All-employee share ownership

All-employee share ownership schemes are used by companies who wish to reinforce commitment and loyalty across the workforce as a whole by inviting all or most of their employees to acquire shares in the company or its holding company. This is different to offering share options: a share ownership scheme provides immediate shareholder status whereas share options are merely rights to acquire shares in the future.

Occasionally, employers operate all-employee schemes by means of a straightforward gift to employees or the opportunity to purchase shares from taxed salary. However, if the shares are offered at less than full market value the benefit will be subject to income tax at the highest rate and if the shares are readily convertible assets the benefit will be subject to national insurance contributions ("NICs") as well.

In most cases, all-employee share ownership schemes are run within the rules of a Share Incentive Plan ("SIP") which offers considerable tax advantages but is also subject to detailed restrictions.

The Share Incentive Plan

Awards

Under a SIP, each employee can receive a gift in trust ("appropriation") of shares worth up to £3,000 in any tax year. These are known as "Free Shares". Employees can also purchase shares, known as "Partnership Shares", with contributions from salary of up to £1,500 per tax year or 10 per cent. of salary if less. The contributions are taken gross, that is, before deduction of income tax and NICs. If employees purchase Partnership Shares, the company can award additional free shares ("Matching Shares") at a ratio of up to 2 to 1. The maximum share value that can be acquired by an employee in these ways is therefore £7,500 per tax year, comprising Free Shares worth £3,000, Partnership Shares worth £1,500 and Matching Shares worth a further £3,000. Additionally, a participant can receive shares in lieu of cash dividends that he or she already holds in the SIP, up to a limit per tax year of £1,500 ("Dividend Shares").

Companies may choose to offer Free Shares only, or Partnership Shares only, or both; and if the company offers Partnership Shares it may choose whether or not also to offer Matching Shares, and if so, in what proportions up to the 2 for 1 limit.

Tax treatment

All SIP shares other than Partnership Shares must normally be held in trust for a minimum "holding period" of three years.1 After this time the employee can ask for them to be released. If at this point the shares have been held in trust for less than five years, then income tax and, where appropriate, NICs will be charged on the lower of their value at the time of release and their value when appropriated to the employee.2 Therefore after three years, all gains on SIP shares held in trust are tax-free.

An employee may elect to leave the shares in trust until five years have elapsed. After this period, the entire value of the shares, including their initial value, is free of all taxes and NICs. Indeed employees can decide to leave the shares in trust for as long as they wish (and as long as the trust continues) and during this time the value of the shares and any subsequent value will remain wholly free of all taxes. Employers may not charge participants for leaving their shares in trust.

In the case of Partnership Shares only, employees can ask for them to be released from trust at any time. If withdrawn within three years, income tax, together with NICs if applicable, will be levied on their market value at the time. This operates to claw back the tax that otherwise would have been paid on the gross income used to buy the shares; if the shares have fallen in value only some of the tax will be recovered. Otherwise the tax treatment is as described above for Free and Matching Shares.

Approved Share Incentive Plan: Summary

• Employers can appropriate shares ("Free Shares") worth up to £3,000 per tax year to each employee in trust.
• Employees may also purchase shares ("Partnership Shares") using up to £1,500 of income in any tax year, before deduction of tax and NICs. 
• An employer may offer up to two additional "Matching Shares" for every Partnership Share purchased. Employees may therefore acquire an interest in shares worth up to £7,500 per tax year (plus Dividend Shares). 
• The value of Free Shares offered can vary in relation to individual salary, length of service, hours worked and historical performance criteria. 
• Broadly, all employees paying UK income tax, including those that are resident but not ordinarily resident, with continuous service of 18 months or more (6 months for Partnership Shares with an accumulation period, must be allowed to participate. 
• Free and Matching Shares must normally be held in trust for 3 years. If then withdrawn the original value of the shares, or the current value if less, will be subject to income tax and NICs, if applicable, but any increase in value will be free of income tax and NICs. Early withdrawal for involuntary reasons will normally not trigger a tax charge. 
• Partnership Shares can be withdrawn at any time, but if within 3 years of purchase, tax and NICs will be due on their value at that time, or if within 5 years, on their original value or market value if less. 
• Employers can require that some or all of the Free and/or Matching Shares held by those leaving within 3 years will be forfeit. The company can also require that if Partnership Shares are withdrawn within that period, some or all of any Matching Shares will be forfeit. 
• Where shares are left in trust for 5 years or more, their whole value including any increase in value will be free of all taxes, including CGT. 
• Corporation tax relief is normally allowed on the value of the shares in the tax year that they are appropriated.

