Administering a share plan

Reporting requirements

Annual returns of information must be filed for all share schemes whether statutory or non-statutory schemes. There are specific types of form for each type of statutory scheme and these can be downloaded from the website of HM Revenue & Customs (www.hmrc.gov.uk). 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.

Any other issue of securities or an interest in securities (such as a share option) to an employee[118] other than by means of a statutory scheme must be also be reported (on a form 42), even if no taxable benefit arises at the point of acquisition. In addition, 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 form 42 should also be completed if options are issued under an EMI scheme over shares worth more than the £100,000 statutory limit.

A form 42 must be completed in relation to all securities or rights over securities issued to or held by owner-directors. All such securities or rights are deemed to be employment related, irrespective of whether the holder has really acquired them in his or her capacity as founder or entrepreneur. 

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 are chargeable in respect of each failure to submit the necessary form. Once the initial penalty has been imposed HM Revenue & Customs can seek permission to impose additional penalties for each day that the omission remains uncorrected.

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 the Revenue will not accept this request unless they are provided with a Board resolution terminating the scheme.

Self-assessment

If employee share benefits are subject to PAYE this is normally dealt with via payroll and many participants in employee share schemes do not normally 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. Employees have a duty to report their liability to tax even if they do not normally receive a self-assessment tax return. Employees are asked to fill in the Share Scheme pages of the return in the circumstances listed below:

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 exempt amount (£8,800 for the tax year 2006/07) 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. However if the income of a trust in any one year is less than £500 and the tax liability is fully covered by tax deducted at source (for example on bank interest) or by a non-payable tax credit (for example on UK dividends) the trustees will not normally be required to complete a return. However they must still do so if required by HM Revenue & Customs, or if there is a capital loss or a discretionary payment is made to a beneficiary the tax credit on which is not covered by the tax pool.[119]

Company law disclosures

The Companies Act 1985 requires companies to keep a register of the interests (including options and other rights) held by each director in the company’s share capital, including rights held by directors as beneficiaries of employee trusts. Directors are required by law to inform companies of any changes in their interests. The company must report directors’ interests as part of its annual accounts submitted to Companies House. 

The Companies Act also requires companies with more than 250 employees to disclose how they have informed and consulted their employees and encouraged their involvement in the company by means of employee share schemes or other methods. Companies must report aggregate details of any employee share scheme in their accounts (in addition to directors’ interests).

Listed companies and those quoted on AIM are additionally required to show in their annual accounts:

The Remuneration Report Regulations 2002 imposed additional requirements on UK companies which are listed in the UK, any other EU state, or on the New York Stock Exchange or NASDAQ. It may be helpful to summarise the requirements though not all are relevant to employee share schemes. The report must include:

There is a personal requirement on directors to disclose any information relevant to this report, which must be voted on by shareholders. However, failure to obtain shareholder approval will not make any past or future payments to directors unlawful.

The UK Listing Rules also require Remuneration Committees to indicate how they have applied the Principles of Good Governance and Code of Best Practice (the “Combined Code”)[120] in considering the merits of directors’ share incentives versus other types of incentive, especially LTIPs (see Glossary). Remuneration Committees are also asked to confirm that directors’ rewards (including share rewards) are not excessive and that they form part of an integrated reward structure.

Scheme registers

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

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.

PAYE and NICs

Where income tax arises on a share scheme benefit, it will be collected via PAYE if the shares are readily convertible assets (see Glossary). Otherwise it is collected after the end of the tax year on the basis of the benefits information supplied on the P11D form. This should be submitted by 6th July after each tax year end. 

PAYE and NICs are paid by the employer by the 19th of each month[121] 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 (irrecoverable) taxation. 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.[122] Where the benefit has resulted from action by the trustees of an employee trust they can appoint the company as its 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 at least consulting the sponsoring company.

