Introduction

In recent years, the use of employee share schemes as part of company benefits packages has become commonplace. This results from a combination of factors:

• Share schemes help to align the interests of employees with those of the company. Despite periods of stock market volatility, large numbers of employees have made sizeable gains through employee share schemes and they are generally perceived by employees as an attractive benefit. Accordingly, they can be a powerful method for attracting, retaining and motivating employees.
• The offer of equity-based incentives through any of the schemes specifically regulated by HM Revenue & Customs can offer striking tax advantages to both employer and employee. 
• In private companies, employee share schemes can offer succession-planning opportunities. Retiring shareholders can transfer shares into the employee scheme(s) and in return receive cash proceeds, without involving outside investors. In some cases, the whole value of a company can be transferred in this way over time.

In the UK about 92 per cent. of listed UK companies now offer some form of employee share scheme, with a total of more than 3.5 million participants. Amongst smaller UK companies, there is currently a rapid growth in the use of share option schemes, due in part to the attractive tax incentives now on offer through the Enterprise Management Incentive.

In the US, the use of employee share schemes is even more widespread, to the point where some executives are now paid only in shares. Share schemes are also available in many other developed countries and are particularly popular in France, Canada and Australia.

Main types of employee share scheme

There are three ways in which employees can be provided with an interest in the shares of their employing company:

• Gift: employees are offered an outright gift of shares and the shares are normally held on the employee's behalf by an employee trust;
• Purchase: employees have the opportunity to purchase shares in their employer, perhaps on advantageous terms; or 
• Option: employees are given the option to buy shares in the future at a price or formula fixed at the date of grant (a share option).

Statutory and non-statutory schemes

In general, all benefits arising from employment are subject to income tax. However, successive UK governments have been keen to encourage employee share ownership because it is perceived to have positive effects on company performance. The result has been the introduction of a variety of schemes which offer substantial tax advantages. These are referred to in this Guide as "statutory schemes". However, to prevent large scale tax avoidance, statutory schemes are subject to detailed rules and restrictions.

Statutory schemes are available for each of the three broad types of arrangement identified above:

• Gift of shares: Under a Share Incentive Plan, employees receive appropriations 1 of shares which are held for them in a special employee trust. Favourable tax treatment is available if the shares are held in the trust for three years, and the value of the shares is free    of all taxes if the shares are held for at least five years. This is in line with the government's objective of encouraging employers to offer incentives linked to share price performance over the medium term and not as a short term substitute for taxable salary. With certain exceptions, the scheme must be offered to all employees.

• Purchase of shares: Employees may also receive the opportunity to purchase shares on advantageous terms, either through the Share Incentive Plan or the SAYE Option Scheme. The SAYE Option Scheme must also be offered to the workforce generally and the tax advantages accrue over the medium term.

• Share options: There are two other Government statutory share option schemes, the Enterprise Management Incentive ("EMI") and the CSOP Scheme. There is no tax on grant and generally no tax on exercise, although some income tax may be payable on an EMI option at exercise if the exercise price is less than fair value at the date of grant. Any gains realised on the eventual sale of the shares will be subject to capital gains tax, not income tax, and any capital gains tax may be reduced by the annual personal capital gains tax exemption. Employers can select the recipients of these options at their discretion.

Employers may also offer share incentives outside the government schemes. These are still regulated by the Taxes Acts but enjoy no statutory reliefs and accordingly they are referred to in the Guide as "non-statutory" schemes. They carry no specific tax advantages but may still offer opportunities for favourable tax planning and they also provide greater freedom in scheme design.

Non-employees

This Guide is concerned with equity incentives offered to employees. Office holders, such as non-executive directors, are generally treated in the same way as employees for tax purposes. However in some circumstances a company may wish to offer equity incentives to contractors or consultants who are not employees or office holders.