The nature of any tax charge will depend on whether the shares are deemed to be readily convertible assets - in broad terms, convertible into cash, but see Glossary. If so, any tax payable will be collected via PAYE and NICs will also be due. If not, the income tax is not payable until after the year end and no NICs will be due. Shares removed from trust will not be regarded as readily convertible if the only reason for doing so is that the trustees have established an "internal market" whereby they offer to re-acquire shares from employees who wish to sell them, and then recycle the shares for the benefit of other participants in the SIP.

This exemption will not apply to any subsequent income tax event in relation to the shares.

Whether or not the shares are deemed to be readily convertible assets, any Dividend Shares, if taxable, will be taxed on the same basis as actual dividends and are therefore not subject to PAYE or NICs.

If a participant leaves employment, any Free, Matching or Partnership shares are automatically withdrawn from the SIP trust. However, if he or she is a "good leaver", there will be no tax or NICs to pay however short the period the shares have been held. A good leaver in this context is an employee who is required to leave as a result of injury, disability, redundancy, retirement on or after the specified age3 or transfer of employment,4 or who dies. Dividend Shares will also come out of the SIP but, if taxable, will not be subject to NICs and any income tax due will be payable under self-assessment rather than PAYE.

On cessation of employment, any money that has been saved towards the acquisition of Partnership Shares, but not yet used to acquire shares, must be repaid to the employee after deduction of income tax and NICs.5

If the shares rise in value after they come out of trust, and are subsequently sold, the gains will normally subject to capital gains tax only, with the benefit of available reliefs.

Shares that have come out of trust 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.

The total value of shares awarded or purchased by employees each year under the SIP is at the employer's discretion, within the stated limits. The employer can stipulate that not more than a certain maximum number of Partnership Shares can be purchased in any period and scale back applications pro rata if demand is excessive. The level of award in one year need not set a precedent for awards, if any, in subsequent years and the rules can also be changed from one award to the next provided that they stay within the legislation. Some employers link the levels of total award to company performance, thus introducing an additional incentive.

In companies that are not quoted (see Glossary) the value of the shares in question must be agreed with HM Revenue & Customs before they are appropriated or purchased as the case may be.

"Similar terms"

Offers of Free Shares under a Share Incentive Plan must be made on what is known as "similar terms" to all UK employees of the company, including part timers.6 This means that awards can be varied only in relation to certain permitted variables, specifically salary,7 length of service and hours worked.8

Participation can be subject to a qualifying period of service. This qualifying period cannot extend to more than 18 months.9 Awards can also be related to "performance" i.e. some objective test such as sales, profits or on-time delivery, by one of two approved methods. These can be summarised as follows:

• Method 1: 20 per cent. of the shares must be awarded without reference to performance. The remainder of the award can be linked to performance but the highest number of shares so awarded may not exceed four times the highest number of shares awarded without reference to performance.
• Method 2: all the shares can be awarded by reference to performance, but approval of the scheme will be withheld or withdrawn unless HM Revenue & Customs is satisfied that each of the performance criteria used can "reasonably be viewed" as comparable, that is, equally capable of being achieved.

The second method, in particular, requires HM Revenue & Customs to make commercial judgments as to what performance targets are, or are not comparable; judgments which, arguably, it is not qualified to make. In practice it has shown flexibility in applying the criteria but the uncertainty involved has discouraged many companies from making use of Method 2.

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 no advantage accrues to directors or higher paid employees, taking the group as a whole.

Where employees are offered the opportunity to purchase Partnership Shares, the value of shares they are entitled to buy can be linked to a formula related to salary, subject of course to the overriding limit on the value of Partnership Shares that can be acquired of £1,500 in any tax year. The agreement can also specify that certain categories of income are not to be included in the formula. It is possible to set an upper limit on the total number of shares that will be available for purchase and, if the number applied for exceeds this figure, to scale back employee applications proportionately.