Dividends

Where dividends are paid on shares held in trust for employees under an Approved Share Incentive Plan, a form R185 is issued showing the tax credit payable and the gross and net dividend. 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 sums received by them as dividends in the form of taxable discretionary payments. Double taxation can be prevented 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 Standard 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 regulation place on business, especially smaller companies, and the fact 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 options to profit and loss account over the expected life of the option. The UK Accounting Standards Board has introduced a virtually identical standard, FRS20.

FRS20 is effective in the UK for accounting periods commencing after January 1 2005 for listed companies and after January 1 2006 for unlisted companies (the “effective dates”). It applies retrospectively to all share incentives issued after 7th November 2002 except if the incentives had already vested by the effective dates.[123] It applies to grants of share rights to employees by existing shareholders (including discretionary employee trusts) as well as directly by companies.

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.

A variety of techniques exist for estimating the value of share options. These include the Black-Scholes-Merton method and the binomial lattice method. 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.[124] 

The binomial method requires the construction of a branching tree of possible future values, with probabilities attached to each. Such models are 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:

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, FRS20 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. Where none of these methods can be used to give a reliable result (though the term “reliable” is undefined by the standard) then in these rare cases 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. 

In the case of a non-market condition the overall value of the award is reduced by the likelihood that not all the options (or other share benefits) will vest. FRS20 requires that this likelihood should be regularly adjusted in the light of actual vesting experience. Option values should also be adjusted for the likelihood that any market-related conditions will be achieved. However in this case the adjustment must be made in the option pricing model itself and no subsequent adjustments are permitted. 

Controversially, FRS20 applies similar logic when share awards are renounced or cancelled. For example, if employees stop saving and renounce their options in an Approved SAYE Option Scheme, (perhaps because the value of the shares has fallen), the whole value of the options as initially calculated 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 Approved 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 FRS20. This applies to companies who can satisfy at least two of the following tests: turnover of not more than £5.6 million, a balance sheet total of not more than £2.8 million and employees of not more than 50. These companies are also exempt from audit. [125]

The application of this accounting standard 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 (FASB123) 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. Distributable profits are likewise unaffected.

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 Partnership Shares under an Approved 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. [126] 

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 Approved 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 value of shares purchased by a company-sponsored trust must be shown as a deduction against net assets[127]. This does not mean however that there is a reduction in distributable reserves, since the payment for the shares is regarded as a capital item and not a deduction from profits.

However, section 154 Companies Act 1985 provides that a public company (plc), 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 if they are purchased from distributable profits. This may prevent the company from financing the purchase of the shares necessary for the operation of its employee share scheme. Note however that in a group of companies, the distributable profits in question are those of the company itself, not the consolidated group. This may provide an opportunity to generate distributable profits in the parent by means of inter-group charges or dividend payments.

The Institute of Chartered Accountants[128] has suggested a technical solution, relying on the distinction between the meaning of “accounts” for the purpose of the Companies Act 1985 and “accounts” prepared for auditing purposes. Many practitioners are unconvinced by this argument. There has also been speculation that Companies adopting international standards will be able to sidestep the problem. 

[118] “employee” is not defined but is presumed to include anyone with a contract of employment or 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.

[119] The tax pool is the amount of tax that the trustees have paid or are deemed to have paid on their income, but excluding non-payable tax credits on dividends. See page 68 for further information on trust taxation.

[120] Published by the Financial Reporting Council, July 2003.

[121] Extended to the 22nd for electronic payments.

[122] The responsibility of the employer to account for PAYE includes situations where taxable benefits accrue to former employees.

[123] All unvested cash-based equity incentives are included irrespective of their offer dates.

[124] Black-Scholes-Merton was developed for estimating the values of traded options, which are dissimilar in several ways to employee share options.

[125] 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. The FRSSE cannot be used by PLCs or certain financial companies.

[126] A profit and loss 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.

[127] 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.

[128] Technical release 64/04 issued by the Institute of Chartered Accountants of England and Wales in December 2004.