Important note: this report discusses general concepts.  The law and tax rates may change from time to time.  No action should be taken without specific advice being sought and obtained.  April 2007

Introduction

The purpose of this report is to give information on what tax effective plans exist in the UK that are aimed at employee share ownership, and to give an indication of common practice among large quoted companies.

All-employee plans can be split into two main categories:

·          Those that give the employee the benefit of the appreciation of the share price from a base point over a period of time.  The employee is not a shareholder as such and does not receive dividends nor have voting rights over the shares; and

·          Those that give the employee the entire value of the share and usually the dividends and votes during the vesting period.

The first category is typically called an option plan and the second category is typically called a full-value or restricted share plan.

The UK has two option plans that can be delivered tax efficiently to all UK resident employees and a Share Incentive Plan that uses full value shares. This report briefly describes the SAYE, CSOP and SIP plans and indicates common practice for their usage.

SAYE

Save As You Earn (SAYE) is also known as a Savings-Related Share Option Scheme (its title in the UK tax legislation) or simply as Sharesave.  Introduced in 1980 it is one of the oldest and most popular employee share plans.  Virtually all of the FTSE 100 companies have these plans.

The concept behind the plan is simple – employees save money so that at the option vesting date they can afford to exercise their option and hold the shares.  Thus there are two parts to the plan: a savings contract and an option grant.

The savings contract

The employee saves money monthly by payroll deduction from after tax pay over a savings period of three or five years.  For seven year contracts the five years of savings remain on deposit for a further two years and earn additional interest.  The money is deposited with a bank or building society in individual employee owned accounts under a special savings contract.  The terms of the contract are specified by HM Treasury including the rate of interest earned that is fixed for the savings period and is free of UK income tax.

Thus the employee and employing company both know exactly what the proceeds of the savings contract will be if the employee saves to maturity.  At maturity the employee has the cash available to purchase the shares and hold them.  As a result it is not necessary for the employee to have to sell some of the shares to find the option exercise price as often happens with option plans that do not have a savings component.

There are limits to the amounts that can be saved under this type of savings contract.  There is a minimum savings amount of GBP5 a month for any one contract and a maximum of GBP250 a month for all savings contracts entered into by an individual.

Table 1. Current interest rates from 1 October 2006.

The option grant

As the employer knows exactly what sum of money will be produced by the savings contract, it can grant an option to each employee to acquire the precise number of whole shares (or fractional shares if local law and the articles permit) that can be purchased with the proceeds of the savings contract.  The employer is allowed by UK tax law to grant the option at a discount of up to 20% of the market value of a share at the time of invitation to employees to participate in the plan.

Tax efficiencies of saye

            Employee perspective

The interest earned by the employee on the savings account is tax free.

The discount (if any) on the option shares is free of income tax.

When the employee exercises the option at maturity of the savings contract there is no liability to income tax.

After the shares are acquired they can be transferred to a tax exempt Individual Savings Account (ISA) from which future growth is sheltered from capital gains tax (CGT).

After the shares are acquired they can be transferred to a registered pension plan and the employee will receive income tax deductions and enhancements for so doing.

Gains realized on the sale of the shares may be liable to CGT, but each individual has an annual exemption (currently GBP9,200 in 2007-08) which is free of CGT.

            Employer perspective

Costs incurred in setting up such a plan are fully deductible for corporation tax purposes.

Notional gains derived by the employee at the time of exercise are deductible expenses for corporation tax purposes.

No liabilities to National Insurance Contributions (NIC) arise for the employer on the discount nor on notional gains derived by the employees.  For an unapproved option the liability of the employer would be to pay NIC of 12.8% of the notional gain.

Common practice among other large quoted companies

Sharesave is a near-universal plan at large UK companies.  The option grant to any one employee is limited by the savings level permitted by the UK’s HM Revenue & Customs (HMRC) and the maximum saving is GBP3,000 a year.  Employees effectively decide how much they wish to save each month.  Statistics from Lloyds TSB Registrars show the following data:

Table 2. SAYE statistics from Lloyds TSB Registrars in September 2006

The key choices for a company in designing its Sharesave offer to employees is –

·          Whether to offer three, five or seven-year contracts

·          Whether to give a discount and if so how large a discount

·          How much effort to put into communicating the plan to employees.  Better communication leads to significantly higher take up by employees.

Most companies offer three or five-year contracts only and as can be seen from Table 2, some 70% to 80% of employees chose three-year contracts.  Where plans are being launched globally it is common to limit the selection and offer only a three-year option.