A person who provides services to a company may be deemed to be an employee for tax purposes even if there is no employment contract. This would apply if for example the person provides services through an intermediary, such as a service company, in such a way that if the intermediary did not exist the person would be in a relationship of employment with the company. Contractors supplied by agencies may also be regarded as employees for tax purposes. Where one or more individuals are employed by companies whose main purpose is to supply the services of those individuals to customers or clients (a "managed service company"), there is a potential for avoidance by paying such individuals partly in dividends, which carry no national insurance cost. Anti-avoidance legislation exists to prevent this.2

However in certain cases companies may offer share based incentives to individuals who are not employees and are not treated as such for tax purposes. In such cases the value of any gifted shares, or rights over shares, will be deemed part of the income of their trade or profession. The share option will not normally be taxable at grant or exercise and any gains on sale of the shares acquired will be subject to capital gains tax.

However the following issues should be considered:

• HMRC has in the past argued that the grant of share options to non-employees is an indication that they are, in fact, employees. This could have implications for their overall tax treatment.
• The economic value of a share option is normally greater than the difference, if any, between the value of the share at the date of grant and the price payable to acquire the share ("exercise price"). On grant of an option to a non-employee, HMRC may seek to tax this value. 
• To the extent that the value of an equity based incentive represents payment for services, HMRC may seek to recover VAT from the non-employee which generally would not be recoverable from the client since the "payment" to the non-employee would be deemed already to include the VAT unless, very unusually, the incentive documentation excluded it. 
• If the incentive involves providing the contractor or consultant with financial assistance to acquire shares in the company, this could be unlawful or create other problems. 
• An invitation to a non-employee to acquire securities could easily result in a criminal breach of the Financial Services and Market Act 2000, which exists to protect members of the public against certain types of investment promotion.

It is also possible to grant share options or other rights over shares to companies. Provided that there are no complicating factors, such as an attempt to conceal a relationship of employment, the company will pay corporation tax on any gains realised.

Effectiveness of schemes

Any company considering the introduction of an employee scheme will be keen to know if it is likely to be successful in meeting company objectives.

There is a great deal of anecdotal evidence to suggest a positive link between the introduction of employee share ownership and company performance. This has led to a broad consensus from all sides of industry that employee share incentive schemes contribute to improved company performance. For this reason, all UK governments since 1978 have offered substantial tax concessions to encourage employers to offer such schemes.

During the 1990s a firm known as Capital Strategies published an index of the stock market performance of 36 listed companies where employees, excluding directors, owned at least 10 per cent. of the company. Over a six year period to 1998 this index of companies outperformed the FTSE All-Share Index by more than 70 per cent. Research in the US has also shown that companies offering employee share schemes achieve superior share price performance.

Research by Professor Richard Freeman of Harvard and Michael Conyon, undertaken in 2001 across 300 UK companies and a five year time period, found significant productivity gains in companies that had introduced share schemes, as follows:

Evidence is also available from the share price movements of quoted companies. Statistics collated by the consultancy Equity Incentives Limited in the early 2000s indicated that over a short period, quoted companies offering employee share schemes had under-performed other quoted companies. This may have stemmed from the fact that employee share ownership is particularly widespread among companies in the IT, media and business support sectors, which experienced a strong downturn during these years due largely to the collapse of the "dot-com bubble". Over a three year or five year view, however, companies offering employee share schemes strongly outperformed the stock market averages.

The stock exchange group NYSE Euronext maintains an index of 38 listed European companies where at least 3% of the company's shares are owned by employees and more than 25 per cent. of employees are shareholders. Over a three year period to September 2007 it increased in value by almost 50 per cent. compared to a rise in the FTSEurofirst 100 index of 38 per cent.

In April 2004 HM Revenue & Customs published the results of a survey, undertaken by FDS International Ltd., of 91 companies which had adopted EMI share option schemes. The survey concluded that in certain sectors, such as information technology, biotechnology, advertising and film, equity based incentives are now regarded as a normal part of employee remuneration. The incentives were generally seen as a motivational tool to help retain and attract important staff, and in turn boost company performance.

In August 2007 a further study of productivity effects was published. This study, undertaken for HM Revenue & Customs by Oxera using data over a 10 year period, found that when turnover growth was used as a measure of productivity, companies in the manufacturing sector using employee share schemes showed increased productivity of 5 per cent. over the study period. In the financial intermediation sector the gain was 11 per cent. and in the electricity gas and water industries the gain was 24 per cent. However the report also concluded that use of tax advantaged schemes was not sufficient of itself to improve productivity. Higher productivity was more likely if, in addition to offering share incentives, the company was listed and/or offered other types of employee incentives.