The SIP Trust

Free, Partnership and Matching Shares are held in a special trust, drawn up in accordance with the SIP legislation, which has legal ownership of the shares but holds them on behalf of specific employees.

Trustees must act in accordance with the legislation, the trust deed and, to the extent the legislation and the deed permit, the wishes of each employee. These wishes can be important when, for example, there is a rights issue or the company is sold. In the case of a rights issue the participants will normally ask the trustees to sell sufficient rights to allow them to subscribe for the balance of their entitlement; shares acquired with additional monies supplied by the participant cannot be treated as SIP shares.

In a take-over, each participant can direct the trustees as to whether to accept the offer in relation to his or her shares. If the trustees receive no instructions they will take no action. Assuming there is a general offer, and the acquiror accumulates at least 90 per cent. of the shares of the subject company, the acquiror will eventually be able to use provisions of the Companies Act to compel dissident participants to sell.10

In a situation where a shareholder vote is required, participants may also give instructions to the trustees.11 However, in the absence of instruction from one or more participants, and if the trust deed permits, the trustees may act as they see fit, taking account of the financial and non-financial interests of the participants. They may also take account of the long term interests of the company, and of considerations of a moral, ethical, environmental, local or social nature. If the deed does not contain this power of discretion, the shares must not be voted. Trustees may not vote shares which they hold but have not been appropriated.

If the trustees accept a cash offer for the shares they hold12 within the three year holding period, the proceeds will be taxable in the hands of the relevant employees at their highest income rates. However, the legislation allows for participants to exchange their shares for securities of almost any description in the acquiring company, including loan stock, whether or not such securities would normally qualify for use in a SIP.13 In this case no tax will crystallise on the exchange. The new securities will take the place of the old. They will continue to be subject to the rules of the SIP and will be treated for tax purposes and the rules of the SIP as if they were the original securities. However no further appropriations of the new securities may be made.

Eligibility

The shares used must be ordinary shares of the employer, or a company that has control of the employer. The company granting the option must be independent, that is, not controlled by another company, or the subsidiary of a listed company. The shares must also be fully paid up and not redeemable.

If a company's business consists "substantially" of supplying services to one or more persons who control that company, or to another company under common ownership, it may not operate a Share Incentive Plan.

The rights attaching to the shares used for the SIP must not be restricted by comparison to any other company shares, except that:

• The shares can be non-voting. This is helpful to private companies who are concerned about the balance of voting control.
• An employee who leaves within a period specified by the company of not more than three years can be required to forfeit Free or Matching Shares awarded to him or her unless the person is a "good leaver".14 This facility was introduced in response to industry concerns about the potential cost of recovering shares from employees who had not "stayed the course". The employer can also stipulate that if an employee withdraws Partnership Shares within three years of award, and is not a "good leaver", some or all of any Matching Shares can be forfeit.15 
• If the company wishes the articles of association can require that an employee who acquires shares and subsequently leaves employment is obliged to offer them for sale.16 In an unquoted company, this helps to prevent small shareholdings being retained by former employees who may then lose contact with the company. However, the articles must also provide that all holders of shares of the same class must be bound in the same way and cannot sell on more favourable terms.17 This may have negative implications for any employed founder shareholders.

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 either directly or with "associates". This would include shares already held in trust for the participant under the terms of the SIP, or any share options.

Partnership shares

Employees can purchase Partnership Shares from gross income before deduction of income tax or NICs and this substantially increases the number that can be purchased for any given sum. A standard rate tax payer can purchase 45 per cent. more shares from gross salary than net salary; a higher rate tax payer, 69 per cent. more (2008/09 tax rates).

Gross salary used to acquire Partnership Shares can include cash bonuses but not the value of non-cash benefits. The cash is held in a special trustee account and any interest must be paid to the employees.18 Until employee deductions are used to buy Partnership Shares, the employee can ask for them to be repaid at any time, subject to deduction of income tax and NICs.

An opportunity to acquire Partnership Shares must be offered on the same basis to all eligible employees. However, the company can set limits lower than the statutory maxima of £1,500 or 10 per cent. of salary. The company can also impose a total limit on the number of Partnership Shares available for purchase in any specific award and scale back employee purchases proportionately.

