Share purchase by employees

When an employee purchases shares in his or her employer at fair market value, and enjoys no other special advantage, then the employee is an arm’s length investor and the capital gains tax regime should apply. The advantages of this regime are that business asset taper relief will normally be available. This reduces the proportion of gains subject to tax by 75 per cent. after two years, thus creating an effective tax rate of 10 per cent. Tax will be further reduced by the personal CGT allowance (see pages 30 and 32). Finally, no national insurance contributions (NICs) will be payable by employer or employee on the gains.

The difficulty arises in providing the finance for the acquisition of the shares. The employee could do so out of taxed income, or the employer could pay a bonus to finance the share purchase which would itself be subject to income tax and NICs. Neither of these scenarios is attractive.

One solution is to create a class of share which is subject to heavy restrictions at the outset, and so of little value. As the company prospers the value of these shares will hopefully rise rapidly. However if the shares are restricted by comparison with other shares of the same class, some of these gains will be subject to income tax. Alternatively, if restrictions are lifted or other actions taken to enhance the value of the shares following acquisition, the resulting increase will normally be subject to income tax. 

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

The Approved SAYE Option Scheme

Under this arrangement, an employee contracts to save a given amount of money (not more than £250 per month or £3,000 per year) over 3, 5 or (exceptionally) 7 years. This is deducted from salary at source and paid into a bank or building society. The employee is also granted options to acquire a fixed number of shares at a fixed price at the end of the savings contract. On completion of the savings term the employee receives a tax-free lump sum in lieu of interest, equal to a certain number of monthly contributions. This provides a pre-determined capital sum that can be used, if the employee chooses, to exercise the share options. If the value of the shares has increased the employee has made a potential profit, which will be realised on sale of the shares acquired. 

The tax free savings bonus is available to all employees who complete their savings contracts, irrespective of whether they exercise their options. The rates as at September 2006 are shown below. These change periodically in line with changing interest rates.

Savings contract

Bonus – number of monthly payments

Effective

 interest rate

3 year

1.8

3.19 per cent.

5 year

5.5

3.46 per cent.

7 year

10.3

3.52 per cent.

A key feature of the Approved SAYE Option Scheme is that, once the saving contract is complete, employees may ask for a refund of contributions (plus tax-free bonus) instead of exercising the option. This means that during the life of the savings contract the employee is not exposed to any risk, even if the value of the shares falls below the exercise price. Employees can also withdraw their contributions before the end of the savings contract, in which case they will receive a tax-free “early closure” rate of 2.0 per cent.

The exercise price (the price paid to purchase the shares at the end of the savings contract) may be set at a discount of up to 20 per cent. below fair value at the date the contract starts. This gain will also be subject to CGT not income tax. However accounting standards now require the value of any discount to be included in the estimate of option value to be expensed against profit and loss account, and this is causing some employers to reduce or eliminate discounts from new SAYE awards.

Tax treatment

No tax or national insurance contributions are payable by the employee or employer on the grant of an option under an Approved SAYE Option Scheme or on its exercise, providing the exercise is within the rules. On sale of the shares acquired, any gains are subject to capital gains tax and not to income tax or national insurance contributions. However business asset taper relief is available only for the period after option exercise (unlike the Enterprise Management Incentive – see page 57). 

Approved SAYE Share Option Scheme: Summary

The tax advantages of the scheme are therefore that no employer or employee NICs are payable on the benefit, and that taxable capital gains can be reduced by the personal capital gains tax exemption (£8,700 in 2006/2007). As explained on page 32, it may be possible to pool the unutilised personal tax exemptions of a husband and wife and the exemptions can also be spread over two or more tax years.

If an employee leaves employment of the scheme organiser or any associated company[55] before his or her share option matures, the option will normally lapse. The ex-employee can then choose to withdraw the savings up to that point. A small amount of interest may be payable, depending on the number of contributions made and the policy of the savings carrier. Alternatively, the ex-employee can continue the savings contract until maturity. If however the reason for leaving is an involuntary or “good reason”, specifically injury, disability, redundancy (as defined in the Employment Rights Act 1996) or retirement on reaching a specified retirement age, the individual may exercise within six months of the event to the extent possible from the accumulated savings at that time. No tax will be payable on exercise and capital gains tax will be payable only on the eventual sale of the shares acquired. If the company is taken over and the rules permit the option to be exercised, any gains are subject to income tax. The rules may also permit the option to be rolled over into an equivalent option in the acquiring company. If this occurs the option continues to run as before and the normal rules will apply to exercise of the option after the end of the savings period.