A second study by Oxera, published at the same time, used gross value added rather than turnover as a measure of productivity. This study found a rise in productivity of 7.2 per cent. over the study period among companies using tax advantaged share schemes in the manufacturing sector, and 28.9 per cent. in the wholesale and retail sector. However, the report urged caution in relation to the last result and concluded again that tax advantaged schemes, on their own, were probably not sufficient to improve productivity.

A further study by Ipsos Mori in February 2008 found that a majority of firms offering EMI share options had found that their scheme had helped them to retain key workers, improve staff motivation and improve company performance. However EMI options were judged to less important in the recruitment of key staff members.

Articles and capital structure

The Companies Act contains a number of specific provisions for employee share schemes. For example, the directors can allot shares for employee schemes even if their general powers to allot, which must normally be renewed every five years, have lapsed. The Act also permits directors to allot shares directly for use in an employee scheme even if the normal procedure is that new shares must first be offered to existing shareholders.3

However, there are a number of other matters that should be checked, including the following:

• Does the memorandum of association include the provision of employee share incentives (and establishment of an employee trust, if one is to be used) as one of the objects of the Company?
• What rules if any should apply when an employee acquires shares and then leaves? Many companies require leavers to sell, but should this requirement apply also to founder shareholders? Should there be a distinction between good and bad leavers? What if no acceptable buyers for the shares can be found? 
• If employees acquire shares and the company subsequently receives a take-over offer, should the employees be compelled to accept the same terms as the majority ("drag-along rights")? Should employees have a corresponding right to be offered the same terms as the majority ("tag-along rights")? 
• If there are different classes of share, do the scheme shares have inferior rights? If so, they may be unsuitable for some statutory schemes. Differential share rights can also be imposed by shareholder agreements.

In addition the company may need to consider whether its capital structure is appropriate for an employee share scheme. In many private companies a capital reconstruction will be required to increase the number of shares in issue and reduce the fair value per share to a sensible level that can be used in an employee share scheme - usually between £1 and £10. There is also a presentational issue: employees may be more impressed by the grant of options over a larger number of shares of lower value than a smaller number of shares of higher value.

Where a company has very few issued shares, some or all of the following may be needed:

• an increase in the authorised capital of the company;
• a bonus issue of shares:4 this is a free issue of shares to existing shareholders, credited as fully paid, in proportion to their existing holdings; 
• if there are still insufficient shares, a subdivision of the existing shares into a greater number of shares of lower nominal value - for example, a 100 for 1 split of a £1 share produces 100 shares of 1p nominal value.

In other cases there may be sufficient share capital but of the wrong type or value and a consolidation and/or reconstruction may be needed. It may also be necessary to create a new class of share for the scheme; for example, a class of non-voting shares so that the scheme does not disturb the balance of voting control.

If a bonus issue of shares is made, the shares must be credited as fully paid and this requires the company to pay up their nominal value before issue. In most cases this should be done from distributable reserves,5 so if there are no such reserves a bonus issue may be impractical.

In theory any number of shares can be created through subdivision. However, the greater the number created the smaller the nominal value of each will become. Although there is no rule to prevent this, there is a perception in some quarters that shares with a very low par value of say 0.001p are somehow "second rate".

Alterations to the memorandum or articles of association, or to the share capital, will generally require a special resolution of the shareholders.

In quoted companies, alterations to the share capital are generally not needed and the Articles will normally provide the Directors with general powers to operate employee share schemes. However, companies listed on the London Stock Exchange and other major exchanges must normally obtain the permission of shareholders in general meeting for any employee share schemes which they propose to operate. These permissions are given by ordinary resolution. They can be general in nature, giving permissions over a number of years, and often include specific limits on the number of shares that can be issued for this purpose. In the UK these may be framed to take into account the guidelines issued by the Association of British Insurers ("ABI").

