Acquisition of securities by employees

As previously discussed, employee benefits in the form of shares or rights over shares are normally subject to income tax. If the shares are readily convertible assets, national insurance contributions ("NICs") will be due as well. However, if the employee purchases shares in his or her employer at fair market value, and enjoys no other special advantage, then there is no benefit. The employee is an arm's length investor and, when the shares are sold, any gains should be subject to capital gains tax only. This tax will be reduced by the personal CGT allowance.

As an arm's length investor, however, the participant must provide the finance for the acquisition of the shares. Payment could be made from taxed income, or the employer could pay a bonus to finance the share purchase which would itself be subject to income tax and NICs. Neither of these scenarios is attractive.

In the past, companies sought to avoid these problems by offering shares with heavy restrictions, such as an inability to transfer the shares except at nominal value. Employees could purchase such shares at low prices. At some future time, for example on sale or flotation of the shares, the restrictions would fall away. However, the Income Tax (Earnings and Pensions) Act 2003 introduced complex rules to ensure that the proportion of a share's value resulting from a removal of restrictions would be subject not to capital gains tax but the much less favourable income tax regime.

As mentioned in the previous section, another way of allowing employees to purchase shares is through an offer of Partnership Shares under a Share Incentive Plan. However, the value of shares that can be acquired in this way is limited. Larger amounts can be purchased using an SAYE Option Scheme.

The SAYE Option Scheme

Under this arrangement, an employee contracts to save an amount of not less than £5 and not more than £250 per month over three or five years. This is deducted from salary at source and paid into a bank or building society. It is possible to leave the money in the savings account for a total of seven years, although no further contributions are made after five years.

The employee is granted an option to acquire a fixed number of shares at a fixed price at the end of the savings contract.1 On completion of the savings term the employee receives a tax-free lump sum in lieu of interest, equal to a certain number of additional monthly contributions. The total represents a pre-determined capital sum that can be used, if the employee chooses, to exercise the share options. If the value of the shares has increased the employee has made a potential profit which will be realised on sale of the shares acquired.

This scheme has been very popular, with a peak of more than three million participants in approximately 1,400 companies. Current participation is about two million in approximately 920 companies. This decline may be due in part to accounting rules that require companies to expense share options and can be particularly hard on SAYE schemes.

The tax free lump sum is available to all employees who complete their savings contracts, irrespective of whether they exercise their options. The rates as from 1st September 2008 are shown below. These change periodically in line with changing interest rates.

A key feature of the SAYE Option Scheme is that, once the saving contract is complete, employees may ask for a refund of contributions, plus a tax-free bonus, instead of exercising the option. This means that during the life of the savings contract the employee is not exposed to any risk, even if the value of the shares falls below the exercise price. Employees can also withdraw their contributions before the end of the savings contract, in which case they will receive a tax-free "early closure" interest rate of 3.0 per cent. (from 1st September 2008). This is payable only after the first anniversary of the contract start date after and 12 monthly contributions have been made.

Approved SAYE Share Option Scheme: Summary

Under an Approved SAYE Option Scheme employees agree to save up to £250 per month with a bank or building society. They receive tax-free bonuses after fixed periods of 3, 5 or 7 years.
The company grants employees the option to use the proceeds of their SAYE savings to purchase company shares when their savings contracts mature. The option must be exercised within 6 months of the maturity of the savings contract.
All employees subject to UK income tax, including those resident but not ordinarily resident, with a minimum length of service (which can be set at a maximum of 5 years) must be invited to participate, except for those interested, in general terms, in more than 25 per cent. of the share capital. Non-UK employees may also be invited to participate but if they pay overseas tax they will not normally enjoy tax advantages.
The exercise price at which company share options can be granted may be up to 20 per cent. less than the agreed market value of the shares at the time of grant. This creates an immediate gain for the employee, even before the SAYE contract has begun, assuming the shares do not subsequently fall in value.
No income tax or NICs are payable when the share options are granted, when they are exercised, or when the shares are sold. As with other approved share schemes, there is a potential liability to capital gains tax, but only if the gain exceeds the annual exemption (in 2008/2009, £9,600 or £19,200 for a married couple).
The exercise price, that is, the price paid to purchase the shares at the end of the savings contract, may be set at a discount of up to 20 per cent. below the fair value of the shares at the date the contract starts. This gain will also be subject to CGT not income tax. However, accounting standards now require the value of any discount to be included in the estimate of option value to be expensed against profit and loss account, and this is causing some employers to reduce or eliminate discounts from new SAYE awards.

