Administration and reporting

Tax reporting

Where an employee acquires securities or rights over securities by virtue of past, present or prospective employment, any benefit arising will normally be subject to tax.1 There are specific types of form for each type of statutory scheme and these can be downloaded from the website of HM Revenue & Customs. Generally, if there has been no activity during the year (e.g. no grant or exercise of options or appropriations of shares) a nil return is still required.

Where a scheme comes to an end a return should be completed for the year in which the termination took place and a request sent to HM Revenue & Customs to issue no more returns in relation to the scheme. In practice tax officials will not accept this request unless they are provided with a Board resolution terminating the scheme.

Where an employee acquires securities or interests in securities other than through a statutory scheme, the relevant return is Form 42. However, a return will not be required if the shares are subscribed for on incorporation of a new UK company, all the company's shares are subscribed for at nominal value, and the acquiror is a director or prospective director or is acquiring the shares through a bona fide family relationship. Additionally, the acquiror must not acquire other types of securities in the company at the same time and must not be acquiring the shares by reason of, or in connection with, another employment.

If a company issues shares following incorporation, it will also not be necessary to report them if they are issued at nominal value and the company has not commenced trading or acquired assets. The acquiror must be an actual or prospective director or have already acquired shares. The shares must not be acquired in relation to another employment, but again, bona fide family transfers are excluded.

Aside from the acquisition of securities, any transfer of value to an employee arising from an existing holding of company securities must be reported. This includes, for example, situations where:

a restriction (and/or risk of forfeiture) on employee-held securities is released, in whole or in part;
securities convert into other securities with higher value;
an actual or notional loan used to acquire securities is released;
there is an artificial transfer of value into or out of a security;
consideration is received for the release of rights over a security.

A form 42 should also be completed if options are issued under an EMI scheme over shares worth more than the £120,000 statutory limit.

The deadline for the statutory share scheme returns and the form 42 is the 6th July following the end of the tax year in question. Heavy penalties can be imposed for failure to submit a return on time, or for inaccurate or incomplete returns. Once an initial penalty has been imposed HM Revenue & Customs can seek permission from the Special Commissioners to impose additional penalties for each day that the error remains uncorrected.

Where Class 1A NICs arise on the benefit of a notional loan in a deferred share purchase arrangement, this must be reported on form P11Db by 6th July following each tax year in which the benefit arises. Payment must be made by 19th July. Failure to observe these rules will result in a penalty of £100 per month during which the error is not rectified in respect of each block of 50 employees, or part block if fewer than 50.

Reporting by employees

If employee share benefits are subject to PAYE this is normally dealt with via payroll and many participants in employee share schemes do not receive a self-assessment tax return. However, the benefits may not be subject to PAYE, or the correct amount of PAYE may not have been accounted for. In this case the tax will normally be collected through self-assessment. Employees have a duty to report their liability to tax even if they do not normally receive a self-assessment tax return. Employers, meanwhile, are obliged to give employees sufficient information to complete their tax returns.

Employees are asked to fill in the Share Scheme pages of the return in any circumstances where the full amount of tax may not have been paid in respect of a security, and specifically in the following cases:

exercise of a non-statutory securities option;
exercise of a share option under a CSOP Scheme or Enterprise Management Incentive if income tax is due;
securities ceasing to be subject to a Share Incentive Plan in circumstances where tax is payable;
the employee receiving compensation for giving up or for not exercising a securities option;
the employee acquiring securities at less than fair value;
removal of restrictions or a risk of forfeiture on securities;
securities convert to another class of shares;

If the employee does not normally complete a self-assessment form it is possible to have the tax collected via adjustment to the tax code but HM Revenue & Customs should be informed of the circumstances by 5th October following the end of the tax year.

If shares are sold any gains will be subject to capital gains tax. If total gains plus all the employee's other taxable capital gains exceed the annual exempt amount or total proceeds exceed the disclosable amount for the relevant tax year, the employee must fill out the capital gains tax pages of the self-assessment return.

Employees should account for dividend income from employment related securities in the same way as for other dividends, in the main self-assessment return.

Trustees of employee trusts, including Share Incentive Plan trusts, must fill in the trusts self-assessment return in respect of the income and gains of the trustees during the year.

