Share capital considerations

The design of an employee share scheme will normally involve decisions in relation to the shares to be used and the rights attaching to them.

Non-voting shares

The simplest arrangement is for a company to use its existing ordinary shares for the purposes of the scheme. However, there may be concern that this would alter the balance of voting control. In such a case non-voting shares can be used. Non-voting shares can be used in all the statutory schemes. In the case of a CSOP Scheme or SAYE Option Scheme a new class of non-voting shares will need to be created, and a free issue of shares of this class given to the existing ordinary shareholders. The free issue, sometimes known as a "bonus" or "scrip" issue, is to satisfy a regulation that the majority of the shares of any class must be owned other than by employees who acquired them through an employee scheme. This regulation is imposed to help ensure that the employee shares are "worth having".

For the Share Incentive Plan and the Enterprise Management Incentive, a new class of non-voting shares can be issued without the need for a prior free issue to existing shareholders.

Use of shares in subsidiary companies

Subsidiaries of private companies cannot use their own shares to establish a statutory employee share scheme, but it may be possible to circumvent this by using a special class of shares in the parent, perhaps linked to customised vesting arrangements.

In certain circumstances, subsidiaries of listed companies can use their shares for statutory schemes, except the Enterprise Management Incentive. However, the listed parent must not be a close company or a company that would be close if it were domiciled in the UK. In the case of an SAYE Option Scheme or CSOP scheme, the capital of the subsidiary company must consist of a single class of shares only.

In practice the use of subsidiary shares by listed companies for employee schemes is rare. This is because the UK stock exchange regulations require approval by the shareholders of the listed parent for any such use of subsidiary shares, and the practice is also frowned upon by the Association of British Insurers. The alternative of creating a separate class of shares in the parent to reflect the performance of the subsidiary will generally not be practical for listed companies.

If employee incentives are offered in the shares of a subsidiary of a private company, the value of the benefit will not attract corporation tax relief. In order to be qualifying shares for this purpose, the shares must be shares in an independent company or the subsidiary of a listed company.

Loss of rights on leaving employment

Many employee share schemes are designed to encourage employees to stay with the company. Employers may therefore wish to ensure that if employees leave within a certain period, either of their own volition or because they have been dismissed for some offence, they should lose their rights to the shares.

Loss of rights can be enforced under all the statutory schemes. Under the Share Incentive Plan, an employee who leaves within a period of up to three years of receiving Free or Matching shares in trust can be required to forfeit them, unless the employee is a "good leaver".1 A good leaver, broadly, is one who leaves for an involuntary reason such as injury, disability, redundancy or retirement. Under any of the Government regulated option schemes, including the SAYE Option Scheme, employees who are not "good leavers" can be made to forfeit their rights if they leave before exercise of the option concerned.

There will also be occasions where an employee has acquired shares, and then leaves. Most private companies wish to prevent departing employees from taking their shares with them and the company's articles of association can contain a requirement that departing employees must offer their shares for sale. The shares can then be purchased by the other shareholders of the business, by an employee trust or by the company itself, although the proceeds of a company repurchase may be taxed as a distribution, i.e. as income rather than capital gain. The terms on which the shares are to be sold must be laid down in the articles. These terms need not, and usually do not, specify a particular price but instead set down a formula or method for determining the price. Often the auditors or other adviser will be called upon to reach a determination. It should be noted that if a rule requiring sale is introduced in accordance with an approved scheme (a statutory scheme other than an EMI), all employee shareholders including any working proprietors of the business will be bound by this rule, and all those selling shares of the same class will be obliged to do so on no better terms.

Other restrictions on shares

Apart from the above permitted restrictions, in relation to voting rights and the treatment of leavers, the shares used in an approved scheme must not have rights that are more restricted than the other shares of the same class. In Share Incentive Plans, the rights must not be more restricted than any other class of ordinary share capital.

This can create problems where, for example, a private company has issued shares with special rights to one or more investors, or where certain actions can be taken with the agreement of a stated majority of shareholders. Because of these special rights, the shares used for the employee scheme may be regarded by HM Revenue & Customs as restricted by comparison with the shares held by the larger shareholders. It is usually possible to correct this problem, for example by issuing a new class of share for the employee scheme that is not restricted in relation to the investors' shares. In other cases, a capital reconstruction may be required, so that the investors' special rights are held in securities that do not form part of the ordinary share capital.2 Where, however, there is a complex shareholders' agreement, hammered out through long negotiation, it may be impractical to obtain the agreement of the shareholders to such radical changes.

HM Revenue & Customs takes a strict line in this area. For example, if the articles contain a rule that a vote of 95 per cent. of the shareholders can permit the unrestricted transfer of a share, HM Revenue & Customs will deem that shares of that class cannot be used for an approved scheme because the holders of the remaining 5 per cent., who could include the employee shareholders, would have restricted rights by comparison. This is despite the fact that, even if there were no such provision in the articles, a 75 per cent. majority of shareholders could achieve the same effect by passing a special resolution under ordinary company law procedures.

Before making an application for approval of a statutory scheme it is important to examine very carefully the articles of association, any shareholders' agreement and any other documents affecting share capital rights. Professional advice should normally be sought.

Financial assistance

The Companies Act 1985 contains a general prohibition on companies providing financial assistance to purchase their own shares. However, as a consequence of the Companies Act 2006 such assistance is to be permitted for private companies, subject to shareholder approval. The date for implementation of this change was originally stated to be October 2008 but it now appears that the date will be put back. The prohibition will continue for public companies, whether quoted or unquoted.