Tax treatment

No tax or national insurance contributions are payable by the employee or employer on the grant of an option under an SAYE Option Scheme or on its exercise, providing the exercise is within the rules. On sale of the shares acquired, any gains are subject to capital gains tax and not to income tax or national insurance contributions.

The tax advantages of the scheme are therefore that no employer or employee NICs are payable on the benefit, and that taxable capital gains can be reduced by the personal capital gains tax exemption. It may be possible to pool the unutilised personal tax exemptions of a husband and wife and the exemptions can also be spread over two or more tax years.

If a participant leaves the employment of the scheme organiser or any associated company2 before his or her share option matures, the option will normally lapse. The ex-employee can then choose to withdraw the savings up to that point and may receive a small payment of interest at the early closure rate. Alternatively, the ex-employee can continue the savings contract until maturity. If however the reason for leaving is an involuntary or "good" reason, specifically injury, disability, redundancy as defined in the Employment Rights Act 1996, or retirement on reaching a specified retirement age,3 the individual also has the choice to exercise within six months of the event to the extent possible from the accumulated savings at that time. No tax will be payable on exercise and capital gains tax will be payable only on the eventual sale of the shares acquired.

If the company so wishes, the rules can provide that if there is a change of control of the company during the savings period, the option can be exercised to the extent possible with accumulated savings. The rules may also permit the option to be rolled over into an equivalent option in the acquiring company. If this occurs the option continues to run as before and the normal rules will apply to exercise of the option after the end of the savings period.

If an employee leaves through illness, no exercise is permitted within three years of the start of the savings contract. However if the contract is for a longer period the company can stipulate that exercise can take place at any time after three years with the savings accumulated to that point. Otherwise, the options will simply lapse on cessation.

In the case of death the personal representatives must, if at all, exercise within 12 months to the extent possible with the accumulated savings at the time of death. There will be no income tax on the exercise.

If the company so wishes the rules can provide that, if an employee is involuntarily transferred to another employer, perhaps as a result of a sale of part of the business, the option can be exercised within six months.

Eligibility

There are no restrictions on the activities of companies that may offer SAYE options. However, there are requirements in terms of the status of the company and its share capital. The shares must be ordinary shares, fully paid up and not redeemable. The shares used must be those of the employer, or a company that controls the employer. The company must be an independent company4 or the subsidiary of a listed company.

Where there is more than one class of share capital, the majority of the class used for an SAYE scheme must be owned, in general terms, by persons who did not acquire them by virtue of being directors or employees.5 The shares must not be subject to restrictions by comparison with other shares of the same class, except that they can be non-voting and/or subject to a requirement that if the holder is an employee, and leaves employment, they must be offered for sale on the same terms as those applicable to other holders of that class.

All employees subject to UK tax6 with more than five years' service must be invited to participate and employers can make this qualification period shorter if they wish. Employees must be allowed to save on "

similar terms", that is, their entitlement to save may be varied only in relation to length of service and salary or "similar factors", such as hours worked. In a group of companies, individual subsidiaries can be included or excluded at the discretion of management, or can run their own schemes subject to their own rules, provided that the overall effect is not to provide an advantage to directors or higher paid employees, taking the group as a whole.