Operating PAYE

PAYE and NICs are paid by the employer by the 19th of each month 2 in relation to all benefit arising up to and including the 5th of that month. Any PAYE payable by the employee in respect of a share scheme benefit must either be recovered from taxable salary in the relevant month or refunded to the employer by the employee within 90 days, otherwise the amount will be treated as a benefit in kind and itself subject to further taxation which cannot later be recovered. The employer also has the ability to withhold the relevant employee national insurance contributions ("NICs") from the employee's pay in each pay period in the relevant tax year and in the tax year following, without limit on the amount of deduction in each month.

PAYE and NICs will normally be operated by the company through its payroll procedures.3 Where the benefit has resulted from action by the trustees of an employee trust they can appoint the company as their agent for the purposes of paying the PAYE and employee NICs (if applicable). If this is not practicable the trustees can establish their own PAYE scheme with the relevant district of HM Revenue & Customs and make payments directly. However, they cannot pay secondary (employer) NICs on benefits provided to employees since a properly drafted trust deed will prevent the trustees from making payments which would directly benefit the company. In practice, trusts normally do not distribute benefits without consulting the sponsoring company.

If an employee leaves, the company will operate PAYE at only the basic rate since it will not have knowledge of any subsequent earnings. Any higher rate tax should then be collected via self assessment.

Paying dividends

Where dividends are paid on shares held in trust for employees under a Share Incentive Plan, and there is no re-investment within the scheme ("Dividend Shares"), a form R185 is issued showing the tax credit payable and the gross and net dividend.4 The dividends pass through the hands of the trustees to the beneficiaries as if the shares were held personally and the tax effects are identical.

Trustees of a discretionary trust cannot pass through dividends in this way. They may, however, pay out dividends received by them in the form of taxable discretionary payments. It may be possible to avoid double taxation by making a claim under extra-statutory concession A68. Payments to beneficiaries should be accompanied by a form R185 (trust income).

As a matter of good practice, the trustees should produce each year a set of trust accounts, including a statement of settlements, income and assets.

Accounting requirements

In recent years the accounting standards authorities, in particular the International Accounting Standards Board and the UK Accounting Standards Board, have issued a range of regulations concerning the treatment of employee share schemes. Some of these regulations have been controversial and serious questions have been raised over whether they are helpful or correct. There is also concern about the additional burden that these regulations place on business, especially smaller companies, and that the regulators themselves appear to have little accountability.

Expensing share awards

Where incentives are provided to employees in the form of shares or the rights over shares, the cost is borne by the shareholders in the form of dilution of their equity interests. There is no cost to the company unless company funds are used to repurchase the shares. Despite this the International Accounting Standards Board has adopted a standard which requires companies to expense the cost of share incentives to profit and loss account over the period of time that the benefits "vest" (accrue to the employees). The UK Accounting Standards Board has introduced a virtually identical standard, FRS 20.

FRS 20 applies retrospectively to share incentives issued after 7th November 2002 except if the incentives had already vested by the effective dates.5 It applies to grants of share rights to employees by existing shareholders, including discretionary employee trusts, as well as directly by companies.6 However companies adopting the Financial Reporting Standard for Smaller Entities need not adopt FRS20 and can opt for a simpler reporting basis.

A share option will have a positive value if the exercise price is less than the fair value of the underlying share. An option may also have a positive value if the exercise price is equal to or more than the fair value of the share. This is because an option is a right but not an obligation to purchase. It can therefore never have a negative value. In almost every case there will be some chance, however small, that the value of the underlying share will rise above the exercise price of the option, and thus the option will have a positive value.

Tax relief is available in the UK for the cost of share incentives when the benefits are released to employees through a statutory share scheme or where the benefits are subject to income tax and national insurance contributions. However, if the amount subject to tax relief exceeds the estimate for accounting purposes, companies adopting International Accounting Standards 7 may report only the lower figure.

