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Calling all non-executives!

Posted by Chris on April 17, 2012

Tax efficient approved share option schemes (including Enterprise Management Incentives and Company Share Options Plan) are great news if you are an employee. Such plans operate to place participants in the Capital Gains Tax (CGT) regime rather than in an income tax one, and reduced tax means greater reward. Non-Executive Directors (NEDs) are not normally employees, and therefore cannot benefit under such plans.  So what can be done for non-execs?

All too often, NEDs are awarded equity under an Unapproved Share Option Plan (USOP). Tasked with helping an executive board to navigate a safe course of passage for an entrepreneurial business, often for the whole journey from start-up, through fund-raising to commercial viability and ultimately to exit, it is not surprising that many non-execs are less than happy with the income tax charges associated with USOPs. Particularly when you consider that such inefficient incentive awards are probably not just in one company, but across the portfolio of businesses they mentor. So to all those NEDs out there holding or contemplating unapproved share options, we want you to know that there is a more tax efficient way to receive equity in the companies you advise.

Our solution is a Deferred Share Purchase Plan (DSPP), a bespoke RM2 design which has been very carefully constructed around the relevant legislation to ensure that gains are within the favourable CGT regime. Under the DSPP, the participant (an employee or non-employee) contracts to purchase shares at full market value but pays only a small initial deposit. Later, when the shares have hopefully increased in value, they can be sold (perhaps in a trade sale or flotation) and the participant can receive the profit, being the proceeds less the initial market value. This is not a prescribed government approved scheme and can therefore be designed flexibly. Performance and loyalty conditions can be built in, much like an option scheme.

But there is a downside. The participant has contracted to pay the full market value, and therefore if the company goes into liquidation the receiver could pursue the participant for the unpaid balance. This investment risk is the downside price paid to achieve the very significant upside potential gain in terms of tax treatment. If the plan can be set up at an early stage, then the risk can be mitigated as the underlying value of the Company should at this point be small. Indeed, this investment risk can actually be a desirable feature. With an option plan there is no investment risk and option holders can delay any financial commitment until they are sure of a profitable return. The DSPP aligns participants more closely with investors and founder shareholders and thereby acts as a real commitment filter. It can also help keep risk in check. Would the decision outcome be the same about a new commercial channel for the business and consequential deployment of precious seed capital if the decision influencers could lose money too, rather than just risk the funds contributed by others?

So, having established that the downside might actually not be so off-putting and could even be very appealing to the investor community, who might need to approve any such awards, the clear advantage of a DSPP over a USOP is the substantial tax saving potential.  For an additional rate tax payer, the tax difference could be between 28% CGT (if an equity stake of less than 5% was held) and 50% Income tax. If individual equity awards are made in excess of 5% of the voting share capital (fully diluted), then the potential for Entrepreneurs' Relief is also available meaning an effective rate of tax of just 10%. With corporate governance best practice dictating that any NED equity stake be small to ensure their independence, it is all the more important to ensure that what little is available is delivered to best effect.

If a NED's income falls within the bracket, that means the tapering of the personal allowance applies to generate an effective rate of tax of 60% then a potential 50%[1] tax saving is something we ought to be discussing!

We have encountered many situations over the years where unapproved options have been granted to NEDs and it is therefore unsurprising that their opinion of share schemes is often negative. However, cast off that jaundiced view and any green envy of the executive teams' tax favoured equity awards and explore whether a DSPP (or two!) is just what you have been looking for.

For more information on the DSPP, please download our fact sheet, or contact RM2 on 020 8949 5522 to discuss this plan in more detail.


1. Based on 2012/13 rates of income tax.