There is an exemption to the Companies Act 1985 prohibition if the financial assistance is provided for the purposes of an employees' share scheme, as long as the assistance is given in good faith in the interests of the company. An exemption is also available when financial assistance is provided for the purposes of creating or maintaining an internal market for employee shares in a company's shares, for example through an employee benefit trust or the purchase of treasury shares. Additionally, companies are permitted to offer loans to employees for the purposes of acquiring company shares.3 However, it is not permissible for loans to be made to employees for the purpose of acquiring shares through a Share Incentive Plan.

Public companies, whether quoted or unquoted, can take advantage of these exemptions but may only do so if the financial assistance provided either does not reduce the level of net assets or, to the extent net assets are reduced, the financial assistance is funded from distributable profits. This has an unfortunate interaction with the UITF abstract 38, issued by the Accounting Standards Board, which requires that the value of shares held by an employee trust must be shown as a deduction from net assets.

Take-overs and demergers

All the statutory schemes provide that, if the sponsoring company is sold, existing scheme benefits can be "rolled over" into rights over securities in the acquiring company. The market value of the securities and the rights held by the employees over those securities must be effectively the same as before. This would include, for example, good and bad leaver regulations and any vesting schedule. For tax purposes the new rights will then be treated as if the old rights had continued without interruption. This allows for the various time periods attached to the various scheme to continue running uninterrupted, namely the holding period in a Share Incentive Plan, the savings contracts for an SAYE Option Scheme and the three year minimum exercise period in a CSOP Scheme.

For the SAYE Option Scheme and the CSOP Scheme, the new shares must meet the requirements satisfied by the original shares in terms of the eligibility of the acquiring company and the capital structure. However, for the Share Incentive Plan the new securities can be in almost any form, including loan notes and preference shares. The new securities are held by the trustees as if they were the old securities and in due course distributed to the participants in line with the original rules of the scheme. The tax treatment is unchanged.4

Options granted under the Enterprise Management Incentive can also be exchanged for new options in an acquiring company, providing that:

• the acquisition is on a share for share basis, with the sellers receiving new shares in proportion to the old, such that the roll-over provisions of the Taxation of Capital Gains Act 1992 apply;
• the terms of the option are the same as before; 
• the new shares carry the same rights as the old shares;5 
• the acquiring company is independent; 
• the employee remains an employee of the group.

Normally, a company cannot offer EMI options if it has gross assets of more than £30 million or owns any subsidiaries which are not 51 per cent. subsidiaries. However, these restrictions do not apply to a company issuing replacement options.

Under general capital gains tax rules, when a company is sold and shares are exchanged for securities in the acquiring company, it is usually possible to "roll over" the gain into the securities of the other company. The new securities are treated as having the same base cost as the old securities so that effectively the taxable gain is deferred. In a takeover situation, therefore, holders of options under a CSOP or SAYE Option Scheme could exercise without crystallising tax and then defer any capital gains tax on sale of the share by "rolling over" into the new securities. These securities could include loan notes.

This possibility is not available to holders of unapproved options. This is because tax on any gains is payable at the date of exercise of the option, not the sale of the underlying share, so the tax cannot be avoided or deferred. For EMI options, there is no provision in the legislation whereby the shares acquired through exercise can be rolled into loan notes. However such shares can be rolled into ordinary shares of another company, subject to regulations contained in the Taxation of Capital Gains Act 1992.

Demergers

A demerger may result in one company becoming two companies, with the shares in each new subsidiary being distributed the shareholders. In a "partition demerger", the shareholders of the demerged subsidiaries are also separated.

If the parent company continues, but as the holding company of only one or some of the former subsidiaries, the value of those options is likely to be reduced. Moreover any performance conditions attaching to the original options may no longer be appropriate.

A distinction should be made between a demerger and certain other forms of change in capital structure. In the case of a capital change such as a share subdivision or bonus issue, the rules of a share scheme normally permit the terms of the scheme to be adjusted so that the value to each participant remains the same. However, a demerger is a commercial event and any resulting change to the terms of a statutory scheme, designed to compensate participants, will be regarded by HM Revenue & Customs as a disqualifying event which will bring any tax advantages to an end. It may also result in the loss of previous tax benefits. In the case of an EMI option, for example, if there is a compensatory adjustment to the terms of the option following a demerger, all the tax advantages of the option since the date of grant will be lost. HM Revenue & Customs will deem that the old option has been replaced by a new one. Consequently the old option has lapsed and any new option, even if it qualifies, can only shelter future gains.

In some cases, share scheme participants will be transferred out of employment with the original group by reason of the demerger. In this case of EMI options they will become unapproved if not exercised with 40 days of the event, since the participant will not satisfy the employment criteria. Options granted under a CSOP Scheme may, if the rules provided, remain after the participant has left employment. In the case of an SAYE Option Scheme, the option will not lapse if the demerged company remains "associated" with the former parent, that is, owned by the same shareholders.

In the case of a Share Incentive Plan, the participants have beneficial rights to the shares and they should receive any distribution of shares in a former subsidiary as if it were a dividend. Special tax rules and reliefs apply to demergers and these are beyond the scope of this Guide. However in some cases participants in a Share Incentive Plan may avoid the tax charge that would normally arise on distributions. Trustees of discretionary trusts (see Glossary) holding parent company shares will also be entitled to receive any distribution of shares in a former subsidiary and will also be entitled to any available reliefs.

1. Employees cannot be required to forfeit Partnership or Dividend Shares.»
2. Highly artificial arrangements designed to make a company comply with the requirements of a statutory scheme, when otherwise it would not have done so, may be reportable under the anti-avoidance regulations.»
3. Loans to directors require shareholder approval unless they fall within one of the exemptions.»
4. However no new shares may be appropriated under the scheme.»
5. Note that the rights must be the "same" not "similar". Therefore even minor differences are likely to disqualify the acquiror's shares and in cases of doubt clearance should be sought from the Small Companies Enterprise Centre.»