Introduction to share plans
Awards of equity can form an important part of employees’ remuneration. From an employer’s perspective, share awards can be an effective way to incentivise, recruit and retain employees.
Equity awards align the interests of employees with the interests of shareholders, giving employees a stake in the success of their employing company, and encouraging them to work to increase the value of the company or work towards an eventual sale or flotation. Where the value delivered to employees by an equity award is dependent on the employee continuing in employment, the equity award can assist in the retention of key employees.
There are other reasons why a company might wish to put in place a share plan. Some SMEs with limited cash resources might find awards of equity an effective substitute for cash bonuses. Private equity investors are likely to require that the senior management team of their investee companies have ‘skin in the game’ in the form of an equity holding. Some companies regulated by the Financial Conduct Authority might be required to provide a portion of their employees’ variable remuneration in the form of shares or other securities. For many companies, there is simply an expectation that equity forms an integral part of a balanced remuneration package.
Forms of equity award
Equity awards are generally made to employees on consistent terms, set out in a set of plan rules. The rules set out the standard contractual terms of the plan, such as when and how awards can be made, who is eligible to receive awards, what happens when an award holder ceases employment, what happens if there is a change of control, and how the terms of the plan itself or individual awards can be amended.
Share plans take many forms, the main ones of which are:
- Options. Options give an employee the right to acquire a specified number of shares at a pre-determined price, and at a time or on the occurrence of an event specified when the option is granted. Very commonly options are granted with an exercise price equal to the value of the underlying shares at the time of grant, so that employees benefit only from the increase in the value of shares after the option has been granted.
- Free share awards. Under a free share award, an employee is promised an award of shares at no cost at a future date. Sometimes receipt of the shares is made subject to the satisfaction of conditions which might be based on the financial performance of the grantor company, or on the employee achieving certain personal targets, or might simply be based on the employee remaining in employment until a specified time. Sometimes free shares are awarded in substitution for a portion of an employee’s cash bonus.
- Upfront awards of shares. Employees can be given shares up-front, with retention of the shares dependent upon certain conditions being satisfied. The conditions generally relate to continued employment.
Share Plans and Tax
The usual position is that the value an employee receives from an award under a share plan is taxable as employment income. However, in certain circumstances, favourable tax treatment is available. The tax advantage generally takes the form of an exemption from income tax and National Insurance contributions (“NICs”) when shares are acquired by the employee, for example when an option is exercised. The value the employee receives is then eventually taxed as capital gain when the employee subsequently sells the shares. Capital gains are taxed at lower rates than employment income, and so the employee benefits both from the deferral of tax and from the lower rates of capital gains tax.
Tax-advantaged share plans available to companies
There are several tax-advantaged share plans available to companies. Each type of tax-advantaged share plan is subject to its own particular set of conditions which must be satisfied in order for a company to be eligible to grant tax-advantaged awards and for those awards to benefit from the tax advantages. These conditions might relate to the grantor company (for example its independent status or its size) or to the employees eligible to receive awards (for example, can awards be made on a discretionary basis or must all employees be offered participation). Tax-advantaged plans might also specify what happens to awards in certain leaver circumstances, or how much discretion the grantor company can retain.
The conditions attaching to each type of plan can place restrictions on how a company is able to offer awards to employees and the terms of those awards. This can increase the administrative burden of administering the relevant plan to ensure compliance with the conditions. However, because tax-advantaged status also confers exemption from NICs, the employing company will itself obtain an advantage in that no employer NICs will be payable in relation to the tax-advantaged awards (subject to the conditions continuing to be satisfied).
Requirements for companies to grant tax-advantaged awards
The requirements that must be satisfied in order for a company to be able to grant tax-advantaged awards under the various tax-advantaged share plans are set out, along with the main features of each type of tax-advantaged plan, in the following guidance notes:
- Enterprise Management Incentive option plans.
- Company Share Option Plans.
- Save As You Earn option plans.
- Share Incentive Plans.
Alternative forms of award
Where a company does not satisfy the conditions necessary to be able to grant tax-advantaged awards to employees, it might nonetheless be possible to structure awards of shares in such a way that value is delivered to employees as capital gain rather than as employment income. Such arrangements include ‘growth shares’ and Joint Share Ownership Plans (“JSOP”).
These alternative forms of award generally involve the employee acquiring shares, or an interest in shares, up-front, so that any increase in the value of the shares is then subject to capital gains tax rather than income tax and NICs.
In the case of ‘growth shares’, the rights of the class of share acquired by employees are limited so that the shares participate in the increase in value of the company only over a pre-determined hurdle. The intention is that by limiting the economic rights of the shares in this way, the value of the shares on acquisition can be depressed with the effect that the employee has to pay a lower price for the shares or is taxed by reference to that lower value.
Under a JSOP, the rights of the shares themselves are not limited. The employee acquires an interest in the shares jointly with another co-owner (typically an employee benefit trust) with the respective entitlements of the two co-owners being defined in a way that gives the employee an entitlement to value only over a pre-determined hurdle. In this way, the up-front value of the interest which the employee acquires can be reduced.
Don’t miss our expert insights into alternatives to tax-advantaged share options.
Employee Communication
One aspect of share incentive arrangements which companies can easily overlook is the importance of communicating to employees the benefits of the plan for the employees. If employees do not understand how the plan will benefit them, its effectiveness in incentivising or retaining them will be seriously undermined.
Companies implementing share incentive arrangements should therefore communicate the benefits of the plan to their employees. The terms of the plan must be clearly explained, so that employee understand what they need to do (for example how long they must stay in employment), or what has to happen (for example how any performance conditions will apply to their awards), in order for them to receive value from their awards. Where the awards are granted under a tax-advantaged plan, the conditions for the awards to qualify for tax-advantaged treatment should be explained, and the benefits of tax-advantaged treatment made clear.
