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 (broadly) all employees to become shareholders in the business. 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 (see Glossary) the benefit will be subject to NICs as well.
In most cases, all-employee share ownership schemes are run within the rules of an Approved Share Incentive Plan (“SIP”) which offers considerable tax advantages but is also subject to detailed restrictions.
Awards
Under a SIP, each employee can receive an appropriation (gift in trust) 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 annum (or 10 per cent. of salary if less). The contributions are taken gross, that is, before deduction of income tax and NICs. Employees may accumulate these deductions over an “Accumulation Period” of up to 12 months. If they 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 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 already holds in the Plan, up to an annual limit of £1,500 (“Dividend Shares”).
Companies may choose to offer Free Shares only, or Partnership Shares only, or both; and if Partnership Shares are offered the company may choose whether or not to offer Matching Shares, and if so, in what proportions up to the 2 for 1 limit.
Tax treatment
All scheme shares other than Partnership Shares must normally be held in trust for a minimum “Holding Period” of three years. [46] After this time the employee can ask for them to be released. At this point tax and, if appropriate, employer and employee national insurance contributions (“NICs”) will be charged on the lower of their value at that time and their value when appropriated to the employee, except in the case of Dividend Shares which can be transferred free of all taxes at this time. Therefore after three years, all gains on scheme shares held in trust are tax-free.
When shares are removed from an Approved Share Incentive Plan and are deemed “readily convertible assets” (see Glossary) any taxable amounts will be subject to PAYE and NICs. Otherwise the amounts will be collected under P11D. Shares removed from trust will not be regarded as readily convertible if the only reason for doing so is that the trustees have offered to acquire shares for the purposes of the Plan. Any such arrangement (or “internal market”) must not have any non-Plan purpose, and the exemption will not apply to any subsequent income tax event in relation to the shares.
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 participants can decide to leave the shares in trust for as long as they wish, 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.
Employees can ask for a return of Partnership Shares at any time, including during the initial 3 year Holding Period. If withdrawn within three years, income tax and NICs (if the shares are readily convertible assets) 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. Otherwise the tax treatment is as described above for Free and Matching Shares.
If the employee leaves, any shares in the Plan (Free, Partnership, Matching or Dividend) must come out of the Plan but if he or she is a good leaver, there will be no tax or NICs to pay. A good leaver is an employee who is
required to leave as a result of illness, injury, disability, redundancy,[47] retirement or transfer of employment,[48] or who dies. Any money that has been saved towards the acquisition of Partnership Shares must however be repaid to the employee after deduction of income tax and NICs.
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 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 unlisted companies 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 an Approved Share Incentive Plan must be made on what is known as “similar terms” to all employees of the company, including part timers. This means that awards can be varied only in relation to certain permitted variables, specifically salary, length of service and hours worked.[49]
Participation can be subject to a qualifying period of service. This qualifying period cannot extend to more than 18 months or, in the case of Partnership Shares with an Accumulation Period, more than six months before the commencement of the Accumulation Period.
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 the Revenue 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. HM Revenue & Customs is arguably not qualified to make commercial judgements of this kind. In practice it has shown flexibility in applying these criteria but the uncertainty involved has discouraged some companies from making use of Method 2 performance criteria.
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.
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 and, to the extent this permits, 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 Plan shares.
In a take-over, each participant can direct the trustees to accept (or reject) an offer for his or her shares, whether in cash or securities. If the offer is in cash within the 3 year Holding Period, the value will be fully taxable. 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.[50] In this case no tax will crystallise on the exchange. The new securities will take the place of the old and will be treated for tax purposes as if they were the original securities.
Eligibility
The shares used must be ordinary shares (see Glossary) of the employer, or a company that controls the employer, and be in an independent company (that is, not controlled by another company) or the subsidiary of a listed company. The definition of control is the s 840 ICTA 1988 definition.[51] For further details see page 85. The shares must 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 an Approved 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.[52] 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 articles of association can require that an employee who acquires shares and subsequently leaves employment is required to sell them. However, the articles must also provide that all employee shareholders (including, for example, employed founder shareholders or senior management) must be bound in the same way and cannot sell on more favourable terms.
If the company is a close company no employee with a “material interest” is allowed to participate. Broadly speaking 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” (see Glossary). This would include shares already held in trust for the participant under the terms of the scheme, or any share options.
Partnership shares
The ability of employees to purchase Partnership Shares from gross income dramatically increases their buying power. A standard rate tax payer can purchase 49 per cent. more shares from gross salary than net salary; a higher rate tax payer, 69 per cent. more (2005/2006 rates).
Gross salary used to acquire Partnership shares can include cash bonuses but not the value of non-cash benefits.[53] The cash is held in a special trustee account and any interest must be paid to the employees.[54] 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 accordingly.
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. 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.
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 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 up front 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.
Matching Shares and Dividend Shares
Matching Shares can be awarded at a ratio of up to 2 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, performance conditions cannot be applied to the ratio.
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, or re-invested in the acquisition of further company shares (“Dividend Shares”). In this case, the gross dividends can be re-invested, that is, before deduction of income tax. 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.
Employer and trust tax treatment
The value of the shares appropriated to employees in trust, and the expenses of setting up the plan, are both 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 and reliefs previously given can be clawed back if approval is rescinded.
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 twelve month period a total of 10 per cent. or more of the share capital, then corporation tax relief on the entire value of these shares can be taken in the first tax year.
If the trustees acquire shares for a consideration less than the price at which they are appropriated, a capital gain arises in the hands of the trustees. However, if the shares are readily convertible assets (i.e. there are arrangements whereby the shares can be exchanged for cash – see Glossary), trustees of a Share Incentive Plan are protected against a charge to capital gains tax for two years from the date of acquisition. The existence of arrangements in a SIP whereby employees can sell back their shares to the trustees of the Plan 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. If the shares are not readily convertible assets, the period of exemption is extended to five years. The period is extended to 10 years 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.
[46] The company can specify a holding period of up to 5 years except for Dividend Shares.
[47] Within the meaning of the Employment Rights Act 1996.
[48] 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.
[49] 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 not multiplied together and (iii) the scheme does not provide an advantage to the higher paid.
[50] Including both qualifying and non-qualifying corporate bonds (the former are exempt from capital gains tax).
[51] The section 840 definition refers to control of a company’s affairs exercised by any means (either alone or with associates). This could be achieved by control of the Board even if there is no shareholding control. This definition is regarded as distinct from the definition of control contained in section 416 ICTA 1988 which refers specifically to rights over share capital or assets (although it also refers to control in the general sense).
[52] But not Partnership or Dividend Shares.
[53] Employees must be allowed to stop and start deductions but may not be permitted to make up missed contributions and, in the case of an Accumulation Period, the company can require that they restart not more than once in any such period.
[54] 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.