Most companies give the full discount of 20%.  However, where a global design is used including US employees the discount is often reduced to 15% as that is the maximum discount permitted under a qualifying section 423 Stock Purchase Plan in the US.

Most companies do not communicate the benefits of the plan well.  This explains the low take-up rates which can be significantly improved by a better communication campaign.

CSOP

The Company Share Option Plan (CSOP) was originally introduced in 1984 as an Executive Share Option Scheme with very large limits permitting tax-effective option grants over the greater of GBP100,000 or four times pay.  It permits a company to select participants; it is not like the SAYE and SIP where all-employee participation is compulsory.

In 1995 tax relief for the CSOP was withdrawn but reintroduced in 1996 with a much reduced limit on its tax efficiency.  The current limit which is unchanged since 1997 is that no more than GBP30,000 worth of shares at any time can be placed under option in a CSOP.  The price of the share for this purpose is fixed at the date the option is granted and cannot be less than the market value of the shares at that date.  To be tax effective the option cannot be exercised for three years from date of grant and must expire on the tenth anniversary of its grant.

Structure

Under a CSOP an employee is granted the option (a right but not an obligation) to acquire a fixed number of shares at a fixed price at a future date.  There is no need to have a savings contract linked to the option grant.  As a result the vast majority of employees are unable to find the cash needed to exercise the option and hold the shares.  Standard procedure is to perform a so-called “cashless exercise” where the employee sells some of the shares acquired on exercise to fund the exercise price.  Once the employee is selling some shares typically all of the shares under option are sold for cash and the employee does not become a shareholder.  HMRC permits cashless exercise provisions to be written into the plan rules.

Tax efficiencies of CSOP

            Employee perspective

There is no liability to income tax when the option is granted.

When the employee exercises the option after a period of three years from date of grant but less than ten years after date of grant, there is no liability to income tax.

Gains realised on the sale of the shares may be liable to CGT, but each individual has an annual exemption (currently GBP8,800 in 2006-07) which is free of CGT.

            Employer  perspective

Costs incurred in setting up such a plan are fully deductible for corporation tax purposes.

Notional gains derived by the employee at the time of exercise are deductible expenses for corporation tax purposes.

No liabilities to NIC arise for the employer on the notional gains derived by the employees.  For an unapproved option the liability of the employer would be to pay NIC at the current rate of 12.8% of the notional gain.

Common practice among other large quoted companies

CSOP is widely used among large UK companies.  However, it is preponderantly used as an executive incentive arrangement with performance targets applied for options to vest.  It is extremely uncommon for CSOP to be used for all employees.  There is a history of large retailers using it in this manner and ASDA (now a subsidiary of Wal-Mart) and Kingfisher have given grants to all employees in the past, but do not currently do so.

A design feature that could be appealing to an employer is to reward all employees by means of an option grant if specific targets for a year are achieved.

SIP

The Share Incentive Plan is a complex arrangement that gives significant tax efficiencies for companies using full value share plans for all employees.  It was introduced in 2000 as part of the UK Government’s objectives of improving productivity and promoting a new enterprise culture.  The tax breaks are the most generous available in the UK and are deliberately there to offset the risk of immediate share ownership.

There are four different ways that the SIP can be used to deliver employee share ownership, and each has a particular name given by the tax legislation.  They are Free Shares, Partnership Shares, Matching Shares and Dividend Shares.

Structure

Under a SIP shares are held on behalf of employees by UK resident trustees.  There are many institutions that offer this trusteeship service to companies and the UK resident trustees can acquire  shares from the company, the market or from trustees of an Employee Share Trust if there is one in place.  The trustees have specific obligations to HMRC to operate the SIP in accordance with the trust deed and rules and to withhold and account for income tax and NIC when necessary.

            Free Shares

Free shares of up to GBP3,000 a year can be given to each employee.  All employees must be treated on a similar basis receiving either the same number of shares or shares worth the same percentage of salary.  Typical usage is as a share of profits but other methods can be used.  The shares are awarded free of income tax and NIC.  It is possible but not necessary to introduce a three year vesting requirement so that if an employee leaves during the vesting period the shares are forfeited.  Shares that remain in trust for a five year period can emerge from trust completely free of income tax, NIC and CGT, no matter how much they are worth.

An employer may link awards of shares to its employees' performance, for instance the performance of a team, division or other work unit.   Awards made to employees in each performance unit must be made on similar terms to the other employees in that unit.  If the award is linked to performance, the company must set out clear targets in advance and tell employees what those targets are.