If the company is a close company no employee with a "material interest" is allowed to participate. In general terms a material interest for this purpose is an interest of more than 25 per cent. in the share capital or assets of the company held directly or with one or more "associates". This would include shares over which options are being granted pursuant to the scheme.

Options under an SAYE Option Scheme can be offered by an employee trust, and this may have advantages in relation to the operation of an internal market and/or succession planning.

Shares acquired through option exercise can be transferred within 90 days to an Individual Savings Account (ISA) or to a stakeholder pension, subject to the value limits applicable to these schemes. This will avoid liability to tax on subsequent gains.

Costs

There is no reason in principle why small private companies should not operate an SAYE Option Scheme. However, only certain types of financial institutions may operate the savings contracts. These are, in general terms, banks, building societies and European Authorised Institutions.7 The charges made by savings carriers have increased substantially in recent years and initial fees may exceed £10,000 even for a small plan of less than 50 employees and where the savings carrier offers limited administration.

As an alternative to an SAYE Option Scheme, a company can establish its own savings scheme into which employees make voluntary deductions. The rules can be set as the company wishes and over whatever timescale seems appropriate. Participants can also be issued with options, perhaps under the Enterprise Management Incentive, which can be exercised with the proceeds of the savings contract. The company can provide that, as with an SAYE Option Scheme, employees can request a return of contributions at any time.

Before an SAYE Option Scheme can be introduced, the scheme documents and ancillary papers must be submitted to HM Revenue & Customs for approval.

Deferred Purchase Plan

As previously mentioned, there are strict limits on the value of shares that can be acquired through an SAYE Option Scheme or by means of Partnership Shares through a Share Incentive Plan. Participation in these plans must also be offered to the workforce as a whole, subject to eligibility criteria. Under a deferred purchase plan, however, employers can offer selected employees the opportunity to acquire shareholdings of potentially any size at low initial cost.

Shares may be sold at full market value to one or more selected employees on the basis that only part of the consideration is paid at the date of purchase. The employee contracts to pay the rest of the purchase price at some defined point in the future, such as sale, flotation or a default date.

Notional loan

The balance of the purchase price is treated for tax purposes as a notional loan, and, assuming that the "loan" is interest free, the employee will normally pay tax on the notional interest that would have been paid if the loan had been on commercial terms.8 Employer Class 1A national insurance contributions are also payable, normally at the rate of 12.8 per cent. Loans of up to £5,000 are disregarded but tax on notional interest is payable in respect of the whole amount of loans of more than £5,000. If there is no other benefit to the employee,9 any gains on eventual sale should be subject to capital gains tax, instead of income tax and, where applicable, NICs.

The tax on the interest free notional loan from the company will not be payable if the greater part of the individual's time is spent in the actual management or conduct of a close company or has an interest of 5 per cent. or more in the equity.10 This mirrors the provision that such a person borrowing money for the purposes of investing in the shares of a close company can claim the interest as a deduction against tax. The shares can be new shares issued by the company or shares acquired from an existing shareholder. HM Revenue & Customs takes a strictly factual view of whether a person is actively involved in the "actual management or conduct" of a business.

Where a company makes a loan to a "participator" (usually this means shareholder, but see Glossary) the company must pay a special corporation tax charge of 25 per cent. of the amount advanced.11 However a deferred purchase plan will not normally constitute a loan because no debt is incurred unless the company calls for payment on the shares; in a deferred purchase plan, if the unpaid balance is not paid, the participant will simply lose the economic benefit of the shares. Where the shares are being sold by an existing shareholder, such as another group company, the participant may well not be a shareholder of that company and so the problem does not arise.

The Companies Act requires that loans to directors can be made only with shareholder approval, subject to certain exceptions.12

It is generally held, however, that a deferred purchase plan does not constitute a loan for Companies Act purposes because no debt obligation is created.

The Companies Act also prohibits a company offering financial assistance for the purchase of its own shares, subject to certain exceptions. Again, however, because no debt obligation is created no financial assistance is created.