The ABI guidelines

Directors often ask for guidance on the proportion of share capital they should set aside for employee share schemes. There can be no clear answer to this since the proportion will depend on whether all employees, or only selected employees, are to participate; on the total cost of employee remuneration in relation to profits; and on the competitive position of the company. In very general terms it can be said that most companies that introduce schemes allocate somewhere between 5 and 15 per cent. of their share capital for this purpose. There are a considerable number of exceptions.

The Association of British Insurers, with the support of the National Association of Pension Funds, issues detailed guidelines in relation to the remuneration of employees and directors, including employee share-based awards.6 The ABI has around 440 institutional members which together manage more than £1 trillion of assets.

The principal objectives of the guidelines are to discourage company directors from voting themselves excessive rewards at the expense of institutional shareholders, and to ensure share based awards are linked to performance and properly monitored. At the same time, the guidelines encourage the acquisition of meaningful shareholdings by executive directors and senior executives.

The guidelines have no legal force but the ABI, through its Institutional Voting Information Service (IVIS), monitors the shareholder meetings of all listed companies and of other quoted companies by request. Proposed resolutions are examined for compliance with both the ABI guidelines and the Combined Code. IVIS produces reports, available by subscription, with different coloured headings to indicate the level of its approval. Blue indicates complete compliance, amber denotes a situation of apparent non-compliance which is under discussion, red is non-compliant and green denotes a situation which was or may have been non-compliant, but has now been resolved.

The guidelines were developed for listed companies as distinct from non-listed companies quoted on PLUS and/or AIM. Nevertheless all companies are encouraged to observe the guidelines "in the spirit of best practice". In practice, not all listed companies observe the guidelines and significant numbers of companies on the AIM and/or PLUS markets choose not to conform at all or to conform only in part. Quoted companies often choose to approach their institutional investors directly to seek support for their incentive arrangements. Some companies feel that if institutional shareholders are supportive, the ABI guidelines are of limited relevance.

The guidelines clearly cannot apply to private companies without institutional shareholders. Private companies planning to attract institutional investment through flotation should also not be concerned. This is because the company's shareholding structure, which may or may not include employee shareholders, will be a known fact at flotation and institutional investors will take their investment decisions accordingly.

The term "share-based awards" includes any arrangement, such as share appreciation rights, where the value of gains in share value is satisfied in cash instead of shares. Although not explicitly stated, it appears that the guidelines are not intended to cover the use of existing, as opposed to new, shares for the purposes of employee incentives.7