A variety of techniques exist for estimating the value of share options. These comprise mathematical solutions, principally the Black-Scholes-Merton method, and a variety of simulation methods including the binomial lattice, trinomial lattice and Monte Carlo models. The standard does not specify the method to be used but makes clear that it regards the Black-Scholes-Merton model as insufficiently flexible in many cases.8

The most popular simulation method is the binomial lattice. This requires the construction of a branching tree of possible up and down movements in the value of the underlying share, with probabilities attached to each. This is the simplest simulation model but even so it is elaborate, theoretically complex and beyond the means of smaller companies. A company's auditors are not able to undertake the valuation procedure since this is deemed to be incompatible with the auditor's impartiality. Fortunately tools now exist which allow companies to prepare independent estimates of their option expense at reasonable cost.

The standard requires that an option pricing model will take account of at least the following inputs:

exercise price of the option
current market price of the underlying share
expected volatility of the share price
dividends expected to be paid on the shares
risk free rate of interest
the length of time over which the option will vest (become capable of exercise)

For unquoted companies, the main difficulty arises in relation to volatility, since there is no history of quoted share prices on which such an estimate can be based. In these cases, FRS 20 calls on unquoted companies to use the volatility of share prices of comparable quoted companies, or to estimate a proxy for volatility by looking at the pattern of profits or changes in asset values. In supposedly rare cases where none of these methods can be used to give a reliable result (though the term "reliable" is undefined by the standard) the use of simple intrinsic value is allowed, that is, valuation based on difference between the exercise price and the underlying share value. This value is revised periodically as the value of the share changes.

Vesting conditions

The value of the option will be affected if its vesting is subject to conditions. These can include non-market conditions, such as the completion of a period of service or the achievement of personal, departmental or company performance targets; and market-related conditions, such as the achievement of a target share price.

If the vesting of the option is likely to be subject to non-market conditions, the number of equity instruments (i.e. shares over which the option has been granted) which are to be expensed should be reduced to reflect the likelihood that these conditions may not be achieved in whole or in part. FRS 20 requires that this likelihood should be regularly adjusted in the light of actual vesting experience. In the case of a market-related condition the overall value of the award is reduced by the likelihood that not all the options (or other share benefits) will vest. The adjustment must be made in the option pricing model itself and no subsequent adjustments are permitted.

Controversially, FRS 20 requires that if share awards are renounced or cancelled they must still be expensed. For example, if employees stop saving and renounce their options in an SAYE Option Scheme, perhaps because the value of the shares has fallen, the whole value of the options as initially calculated, subject to any adjustment for failed non-market performance criteria, must still be expensed to profit and loss account. Indeed the charges will be accelerated because the expense is being spread across a shorter period. A survey of FTSE 500 Companies undertaken in 2005 indicated that 17 per cent. had ceased offering SAYE Option Schemes as a direct result of the new rules.

Companies that adopt the FRSSE ("Financial Reporting Standard for Smaller Entities") are not obliged to adopt FRS 20. Instead, they must simply report the main features of the award - the grant date(s), the exercise price(s) if applicable, the number of shares, the number of employees, and the nature and duration of any performance conditions.9 This treatment is available to companies who qualify under the small companies regime of the Companies Act 2006.

Small companies are those that can satisfy at least two of the following tests: turnover of not more than £6.5 million, a balance sheet total of not more than £3.26 million and employees of not more than 50.10 In the case of a group of companies, the maximum turnover and balance sheet figures are increased by 20 per cent., to £7.8 million and £3.9 million respectively, but these figures must be taken before elimination of intra-group transfers.11 Companies that qualify as small can also elect to be exempted from audit unless an audit is demanded by the holders of at least 10 per cent. of the nominal value of the issued share capital.12

The application of FRS 20 reduces reported profits which might be seen as a negative factor for quoted companies. However research in the US has suggested that companies who were "early adopters" of the equivalent US standard (FASB 123) did not experience a significant loss of stock market rating by comparison with those who did not adopt the standard, suggesting that investors were disregarding the effects of the standard. Unquoted companies, meanwhile, are less interested in accounting measures of profit than in cash flow, which is not affected by the standard.

If a company is unwilling to take a charge to profits in relation to a share incentive scheme, it may wish to consider a share purchase scheme such as an offer of Partnership Shares under a Share Incentive Plan or a deferred purchase plan. Since the shares are being acquired at fair value during the accounting year, there is nothing to expense.13

Shares held by employee trusts

In some cases, an employee share scheme is operated in conjunction with an employee trust. This is a requirement in the case of the Share Incentive Plan and an option for every other kind of employee scheme. The UK Accounting Standards Board has issued a requirement, known as UITF 38, which states that the consideration paid for shares purchased by a company-sponsored trust must be shown as a deduction against net assets.14 This does not mean, however, that there is a reduction in retained profits, since the deduction is made from share capital rather than retained profits.