Difficulties can arise if shares are to be offered on deferred terms to non-employees and the company is a public limited company or a private limited company intending to convert to public status. The Companies Act requires that the capital of a public company must be paid up as to 25 per cent. of the nominal value and the whole of the premium, being the amount by which the subscription price of the share exceeds the nominal value. There is an exemption for employee share schemes as defined in the Act, but for non-employees, the requirement to pay up the whole of the premium on the shares would normally result in the initial amount payable being a large proportion of the total initial value.

There is, however, a "let out" provision under which, if the shareholder pays less than the statutory minimum, the shares shall be treated as if the minimum had been paid but the shareholder is then liable for the balance and must account to the company for interest at the "appropriate rate" for as long as the balance remains unpaid.

Certain other issues must be addressed if securities are offered to non-employees.

Realising the gains

A deferred purchase scheme is a route worth considering if the company is at an early stage of growth and a specific exit is planned. The employee will not have to pay the full amount for the shares until funds are available, perhaps from a company sale or flotation, when with luck the shares will be worth considerably more.

The notional loan is deemed to be discharged when the shares are disposed of. If the loan is not repaid at this point, the participant will be charged to tax on the unpaid amount. Normally the participant will pay off the loan from the proceeds of sale or flotation. However this may be difficult if the company is sold by way of exchange of the existing shares for securities in the acquiring company. Assuming such a transaction falls within the roll-over provisions of the Taxation of Capital Gains Act 1992, such a transaction will not normally crystallise a capital gains tax charge. However, HM Revenue & Customs considers that it does constitute a disposal for income tax purposes, and therefore the income tax and NI on any unpaid notional loan will become due. The same would apply in an internal reorganisation whereby the shares of one group company are exchanged for another.

There is also a potential risk to the employee and/or the employer, namely that if the value of the shares falls, the amount of the notional loan will remain unchanged. In this case the loan will have either to be repaid from other resources, or written off. If the loan is written off, the employee will face a tax charge on that amount as a benefit in kind. If the employee does not pay the tax, the employer will be liable to account for income tax13 and national insurance contributions on the value of the loan written off, an amount which will itself have to be grossed up by income tax.

If the shares acquired are new shares in a close company, and a loss is subsequently incurred, the individual may be able to set the loss against his income in the current or previous tax year, subject to detailed conditions.14

The shares must be disposed of at arm's length terms, on liquidation, or on a claim for negligible value. Losses on a share for share exchange do not qualify. If the shares are acquired from an existing shareholder, any loss will be available only to set against other capital gains.

If the right to the shares is conditional on continuing service, then a charge to tax could arise when the "restriction" is lifted - that is, when the employee completes the required period of service. However, this may be avoided if the articles stipulate that all directors and employees of the company who hold shares must sell them on leaving employment. This is a common provision in the articles of private companies, but is not normally suitable for quoted companies. Another solution would be for the employee to sign a section 431(1) election at purchase.

If the value of the shares rises, this value is not available as a deduction from the taxable profits of the sponsoring company. This is because full beneficial ownership of the shares is acquired at the outset and any subsequent gains accrue to the employee as an arm's length investor.

Joint Ownership Plan

Under this arrangement the employee ("participant") acquires shares in the employing company jointly with another shareholder ("joint owner") which is typically a discretionary employee benefit trust established for the purpose. The ownership is split between the joint owner and the participant such that the joint owner has the rights to the existing share value at the date of acquisition, and the participant has the rights to any future increase in value.

Joint Ownership Plans were first devised in 2003 following changes to tax legislation in that year. They have slowly become more popular but at the time of writing are still relatively uncommon. This is an unapproved arrangement so no specific tax advantages apply. However, as in the case of the deferred share purchase plan, the aim is to put the employee in the position of an arms length investor and therefore within the capital gains tax regime.