The guidelines can be summarised as follows:8

• Share-based incentives should not be made to those who are not employees or directors and should not be granted at a discount to market value.
• No more than 10 per cent. of share capital, including re-issued treasury shares may be used for share-based incentives in any 10 year rolling period, of which not more than 5 per cent. should be used for discretionary awards to individuals, as opposed to all-employee awards.9 However, the latter figure can be exceeded if the performance targets are particularly stretching, and small companies are allowed up to 10 per cent. as long as the total market value of all awards does not exceed £1 million, measured at the respective dates of grant.
• Companies should regularly review and report on the appropriateness and effectiveness of their share-based incentives and in particular explain why they are robust, demanding and linked to shareholder value. There should be disclosure of all relevant information including expected award values,10 costs, performance conditions, maximum and expected dilution, employee trust holdings, any exercises of discretion and, in relation to individual participants, the relationship of maximum and expected award values to base salaries.
• All new share-based incentives should be approved by shareholders as should any substantive changes including changes to limits or performance targets.
• The arrangements for providing the shares for incentive purposes must be prudent and appropriate and must be fully disclosed.
• If a share-based award is based on the achievement of performance conditions these should be measured over not less than three and not more than ten years and should be challenging in nature. Phased vesting is encouraged. Targets should be expressed in comparative terms, using a financial measure such as total shareholder return11 or earnings per share in relation to a representative peer group or other benchmark.
• Awards should not crystallise (or "vest") for less than median performance and if performance levels are later found to have been misstated, awards should be modified or withdrawn.
• Threshold vesting amounts should not be significant by comparison to the annual base salary of participants. Full vesting should require correspondingly tougher performance targets than partial vesting, and sliding scales are encouraged. Any award of additional or matching shares should be subject to performance conditions. A premium exercise price is not a substitute for performance conditions.
• Awards should be made only within a period of 42 days from the announcement of results, except for pre-determined appropriations under a Share Incentive Plan.12
• Once granted, share-based incentives should not be re-priced, or surrendered and substituted with awards on more favourable terms. If options have performance-based vesting conditions and there is a change of control or capital reconstructions, any vesting at that point should be linked to the performance achieved at the relevant date and not simply pro-rated on a time basis.
• Once set, performance conditions should not normally be altered although, if there is a company sale within the vesting period, equally robust performance measures can be substituted for a shorter period.
• To preserve their impartiality, Chairmen and non-executive directors should not participate in share plans geared to share price or corporate performance.
• Annual awards are encouraged since these are likely to provide smoother, more consistent incentives, with less risk of "underwater" share options.
• When awards of whole shares vest, including restricted shares and nil-cost options, the participant should receive a payment equal to the dividends that would have been received on the relevant shares over the vesting period. The number of shares initially awarded should be reduced by the expected value of these dividends.
• Recipients who leave employment voluntarily, prior to full vesting, should normally lose their share entitlements, but if a recipient dies or leaves for "good" reasons such as ill health, redundancy or retirement, it is acceptable for awards to vest in proportion to the performance to that date. Any vested rights should be exercised within 12 months of cessation or the end of the performance period, whichever is later.
• The shares of joint venture companies should not normally be used for share incentives. Shares in subsidiaries can be used only if:
• vesting is conditional on sale or flotation of the subsidiary; or
• at least 25 per cent. of the subsidiary is already separately listed and externally held; or 
• in the case of an overseas subsidiary, it is required by local legislation; or 
• the use of subsidiary shares is fully justified in relation to value creation.

In the last case, the incentive should be available only to full-time personnel. There should be full disclosure of the accounting treatment, the dilution effects, any conversion rights into the parent company shares and the estimated value and volatility of the shares in question, including the methods used and the identity of the valuer.

• Employee share ownership trusts should not warehouse shares in excess of the requirements of current incentive schemes. Shareholders' approval should be sought for any holding in excess of 5 per cent., and employee trusts should not vote unvested shares.

In supplementary correspondence the ABI has confirmed that reward policies should not be more generous than commercially necessary. Rewards for minimum levels of performance should not be significant in relation to salary but maximum potential rewards should not be so great that executives are tempted to take excessive risks.

Certain institutional investors also make their views known from time to time. For example, F&C Management publishes guidelines on corporate governance which include a section on equity remuneration. These guidelines broadly follow the ABI principles but are much less complex and also provide for greater commercial flexibility.

The Pre-Emption Group13 is another non-statutory organisation which publishes guidance ("Statement of Principles") on the disapplication of pre-emption rights and monitors and reports on how this guidance is applied. It is supported by the ABI, the National Association of Pension Funds and the Investment Management Association. The guidance is intended for listed companies only, not those quoted on other public markets.

The guidance distinguishes between "routine" and "non-routine" proposals to issue shares on a non pre-emptive basis. Shareholders should normally regard non pre-emptive issues as routine if they amount to less than 5 per cent. of share capital in any year, including issues of treasury shares and not more than 7.5 per cent. over any rolling three year period, not including issues of treasury shares. If the issue is not routine, management should be able to present a strong business case for it, including reference to the size and stage of development of the company. Management should demonstrate a strong record of governance and be able to explain what other financing options are available, the level of dilution of value and control for existing shareholders, how the non pre-emptive issue would be managed if shareholder approval was given and what contingency plans are in place should approval not be given.

The guidance suggests that securities issued on a non pre-emptive basis should be at a discount of not more than 5 per cent. to the prevailing market value.

Use of share schemes by unquoted companies

Although share schemes, both statutory and non-statutory, are widely used by UK quoted companies, the picture is very different in the unquoted sector. Only a small minority, probably fewer than 5 per cent, offer equity incentives to their staff.