The purchase amounts can be deducted over a period specified by the trustees of up to 12 months (an "accumulation period") and are then applied by the trustees to acquiring shares.19 If there is an accumulation period, the employees can acquire shares at the lower of the prices at the start or the end of the period.20 For an unquoted company, the share "price" will be its value as agreed with HM Revenue & Customs. For quoted companies, the price will be determined according to a specific method laid down in the rules; this may be an average of the mid-market prices over the last three or five dealing days, or if acceptable to HM Revenue & Customs, the actual price paid.

In a quoted company, if the SIP rules provide for an average price formula, small differences can arise between the price actually paid for the shares and the value of the shares as set down in the rules. If too few shares have been acquired, the company will have to make good these shares from market purchases.

Accumulation periods are popular with unquoted companies, because they avoid the need to make monthly purchases of shares. They are less popular with quoted companies which acquire shares for the SIP on the open market. This is because, if the share price rises during the accumulation period, the employee deductions will be insufficient to finance the acquisition of the shares to which they are entitled, and the company will have to fund the difference, or issue the necessary new shares. Alternatively, if the trustees acquire the shares at the beginning of the accumulation period and they then fall in value, the trustees will have to purchase, or be allotted, more shares at the end of the period to satisfy the employees' entitlement.

If there is no accumulation period the amount of employee deductions can vary from month to month, as long as the total in any tax year does not exceed the statutory maximum. In fact, it may be advantageous to arrange the whole year's deductions in a single month since the proliferation of different prices in the scheme records can lead to administrative complexity.21 On the other hand, if shares are acquired month by month, the participant benefits from "pound cost averaging".22

If shares to be appropriated by the trustees as Partnership or Dividend Shares (see below) are acquired from existing shareholders, stamp duty is payable in the normal way. However a special relief prevents double duty when the shares are subsequently transferred to the participants.

Matching Shares and Dividend Shares

Matching Shares can be awarded at a ratio of up to two Matching Shares for every Partnership Share purchased. The ratio can be varied from time to time, but participants must be informed of any change before the relevant Partnership Shares are purchased. The ratio of Matching Shares to Partnership Shares in any one award must be the same for all participants, so that, for example, the ratio cannot vary from one subsidiary to another on the basis of performance conditions.

If dividends are paid, employees are entitled to receive them as if they were shareholders, even though the shares are still held by the trustees. Dividends may be received directly as cash. Alternatively, the cash dividends (before tax credit) can be re-invested without deduction of tax in the acquisition of further company shares ("Dividend Shares"). There is no requirement to disclose the details on the individual's tax return. However, amounts of dividend paid must be reasonable in all the circumstances. HM Revenue & Customs will penalise companies which seek to place "excess" dividends in the hands of employees, since this is regarded as avoidance of national insurance contributions.

Dividends received by the trustees on shares which have not yet been appropriated are free of tax as long as the relevant shares are appropriated within two years, or five years if the shares are not readily convertible assets - see below.

Employer and trust tax treatment

The value of the shares appropriated to employees in trust is available as a deduction against the employer's taxable profit. No deduction is available for the re-appropriation of shares that have returned to the trustees because of forfeiture.

Corporation tax relief is also available for the costs of establishing and running a Share Incentive Plan. Allowable costs include fees, including professional management fees, stamp duty, commission and any interest charged on amounts borrowed by the trustees to acquire shares.

Tax relief on the value of shares appropriated is normally allowed in the tax year during which appropriation takes place. However, if the trustees acquire during any 12 month period a total of 10 per cent. or more of the company's share capital, then corporation tax relief on the entire value of these shares can be taken in the first tax year, whether or not the shares are appropriated within the same tax year. This recognises the fact that it may take several years for the trustees to appropriate all the shares they have acquired. This benefit will wholly or partly unwind if 30 per cent. of the shares are not appropriated within five years, or all within ten years.

Tax reliefs given in respect of the establishment and operation of a Share Incentive Plan, including tax reliefs in relation to shares acquired by the trustees, can be clawed back if approval is rescinded.

