Shares for Rights – Whilst the media present this as a flop, we look on the bright side for the possible opportunities with Employee Shareholder Status
From 1st September 2013, it has been open to any company to invite any number of selected employees to enter into a written agreement whereby, in return for giving up certain employment rights, including the right not to be unfairly dismissed (subject to certain exceptions), the employer company, or its holding company, issues to the employee new fully-paid shares. This arrangement, the Employee Shareholder Status (ESS) has been the subject of several earlier blogs see:
We have covered much ground in our earlier blogs and therefore the purpose of this article is to look at the evolving landscape as further facets to this new initiative reveal themselves.
This week the Telegraph published an article claiming that the new ESS arrangements (colloquially dubbed “shares for rights”) were being widely shunned by businesses nationwide.
In addition to the challenges posed by the up-front income tax (and potentially NIC) charge on any awards above the £2,000 entry level award (which is the main reason this arrangement falls flat on its face for most) there are a couple of additional problems that we’ve identified.
Issue of new fully-paid shares – the problem for a public company
The shares may be issued pursuant to the directors’ residual authority to issue new shares (within the, typically, 5%, limit set by shareholders). However, the question arises as to how the shares can be issued as ‘fully-paid’ without the employee paying up the nominal value of the shares. Guidance issued by the Dept. for Business, Innovation & Skills (BIS) implies that public companies will need to seek shareholder approval to capitalise distributable reserves and apply them in payment-up of the par value of the new shares. This will, in most cases, be impracticable or commercially unacceptable to shareholders.
Some commentators are also of the view that the agreement to forego employment law rights can be taken by the issuing company to be ‘money’s worth’ so as to allow the company to issue the shares as fully-paid. This may be an answer for a private company, but as such consideration is not “cash”, a public company would be obliged to have the consideration (i.e. the giving-up of employment rights) independently valued (per s 593 et seq CA 2006). Again, this is likely to be impractical for most plcs.
Looking on the bright side, as we are aiming to do here, in the case of a group of companies, a practical solution exists as it is possible for the employer subsidiary to pay to the issuing company the nominal value of the shares, and, if the issuing company is a PLC, rely upon the exclusion from the general prohibition against ‘financial assistance’ where it is given for the purposes of an employees’ share scheme. If the assistance is given by a private subsidiary company it is not necessary for the additional test of ‘no reduction in net assets’ to be satisfied (per s 682(1) CA 2006).
England and Wales only
There is now much doubt cast on whether the ESS can be offer to employees of companies in Scotland and Ireland due to the devolved and separate employment law. We await further guidance on this matter.
Is this an opportunity worth offering?
The survey statistics say the arrangements are being widely shunned, the media and professional advisors declare it a flop and HMRC themselves admit that they have received only a small trickle of ESS share valuation applications so, just what is ESS good for?
Private equity backed companies: The arrangement was originally aimed at start-up companies and SMEs. In practice, it is likely to be of principal attraction to private-equity backed companies in which there exists the opportunity for substantial growth in value of restricted shares, and management job-security is not a principle concern to the senior employees. Such private-equity investment into businesses often carry terms that mean the private-equity house can take control of the company if management is deemed to be under-performing. Such terms often mean the company is not regarded as independent for the purposes of Enterprise Management Incentives (EMI). Where EMI is not available then ESS is definitely worth a look.
The question to then ask is whether the opportunity to benefit from tax-free capital gains on shares in the company, in exchange for the loss of the right to claim statutory compensation for unfair dismissal (etc.), is a benefit which is sufficiently attractive to justify seeking shareholder approval to offer the opportunity to employees, particularly having regard to the up-front cost of income tax and NICs on the value of the shares acquired above £2,000? Where the target exit value is very high and a cliff exit event (like a trade sale) is expected but current share value is low (or can be made low by clever use of share restrictions) then the answer to should we use ESS may well be yes!
Used instead of a nil cost EMI option or concurrent with an EMI award
Until now, the grant of EMI share options by those companies which qualify has been the obvious and most tax-efficient way of structuring management and employee participation. When acknowledging the existence of the new ESS arrangement companies and their advisors often consider the relative merits of these two distinct schemes and fail to realise that they can actually co-exist.
It almost seems too good to be true that someone might get £250,000 under EMI and also up to £50,000 under ESS but whilst most of the published guidance seems to infer that the ESS is a distinct arrangement, having reviewed again the Growth and Infrastructure Act 2013 and Schedule 23 of Finance Act 2013 it is clear that there is no express probation that prevents an individual double-dipping as it were into both the ESS and approved share plans provided they do not breach the respective material interest test (25% for ESS and 30% for EMI).
Paragraph 25 of Schedule 9 to ITEPA defines an eligible employee simply as an “employee” of the issuing company or another group member. Since under the employee shareholder rules, participants give up certain employment rights but remain employees (i.e. there does not seem to be any suggestion that HMRC would regard an employee shareholder as self-employed), without an express prohibition in either relief for someone participating in the other relief there appears to be nothing to prevent someone participating in both.
In contrast, when EMI was introduced in 2000, provisions were put in place to ensure a single employee could not benefit both from the full EMI limit of options and the limit under the older approved CSOP regime. But here, as far as they are aware, nobody seems to have thought of extending that limitation to employee shareholder grants.
The relevance therefore is that if EMI limits have been exhausted ESS can provide a tax efficient top-up. The downside of course is that there is the up-front tax charge to wear when the ESS shares are acquired. How affordable and palatable that is will depend on the individual concerned. Of course the employer company might agree to vote a grossed up bonus to the employee to provide them with the funds to settle the tax charge on the acquisition of the ESS shares. Not all employers will be so benevolent but some will. Indeed sometimes companies consider granting EMI options at nil cost that are immediately exercisable and have agreed to pay a grossed up bonus to the employee to meet the tax charge that arises on exercise of the option in such circumstances. Usually this is only considered by an employer company where an equity award is being made to reward an employee for past services. In such circumstances the up-front tax charge under ESS is the same as under EMI but the ESS affords complete CGT exemption on sale…
One thing that is certain is that the shares for rights debate rumbles on. However there are some chinks of light that provide opportunities. The best thing the Chancellor could do to encourage take up of ESS, and save face, would be to increase the £2,000 limit on the income tax and NI exemption but sadly I fear we will not hear that as part of the Autumn Statement on 5th December, although we live in hope….
For more information contact Liz Hunter or call the RM2 office on 020 8949 5522.