For many unquoted companies their single biggest challenge is to attract and retain staff of good quality. They are often competing with larger companies with deeper pockets and perhaps a stronger "brand name" to offer. If these larger companies are also offering tax-efficient employee share schemes, the odds are stacked heavily against unquoted companies.

Why then do so many unquoted companies still not make use of equity incentives? There are several reasons, based mainly on misconceptions:

• Some private companies believe that they need quoted shares to operate an employee share scheme, and that employees are unlikely to be attracted or motivated by share certificates that cannot be exchanged for cash. In fact an external market for the shares is usually not required. Many private company incentives are focused on an eventual exit, such as a sale or flotation, when the value of the shares can be realised. Private companies can also arrange for employees to sell their shares for cash through an internal market in the company's shares, created and managed by the employer.
• Many smaller companies are unaware of the tax benefits of operating statutory employee share schemes. In addition to the potential income tax savings mentioned above, the employer may save substantial sums in employers' national insurance contributions. 
• Smaller companies may be concerned about the complexity of establishing employee schemes. It is true that some arrangements, especially those sponsored by HM Revenue & Customs, can be technically complex. However, a good specialist adviser will be able to deal with these issues. The real problem is that many smaller companies find it difficult to obtain the advice they need from a single source at a sensible cost.

Despite these issues the number of private companies offering employee share incentives continues to grow rapidly. This appetite does not appear to be diminished by periods of stock market volatility since, for private companies, stock market values are only indirectly relevant. The real issue for most private companies is how to create value in their own businesses.

For many private companies there is the prospect that one day they may float on a public stock exchange. Prior to flotation, the company's share structure should be as simple as possible. The owners should resist the temptation to create multiple classes of capital for employee share schemes, or if they do, there should be clear plans for simplification of the capital structure before the flotation takes place.14

If there is a possibility of a company sale, any share rights should ideally be exercisable before the acquisition is completed.

1. A Share Incentive Plan Trust, unlike a discretionary trust, holds shares for the benefit of named employees but this is subject to conditions set out in the trust deed, scheme rules and employee share agreements.»
2. These notes are a brief summary only. The legislation relating to employment status is complex and a full description is beyond the scope of this Guide. »
3. It is possible for the articles of association to disapply this exemption.»
4. Also known as a scrip issue or a capitalisation issue.»
5. Distributable reserves are, very broadly, the accumulated profits of the company. In a private company bonus shares can also be paid up from the proceeds of a fresh issue of shares or following a capital reconstruction sanctioned by the court.»
6. The Guidelines also address base pay, bonuses, pensions, contracts and severance pay but these aspects are not covered in this Guide.»
7. Treasury shares are explicitly within the guidelines. At the time of writing the position regarding existing shares other than Treasury shares is being reviewed. There is arguably a case for bringing gifts of securities within the guidelines but it is more difficult to see why shares offered for purchase at fair value should be included.»
8. This summary is not intended to be a replacement for the full text of the guidelines, a copy of which can be obtained from the Association of British Insurers, 51 Gresham Street, London, EC2V 7HQ, telephone 020 7600 3333.»
9. We understand that these limits refer to the amounts granted, less any amounts that become incapable of vesting.»
10. If changes to awards are recommended, the effect on expected award values should be disclosed and justified.»
11. The guidelines stipulate that shareholder return should calculated by reference to "short" periods at the beginning and end of the performance period.»
12. This is significantly more restrictive than the "close period" imposed by the London Stock Exchange Model Code for Directors' Dealings.»
13. The Pre-Emption Group, Financial Reporting Council, 5th Floor, Aldwych House, 71-91 Aldwych, London WC2B 4HN»
14. Employees are sometimes given a priority allocation when shares are offered to the public. If employees are also offered a discount on the price of the shares this will be taxable in the normal way. However the advantage of the priority allocation will not be subject to tax, provided that (i) those employees entitled to a priority allocation are entitled to it on similar terms, which can be varied according to length of service, remuneration or other such factors; (ii) those employees are not just the directors or those whose remuneration exceeds a particular level; and (iii) not more than 10 per cent. of the shares being offered are made available to employees (subject to certain exceptions if there is more than one share offer).»