However, the Companies Act 2006 provides that a distribution cannot be made if it would result in net assets falling below the sum of distributable reserves and paid up share capital. This means that in some cases UITF 38 will operate so as to reduce the level of distributions that a company can make.

The Companies Act also provides that a public limited company, whether quoted or unquoted, can provide finance for the purchase of its own shares only if net assets are not reduced (which they are, by virtue of UITF 38) or they are purchased from distributable profits. This may prevent some companies with a shortage of distributable profits from financing the purchase of the shares necessary for the operation of their employee share schemes. Note however that in a group of companies, the distributable profits in question are those of the company offering the share incentives, not the consolidated group. There may be an opportunity to generate distributable profits in the relevant group company by means of intra-group charges or dividend payments.

Quoted company reporting

In general terms, the interests of directors in the quoted 15 shares of their companies, and any changes in those interests, must be disclosed. From April 2008 the regulations governing the contents of annual financial reports are referenced by the Companies Act 2006.

The annual report must contain a statement of the company's remuneration policy. In relation to awards of shares or options to employees, this must include:

a summary of the performance conditions relating to the grant or exercise of any share options or LTIPs (see Glossary), the reasons for the conditions and how they are to be assessed;
an explanation of any comparative performance figures to be used;
details and explanations of any changes to share option or LTIP entitlements;
justification of any share options or LTIPs which are not subject to performance;
justification of how directors' share awards compare with other awards within the company or group;
the number of directors making gains from share options or LTIPs during the course of the year and the aggregate of gains made.

Additionally, the report must show, for each director:

the number of shares subject to option at the beginning of the year and at the end of the year, or date of cessation if earlier, differentiated by share options with different terms and conditions;
the options granted during the year and those that were exercised, lapsed or the terms of which were altered;
for any option that was current during the year, the price paid (if any) for the option, the exercise price, the first exercise date and the date on which it lapses;
a description of any changes to share option conditions;
for any share option exercised during the year, the market price of the share at the date of exercise and the highest and lowest market price during the year.

The requirements for LTIPs are similar except that these are referred to as "scheme interests". The market value of the shares at the date of award of an LTIP must also be shown.

Where in the opinion of the directors the forgoing disclosures would result in a report of "excessive length" there are provisions for certain of the information to be aggregated, except that information must be shown separately for "underwater options" and options the terms of which have been varied.

Companies employing more than 250 people in the UK must state what action has been taken during the financial year to:

provide employees with information on matters of concern to them;
consult employees or their representatives on key developments;
encourage the involvement of employees through an employees' share scheme or some other means;
encourage employee awareness of the financial and economic factors affecting company performance.

The UK Listing Rules require Remuneration Committees to indicate how they have applied the Principles of Good Governance and Code of Best Practice (the "Combined Code") in considering the merits of directors' share incentives versus other types of incentive, especially LTIPs (see Glossary). Remuneration Committees are asked to confirm that directors' rewards, including share rewards, are not excessive and that they form part of an integrated reward structure.

Transactions in shares must also be disclosed under rules published by The Financial Services Authority. These relate to transactions in quoted company shares undertaken by "PDMRs" (persons discharging managerial responsibilities). These rules, known as the Disclosure and Transparency Rules, extend to companies quoted on the London Stock Exchange, the AIM and PLUS markets in the UK and many European markets. Transactions by PDMRs to be disclosed include any acquisitions or disposals of shares in the relevant company, any acceptance of share awards, and any grant or exercise of options. Transactions must be disclosed within four business days to the company and within five business days to the information services of the stock exchange(s) on which the company is quoted.16

These regulations extend also to persons "connected" to a PDMR. Connected persons include spouse, civil partner, and child or step-child, but not other relatives unless they have been part of the same household for 12 months. Other connected parties include companies in which the PDMR has an equity stake of 20 per cent. or more, companies where the PDMR otherwise has a high degree of control, or the trustees of a trust of which the PDMR is an actual or potential beneficiary. The responsibility for disclosure rests with the connected person, not the PDMR. This seems likely to give rise to situations where transactions, undertaken innocently by parties who are unaware they are connected to a PDMR, will be penalised.