            Partnership Shares

Employees can be invited to purchase shares with pre-tax and pre-NIC pay.  The employer also saves the 12.8% NIC that would have otherwise been paid on the cash pay of the employee.  The limit on such purchases is GBP125 a month or GBP1,500 a year.  As the employees use their own money to purchase the shares they cannot be forfeited and can be withdrawn from trust at any time.  However, the withdrawal will only be free of taxes and NIC if made after five years from purchase.  Earlier withdrawals will lead to income tax costs for the employee and NIC for both employee and employer.

            Matching Shares

If an employee has purchased Partnership Shares then and employer can award Matching Shares in a ratio communicated to employees before they purchase their Partnership Shares.  The ratio can be any ratio with a maximum of two Matching Shares for each Partnership Share.  Thus for an employee who purchases GBP1,500 a year of Partnership Shares an award of Matching Shares of up to GBP3,000 a year can be given.  All employees must be treated on a similar basis.  The shares are awarded free of income tax and NIC.  It is possible but not necessary to introduce a three year vesting requirement so that if an employee leaves during the vesting period the shares are forfeited.  If an employee withdraws the Partnership Shares from the trust then the matching shares are forfeited.  Shares that remain in trust for a five year period can emerge from trust completely free of income tax, NIC and CGT, no matter how much they are worth.

            Dividend Shares

Employees are the beneficial owners of the shares while they are held in trust and therefore they will receive all the rights of a shareholder including dividends and other distributions.  If the employee reinvests the dividends in the purchase of further shares then the shares so purchased are free of income taxes.  The limit on shares purchased from dividends is GBP1,500 a year.  Dividend shares must remain held in trust for a three year period for them to emerge free of taxes.

Departing employees

Employees who leave the employment of the Group must remove their shares from trust.  There are tax exemptions for good leavers such as disability, redundancy, retirement or death, but a voluntary leaver will be liable to income taxes and for all except Dividend Shares NIC as well.  The employer will have a NIC liability if the employee is liable to NIC.

Tax efficiencies of SIP

            Employee perspective

Free shares are free of all taxes and NIC if held in trust for five years.

Partnership Shares are purchased from pre-tax and pre-NIC pay and become entirely tax free if held in trust for five years.

Matching Shares are free of all taxes and NIC if held in trust for five years.

Dividend Shares are free of all taxes if held in trust for three years.

Gains realised on the immediate sale of the shares when they emerge from the trust after five years are exempt from CGT.

After the shares are taken out of trust they can be transferred to a tax exempt Individual Savings Account (ISA) from which future growth is sheltered from capital gains tax (CGT).

After the shares are taken out of trust they can be transferred to a registered pension plan and the employee will receive income tax deductions on the market value of the shares and enhancements for so doing.

            Employer perspective

Costs incurred in setting up and administering such a plan are fully deductible for corporation tax purposes.

The gross salary allocated by employees to purchase Partnership Shares and costs of acquiring the shares if greater than the employees contribution are deductible for corporation tax purposes.

The market value of Free and Matching Shares at the time they are acquired by the trustees are deductible for corporation tax purposes.

Where Free and Matching Shares are transferred into the plan from another trust then a corporation tax deduction will be available for the market value of those shares to the extent that no corporation tax deduction has already been given for the acquisition of those shares by the other trust.

Common practice among other large quoted companies

SIP is widely used among large UK companies.  However, not all companies use all of the features of the legislation.  An analysis of SIP conducted by Capita Share Plan Services in March 2006 can be found on our website.

            Summary of conclusions drawn by Capita

Capita’s analysis shows that Share Incentive Plans continue to be an attractive benefit for employers to offer their employees.  The broad range of companies using SIP is testament to its widespread appeal as an employee incentive.

However, whilst every company is different so too are the SIPs they put in place.  One company may be looking for a different method of rewarding staff, as an alternative to the usual cash bonuses, by introducing Free shares without forfeiture rules.  Another may be looking for ways in which to tie in staff to the productivity and success of the company in the long term and therefore implement a Partnership scheme with a high matching ratio and a three-year holding period.

The reasons may be very different but the SIP wears many different ‘hats’, enabling many companies to finding an efficient and cost effective method that is particular to them of rewarding their employees.

There is also a significant trend towards more generous plans being introduced.  The popularity of improved matching and free share offerings to employees suggests a move by some employers to make sure their offering remains competitive in the market place.  This could be in an attempt to decrease staff turnover, or maybe just an attempt to have more employees sign up to SIP for the resultant benefits available to both employer and employee, or simply that employees are more aware of the benefit of SIP now.