At the spring residential conference of the Chartered Institute of Taxation in Cambridge, Andrew Thornhill QC delivered a very interesting paper on taxation of employment related securities.
In particular he suggested an alternative method designed to produce similar economic results to options but by different means. The key advantage of his method is to produce a liability to capital gains tax (CGT) at 10% rather than a liability to income tax and NIC of 41% for the employee.
Outline of the concept
An option can be seen as an interest free loan to buy shares, the loan only being repayable if the employee chooses to exercise the option. Andrew Thornhill has pursued this train of thought and suggested the following structure:
The employer creates an Employee Share Trust (EST)
The employer lends money to the EST to enable it to buy shares in the employer. If new shares are subscribed then there is no cash cost to the employer
The Trustees appoint shares to the employees subject to and charged with repayment of the loan from the employer
The employer can at any time recall the loan and bring about a share sale
The tax consequences of this structure are anticipated to be as follows:
The employee has received a restricted interest in securities. The employee and employer can jointly make an election under section 431 ITEPA 2003 to have the interest taxed as though it were unrestricted. The value of the shares subject to a loan would be very low and the income tax payable should be correspondingly low or even negligible. This small income tax liability will be met by the employee.
The employee is absolutely entitled to the assets for CGT purposes and can claim business asset taper relief. As a result, after holding the shares for two years or more there is a 75% relief for CGT purposes and the current top rate of CGT at 40% is reduced to 10%
There is no employment-related loan and so no benefit-in-kind assessment arising on the interest free loan. The loan is to the Trustees of the EST. The employee is the beneficial owner of the securities subject to an equitable charge
The economic effect, ignoring dividends which are referred to below, is the same as an option to acquire shares at market value on the day of grant
Advantages of arrangement
The total tax liability for the employee is 31% lower than a conventional unapproved option. The employer does not have to pay employers NIC at 12.8% of the gain arising to the employee on exercise of the option and sale of the shares.
Disadvantages
The employer does not obtain a corporation tax deduction in respect of the gain arising to the employee. Such a deduction will only be given if the gain is liable to income tax in the hands of the employee.
Corporate Governance Implications
Andrew Thornhill did not discuss the requirement to include performance targets in the arrangements. Clearly a form of performance hurdle will be necessary to get acceptance of the proposal from shareholders. I asked during questions whether it would be possible to incorporate a performance target but retain the tax advantages. Andrew Thornhill replied that it was possible to incorporate a performance target by making the loan subject to a variable rate of interest in the event that the performance hurdle was not achieved. In this way no benefit would accrue to the employee if the performance targets were not achieved as the loan and interest on it would effectively force a sale of the shares for no profit.
On further reflection away from the conference it seems that a conventional set of performance targets could be imposed which, in the event of not being achieved, would lead to forfeiture of the shares. The key point is that by joint election employer and employee can for taxation valuation purposes only disregard those conditions at the time of grant and thus move into the CGT regime.
Dividends
As the employee has ownership of the shares he would be entitled to any dividends that are paid on the shares. This is a different outcome from an option holder where no dividends arise on outstanding options. If the company wanted to replicate the option position as closely as possible it could charge a rate of interest on the loan equal to the after tax dividend in the hands of the employee. This rate of interest would be equivalent to 75% of the cash dividend paid, for example a 4% dividend would have a 3% interest charge.
Does this apply to options only or options and performance shares?
The presentation given by Andrew Thornhill dealt with alternative structures to unapproved options. However, it seems that the concept could equally be applied to performance shares. The key difference between options and performance shares is that under a performance share there is no consideration payable by the employee whereas under an option the market value of the share at the date of grant is payable upon exercise.
One way to extend the concept to performance shares would be to give the employee, on the date of exercise following vesting and satisfaction of the performance targets, a cash bonus equal to the exercise price. That amount would be liable to income tax and NIC at 41%, employers NIC at 12.8% but would be deductible for corporation tax purposes if the company has a liability to corporation tax.
Accounting for the transactions
Notwithstanding the tax treatment effectively available by joint election by employer and employee, the accounting treatment is likely to be conventional in accordance with IFRS2 and an estimate of the cost of the arrangements will need to be expensed in the income statement in accordance with the standard. As no corporation tax deduction will be given for the share appreciation gains arising to employees, the taxation difference will be permanent not temporary and so a higher rate of corporation tax may appear to be charged in the income statement.
Important note: this article discusses an outline concept. No action should be taken without specific advice being sought and obtained.
Set out below is a note kindly prepared by Davit Pett of Pinsent Masons explaining the ExSOP he has developed and is reproduced with his permission. David can be contacted on Tel +44 (0)121 629 1626
As an alternative to traditional share options a number of companies have, since 2003, afforded employees an opportunity to benefit from growth in value of a given number of shares by arranging for such shares to be acquired by the employee jointly with an employees' trust.The joint owners (i.e. the employee and the trust) agree between themselves at the outset how the eventual proceeds of sale of the jointly-owned shares will be divided between them.Typically, this is on the basis that the employee will be entitled to growth in value above a threshold amount – typically the initial market value of the share plus the initial value of the shares ("the carrying cost").The jointly-owned shares are acquired at the outset on the basis that the employee pays a small sum (say 1p in the £) and the co-owner pays the balance which it is loaned by the employer company.If the shares increase in value above the carrying cost, then when the shares are sold (typically after three years) the co-owner will receive an amount sufficient to repay its initial borrowing, with interest, and the employee will recover the balance.Such joint ownership plans have become known as ExSOPs (executive/employee shared ownership plans).
Although the employee will, if the appropriate election is made within 14 days of acquisition of his interest in the jointly-owned shares, be chargeable to income tax and NICs by reference to the unrestricted market value of his interest (less any amount he pays for it) when the interest is first acquired, this is typically a relatively modest amount.Any growth in the value of the employee's interest should be taxed as capital gain.Typically, when compared with an unapproved share option or an L-TIP award, an ExSOP award may allow a company to provide a comparable net benefit using a lesser number of shares.However, by contrast with a share option or most types of L-TIP award, in the case of an ExSOP, the employer company is not entitled to relief from corporation tax for the amount of the growth in value realised by the employee.The making of an ExSOP award is therefore not always to the advantage of the company if (assuming the company would qualify for, or be able to make use of relief from corporation tax for share option gains) the growth anticipated is likely to be high relative to the historic value of the shares.
A significant advantage of an ExSOP award is that the accounting charge to be recognised by the employer company may typically be less than would be the case if such award was structured as a share option or L-TIP award.
