The commercial benefits to companies of providing equity or options to senior employees are well documented. Indeed, it is unlikely that many new technology companies, such as Google or Facebook, would have succeeded without them. However, as well as being an excellent way of ensuring that the interests of senior employees are aligned with those of the owners, grants of shares or share options can be a very tax efficient means of rewarding staff.
Companies looking to provide equity incentives will have to decide whether to grant options or to invite employees to subscribe for shares directly. A share subscription creates an immediate feeling of ownership and provides an opportunity for employees to receive tax efficient dividends from the profits that they help to generate. However, many business owners are uncomfortable with the legal aspects of giving shares- for instance, the shares may carry voting rights and provision may need to be made for recovering shares from employees who leave. There is also the issue that a subscription for shares will bring the employee within the employment related securities rules- if the employee pays less than market value for the shares or receives benefits (generally excluding dividends) from them post acquisition, he or she will be subject to an income tax charge.
Faced with these complications, many businesses prefer to grant share options to employees. A number of share option schemes exist in tax legislation, but the most tax efficient is the Enterprise Management Incentive (“EMI”) scheme. For the employer, there is a corporation tax deduction equal to the difference between the market value of the shares on the day when the options are exercised and the price paid for them. If options are exercised on a sale of the company, which is often the case, this tax deduction can be extremely valuable and can be used to increase the consideration received on sale. For the employee, the principal benefit is that he or she pays capital gains tax rather than income tax and national insurance on the increase in value between the date of grant and the date of exercise.
Benefiting from entrepreneurs' relief
With effect from April 2013, a further enhancement of the EMI regime was introduced, with shares acquired through the exercise of EMI options now qualifying for capital gains tax entrepreneurs' relief provided that the employee has held the options or shares for at least 12 months prior to sale. This means that options exercised immediately prior to a sale of a company can qualify for entrepreneurs' relief provided only that the options were granted more than 12 months before. This applies regardless of the number of shares held, so the normal entrepreneur’s relief requirement to hold at least 5% of the voting rights and 5% of the ordinary shares is relaxed. This relaxation also provides an interesting opportunity for companies wishing to issue share capital rather than options. If the subscription is made by way of EMI options, entrepreneur’s relief is available. If the subscription is direct, the 5% minimum voting rights and percentage shareholding requirements apply, making entrepreneur’s relief much more difficult to obtain for managers with small minority shareholdings. There are a number of issues which need to be considered when implementing either type of share based reward and we have extensive experience of implementing both. The issues that we would normally advise on include:
- Design of the option or subscription mechanism to ensure that it fits your specific circumstances and achieves your commercial objectives
- Working with your lawyers to ensure that the option documents reflect the commercial agreement
- Advising on the impact and application of the employment related securities rules, including the Memorandum of Understanding (“MoU”) between the British Venture Capital Association and HMRC
- Agreeing valuations with HMRC’s share and assets valuations division
- Compliance with HMRC’s reporting requirements.