If the trustees of a Share Incentive Plan acquire shares for a consideration less than the price at which they are appropriated, a capital gain arises in the hands of the trustees. If the shares are not readily convertible assets (i.e. there are no arrangements whereby the shares can be exchanged for cash), the trustees are protected against a charge to capital gains tax for five years from the date of acquisition. If on the other hand the shares are readily convertible assets, the period of exemption is reduced to two years. However if the trustees hold 10 per cent or more of the share capital of the company and have acquired this from one or more individual (non-corporate) shareholders over a period of not more than 12 months commencing on the date of the first acquisition, the trustees are sheltered from capital gains tax for 10 years.

The existence of arrangements in a SIP whereby employees can sell back their shares to the trustees of the SIP will not, of itself, cause the shares to be readily convertible assets as long as there are no other arrangements, for example with a second trust, whereby shares can be sold.

Before a Share Incentive Plan can be introduced, the scheme documents and ancillary papers must be submitted to HM Revenue & Customs for approval.

1. The company can specify a holding period of up to five years except for Dividend Shares, where the holding period must be three years.»
2. Except for Dividend Shares which can be transferred free of all taxes after three years.»
3. The favourable treatment accorded to retirees 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 2 of ITEPA.»
4. Transfer of employment is within the meaning of The Transfer of Undertakings (Protection of Employment) Regulations 2006; for example, where part of a business or a subsidiary is sold to another group and the employee is transferred with the business. Redundancy is defined in The Employment Rights Act 1996.»
5. If a Participant leaves employment at a point in the tax year when his or her salary deductions made in respect of that tax year are more than 10 per cent. of the salary earned prior to cessation, there will be a claw back of tax in relation to the excess deductions and a loss of the relevant proportion of Matching Shares, if any.»
6. Employers can choose whether or not to include employees who are UK resident but not ordinarily resident. Overseas employees can also be invited but will not enjoy the tax benefits.»
7. HM Revenue & Customs has sated that awards in relation to salary bands are acceptable as long as the bands are not wider than £5,000 although in practice it has sometimes shown flexibility on this point.»
8. It is acceptable to use a system whereby points are awarded for different factors provided that (i) the points are awarded in arithmetic (not geometric) progression in relation to each factor; (ii) points in relation to different factors are added, not multiplied together and (iii) the scheme does not provide an advantage to the higher paid.»
9. A qualifying period of service can also be imposed for Partnership Shares, being 18 months if there is only one deduction from salary during the year, or 6 months if there is an accumulation period (two or more deductions from salary, usually over a period of several months), irrespective of its length.»
10. If there is more than one class of share, the 90 per cent. threshold will apply to each class. »
11. No such obligations exist if the shares are non-voting.»
12. Or are required to accept in accordance with drag-along provisions (see Glossary), a Court Order or the operation of legal provisions in relation to the compulsory acquisition of minorities.»
13. Including both qualifying and non-qualifying corporate bonds.»
14. A participant cannot be obliged to forfeit Partnership or Dividend Shares.»
15. It is possible to vary the forfeiture period in relation to the reason for cessation, for example, one year for resignation but three years for dismissal with cause. The proportion of shares forfeited can also be varied by reference to the length of service within the maximum 3 year forfeiture period.»
16. This includes those who, not being such directors or employees, have acquired shares from individuals who themselves acquired shares as a result of being a director or employee.»
17. The "terms" include the method of sale and the consideration: the latter may be a fixed price or formula; more commonly however a fair value will be set by the auditors or some other expert in the circumstances of the time.»
18. In most cases the best approach is to ask the bank to set up a non-interest bearing account; the bank will be appreciative and the company is also saved needless administration.»
19. Employees must be allowed to stop and start deductions in an accumulation period but the company can require that they restart not more than once in any such period.»
20. The trustees have 30 days from the end of the accumulation period to acquire shares.»
21. In this case the 10 per cent. limit applies to the whole of the employee's earnings during the tax year. Difficulties may arise if an employee leaves before his earnings for the relevant tax year reach the level of 10 times the deduction(s) made. In these cases the excess shares may be clawed back by the trustees; otherwise they will be taxed as excess shares, i.e. shares passing to the employee other than through the Share Incentive Plan.»
22. A method of accumulating shares by investing fixed amounts at set intervals. The investor buys more shares when the price is low and fewer shares when the price is high; the overall cost is lower than it would be if a constant number of shares were bought at the set intervals.»