sale or flotation of the company;
• limit the scheme to certain key employees; or
• require an employee to have served a certain number of years of service.

It is possible to run a combination of various employee share schemes and/or provide more favourable terms for different categories of employees.

HM Revenue & Customs (HMRC) Approved Schemes

Schemes approved by HMRC have tax and National Insurance contribution (NIC) advantages. Taxed schemes (also known as unapproved share schemes) do not have such tax advantages but they may be simpler in that they are not required to meet the qualifying conditions for approved schemes.

There are two main HMRC approved schemes:

• Company Share Option Plans; and
• Enterprise Management Incentives.

Company Share Option Plans (CSOP)

Employers can grant employees options of up to £30,000 worth of shares each. The share price is fixed on the day the option is granted and must not be lower than the market value of the share on the day of grant. Employees may exercise their options after a specified period at the fixed price and not at the potentially higher market price at the date of exercise of the option.

If they then sell the shares at a profit (and certain conditions are met) no income tax or NICs are payable on the gain. Capital Gains Tax may be payable if gains exceed the employee's annual allowance. The business may obtain corporation tax relief for the costs of establishing and administering the CSOP and for the cost of providing shares under the scheme. Before granting options to employees, HMRC approval must be obtained.

Enterprise Management Incentives ("EMI") schemes

Since its introduction in 2000, EMI options have proved very popular. Options may be granted with a market value of up to £120,000 for each selected employee and up to £3 million for all employees. Eligible employees must work a minimum of 25 hours a week or 75 per cent of their working time in the company granting the option. Approval from HMRC is not required in advance but they must be notified within 92 days of the grant of any options. Corporation tax relief is available for the cost of providing the shares to employees.

Only independent trading companies or trading groups with less than £30 million in gross assets may grant EMI options and trading activities must be carried out mainly in the UK. Certain business sectors are excluded.

There is normally no income tax or NICs to pay when options are granted, nor when they are exercised if the option price is at least the market value of the shares when the options were granted. Options must be exercised within ten years.

The employee pays tax when he sells the shares. Capital Gains Tax is payable (after the annual CGT allowance) at 18% or at 10% if the employee has held the shares for one year and qualifies for Entrepreneur’s Relief (which requires holding at least 5% of the share capital. This compares with income tax rates of up to 40% on exercise of non EMI options or options which are not granted under other HMRC-approved share schemes.  Employer’s NIC can become payable on the gain if the option is exercised at the time of a company sale or if the shares become tradeable on a public market.

Share valuation

It will be necessary to place a value on the company and its shares.  Valuing shares however, especially minority shareholdings in a private company, can be a very subjective business. It is usual to involve an accountant (with experience of private company sales and valuations) to act as the valuer.

Whilst it is not strictly necessary to agree a share price for the EMI options with HMRC, it is good practice to do so to ensure that the relevant limits (£120,000 value of shares per employee and £3 million in total for all option holders) are respected.  Further, if options are granted at below market value (which is permissible) the amount of income tax to be paid on exercise of the option can be calculated. Employees may find this helpful, as will the company because, should the company grant options at less than market value and they are exercised at the point the company is sold, PAYE will need to be operated on that undervalue.

Once the valuation has been approved and the EMI options have been granted, HMRC must be notified within 92 days of the date of the EMI Option Agreement granting the relevant EMI options.  If this deadline is missed, the option will cease to be eligible under EMI regulations.

JMW Solicitors

The Corporate law team at JMW Solicitors are experts at structuring and implementing HMRC-approved Employee Share Schemes and work closely with specialist share valuation departments at leading accountants.

For further information please contact us on 0845 872 6666 or use our enquiry form - we will respond promptly.