The shares are normally acquired jointly by the participant and the joint owner at fair value.15 The joint owner will pay all or nearly all of this sum and the participant will usually pay a nominal amount for the future appreciation rights. The participant will be subject to income tax on the acquisition of the appreciation rights if the amount paid for them is less than their value. However any future gains accruing to the share appreciation rights should be within the capital gains tax regime.

It can be argued that the income tax payable by the participant, if any, should be small since (i) the joint value of what is acquired by the joint owner and the participant cannot exceed the value of the shares themselves and (ii) the joint owner has already paid all or substantially all of this value. However it seems clear that in fact, the joint owner is transferring significant value to the participant, since the joint owner retains all the downside risk but has given up the potential for gain. It is this value, less any amount paid for the rights, which should properly represent the amount subject to income tax at award.16

In some schemes the initial value of the participants' rights is reduced by imposing a hurdle rate on returns of, say, 5 per cent. per annum, so that if the annual increase in the share value prior to sale is less than this figure, the participant receives nothing. It is also possible to arrange for the rights to be acquired on deferred terms, in a similar way to that described in the previous section. This will reduce the initial amount payable for the rights.

In relation to corporation tax, relief may be available in relation to the value of the rights if these are not paid for in full by the recipient. There will be no corporation tax relief in relation to subsequent gains.

1. However if the scheme is in shares denominated in a foreign currency, the number of shares subject to the option will be the maximum number that can be acquired with the sterling proceeds of the savings contract, after conversion into the relevant foreign currency. »
2. A company is associated with another if either controls the other if they are both controlled by the same person(s).»
3. The favourable treatment accorded to those who retire might appear to breach the Employment Equality (Age) Regulations 2006 but there is an exemption where the favourable treatment arises from another statutory provision - in this case, Schedule 3 of ITEPA (see Glossary).»
4. That is, not under the control of another company.»
5. This rule does not apply in respect of shares acquired through a public offer. It also does not apply if the majority of the class is owned by directors and/or employees who are able to control the company. »
6. Including employees who are UK resident but not ordinarily resident. Overseas employees could also be invited to participate but would not enjoy the tax benefits.»
7. A firm located in the EEA which has permission under the Financial Services and Markets Act 2000 to accept deposits.»
8. The official rate of interest at the date of going to press was 6.25 per cent.»
9. If for example the total price to be paid (including the deferred element) is less than fair value at the date of acquisition, income tax will be due on the whole of the discount with respect to the initial date of acquisition.»
10. The company must exist for the purpose of carrying on one or more trades, or investing in land or estates unconnected with the individual, or acting as a holding company for such activities. The relief is not available if the close company is controlled by a company that is not close.»
11. The tax, referred to as quasi-ACT, is to discourage companies from paying salaries in the form of perpetual loans. It is refunded when the loan is repaid. »
12. The exceptions include loans of less than £10,000, loans made for company business, expenditure incurred on defence proceedings or regulatory investigations and loans made in the ordinary course of trade. »
13. Income tax on loans written off is collected via P11D rather than through PAYE.»
14. In brief summary, the company must be engaged in qualifying activities in the UK or a parent of a group which is not substantially engaged in non-qualifying activities. It must be independent, unquoted, have no non-qualifying subsidiaries, own at least 90 per cent. of any property managing subsidiaries, have met these conditions for at least 6 years (a shorter period in certain circumstances), and have had gross assets of not more than £7 million immediately before the issue of the shares in question and not less than £8 million afterwards. Most of the forgoing terms, including "qualifying activity", are defined in a similar way as for the EMI; otherwise see Glossary.»
15. Methods of valuing quoted and unquoted shares.»
16. If the appreciation rights could be classed as options, then it might be possible to avoid an initial income tax charge since no tax is payable on the grant of an option. However if the appreciation rights are options, subsequent gains will be subject to income tax not capital gains tax, which negates the main advantage.»