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

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

If an employee is involuntarily transferred to another employer (perhaps as a result of a sale of part of the business) the rules can (but are not obliged to) provide that the option can be exercised within six months.

Eligibility

There are no restrictions on the activities of companies that may offer SAYE options. However there are requirements in terms of the status of the company and its share capital. The shares must be ordinary shares (see Glossary), fully paid up and not redeemable. The shares used must those 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.[56]. 

Where there is more than one class of share capital, the majority of the class used for an SAYE scheme must be owned (broadly speaking) by persons who did not acquire them by virtue of being directors or employees.[57] The shares must not be subject to restrictions by comparison with other shares of the same class, except that they can be non-voting and/or subject to a requirement that if the holder is an employee, and leaves employment, they must be offered for sale on the same terms as those applicable to other holders of that class. 

All employees with more than five years’ service must be invited to participate and employers can make this qualification period shorter if they wish. Employees must be allowed to save on “similar terms”, that is, their entitlement to save may be varied only in relation to length of service and salary or “similar factors” (such as hours worked). In a group of companies, individual subsidiaries can be included or excluded at the discretion of management, or can run their own schemes subject to their own rules, provided that the overall effect is not to provide an advantage to directors or higher paid employees, taking the group as a whole. 

If the company is a close company (see Glossary) 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 directly or with one or more “associates” (see Glossary). This would include shares over which options are being granted pursuant to the scheme.

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

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

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

Costs

There is no reason in principle why small private companies should not operate an Approved SAYE Option Scheme. However only certain types of financial institutions may operate the savings contracts. These are, broadly speaking, banks, building societies and European Authorised Institutions.[58] The charges made by savings carriers have increased substantially in recent years and may exceed £5,000 even for a small plan of less than 50 employees, and where the savings carrier offers little or no administration. 

As an alternative, a company could establish its own savings scheme into which employees would make voluntary deductions. The rules could be set as the company wished, and over whatever timescale seemed appropriate. Participants could also be issued with options, perhaps under the Enterprise Management Incentive, which would be exercisable from the proceeds of the savings contract. As with an Approved SAYE Option Scheme, employees could request a return of contributions at any time.

Deferred Purchase Plan

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

The balance of the purchase price is treated for tax purposes as a notional loan, and, assuming that the “loan” is interest free, the employee will pay tax on the notional interest that would have been paid if the loan had been on commercial terms.[59] If there is no other benefit to the employee,[60] any gains on eventual sale should be subject to capital gains tax, instead of income tax and NICs (where applicable). It should be remembered in this context that companies may not make loans to directors.[61] To avoid this difficulty the transaction can be structured as a partly paid share subject to call. Alternatively the purchase can be arranged through an employee benefit trust preferably with independent trustees.

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

If the company is close then it must pay a special corporation tax charge of 25 per cent. of any loan advanced to a shareholder or “participator” (see Glossary).[62] This should not apply if existing shares in the employing company are sold to the employee by another group company or other existing shareholder, such as an employee trust. Otherwise, care is needed to ensure that the transaction does not create a debt obligation on the employee but does result in a transfer of beneficial ownership.

A deferred purchase scheme is a route worth considering if the company is at an early stage of growth and a specific exit is planned. The employee will not have to pay the full amount for the shares until they have become worth (hopefully) considerably more, at which point the tax on the increase in value will be reduced by business asset taper relief.

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

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

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

[55] A company is associated with another if either controls the other if they are both controlled by the same person(s). The definition of control is that provided by section 416(2) ICTA 1988. For further details see footnote 49 on page 45. 

[56] The definition of control is provided by section 840 ICTA 1988 (for further details see footnote 49 on page 45)

[57] This rule does not apply in respect of shares acquired through a public offer. It also does not apply if the majority of the class is owned by directors and/or employees who are able to control the company. 

[58] A firm located in the European Economic Area which has permission under the Financial Services and Markets Act 2000 to accept deposits.

[59] Loans of up to £5,000 are disregarded but tax on notional interest is payable in respect of the whole amount of loans of more than £5,000.

[60] If for example the total price to be paid (including the deferred element) is less than fair value at the date of acquisition, income tax will be due on the whole of the discount with respect to the initial date of acquisition.

[61] Loans of up to £5,000 are exempt as are certain credit transactions.

[62] The tax, sometimes referred to as quasi-ACT, is to discourage companies from paying salaries in the form of perpetual loans. It is refunded when the loan is repaid. See also page 77 in relation to employee trusts.