The Listing Rules and Model Code on Directors' Dealings, also published by the FSA, require that all directors' interests in their companies' shares must be reported in the annual accounts. Any subsequent changes over a period ending not later than one month before the annual general meeting must also be disclosed. Again, these requirements extend to connected persons. The Companies Act used to impose a similar requirement on companies generally, including unquoted companies, but this has now been withdrawn. Nevertheless an annual return of shareholding information must still be made to Companies House by all companies.

The FSA disclosure requirements are complex and professional advice should be sought.
Scheme registers

Efficient scheme administration requires the maintenance of a proper scheme register. In the case of a Share Incentive Plan, for example, this register will contain:

a copy of the scheme rules and trust deed and, for reference, all documents issued to employees;
a register of scheme participants at each appropriation date, their respective share entitlements and a cumulative record;
where partnership shares are being offered, a record of contributions (normally monthly);
a record of dividends, if any, paid on the shares;
personal details of the recipients, including dates of birth, national insurance numbers and the dates of starting and leaving employment;
copies of signed application forms;
at scheme maturity, records of share transfers to the participants.

Scheme administrators should ensure that they have appropriate permissions from scheme participants to store and process personal information, in accordance with the Data Protection Act 1998. The necessary wording can be incorporated in the scheme documentation signed by participants.

Communicating with employees

Following the introduction of the Electronic Communications Act 2000, HM Revenue & Customs accepts that communications to employees can validly be delivered by electronic means such as email or internet. For the all-employee schemes, namely the Share Incentive Plan and SAYE Option Scheme, there must be a back up paper system in case some employees do not have internet access. It is also acceptable for employees to apply for scheme benefits by electronic means, including text message. There are no specific rules about how electronic applications can be validated. It is the responsibility of the sponsoring Company to take reasonable steps to ensure that employee applications to participate in share scheme, or exercise share scheme rights, are validly made and properly recorded. This is normally done by asking employees to supply unique identification such as National Insurance Numbers and dates of birth.

An employee includes anyone with a contract of employment or, broadly, one who supplies services to the company and would be an employee if it were not for the existence of an intermediary such as a service company. Directors and office holders are usually treated as employees for tax purposes even if there is no contract of employment.»
Extended to the 22nd for electronic payments.»
The responsibility of the employer to account for PAYE includes situations where taxable benefits accrue to former employees.»
A form R185 will however be needed if Dividend Shares are withdrawn and sold within three years of being placed in trust.»
The standard is effective for accounting periods beginning on or after 1st January 2005 (listed companies) and 1st January 2006 (unlisted companies)»
All unvested cash-based equity incentives are included irrespective of their offer dates.»
Mandatory for UK listed companies in relation accounting periods beginning on or after 1st January 2005 and for other companies, for accounting periods beginning on or after 1st January 2006.»
Black-Scholes-Merton was developed for estimating the values of traded options, which are dissimilar in several ways to employee share options; for example, a traded option normally has a single exercise date whereas an employee option may be exercisable over a period of time.»
Cash settled share based benefits must still be expensed to the profit and loss account, irrespective of the size of company.»
Companies cannot qualify for the small companies regime if they are a public company (PLC), carry on certain regulated financial activities such as banking, insurance or investment management, or have a shareholder who is a PLC or quoted on a recognised foreign exchange.»
The single company and group limits are those applicable from 6th April 2008.»
If the tests cease to be satisfied they are deemed to be satisfied for one more year. If they are again satisfied in the following year, the tests are deemed to have been satisfied without interruption.»
A charge could still result if shares were acquired at the end of an accumulation period, depending on how the share price moved during that period.»
This is distinct from the treatment of other assets held by company sponsored trusts. The sponsoring company is deemed to have control of these assets, even if held by independent trustees, and they therefore appear as assets on the balance sheet of the sponsoring company.»
For this purpose, "quoted" means listed on the London Stock Exchange or quoted on AIM, except for those firms who qualify as small.»
PDMRs are also restricted as to when they can deal in their company's securities.»