UK: Share Incentives Back in Favour

Originally published April 2004

With share prices on the increase, there appears to be renewed interest in shares as a means of remuneration and incentive. Our experience at RadcliffesLeBrasseur is that there was massive interest during the dotcom boom of 1999 and 2000 but, with falling share prices in the following three years, shares as an incentive have definitely been out of favour.

The markets turned in March 2003 and, since November, we have seen a marked increase in interest. So would share incentives be a sensible innovation for your company?

The answer depends on a number of factors. If you are in the charity sector, for example, share schemes are almost certainly out of the question and you are best advised to move on to the next article!

For many trading companies, however, share schemes are likely to be a possibility. You need to bear in mind, however, that shares on their own mean little, the employee needs to convert his or her shares into cash and that means selling them. Therefore a company with a trade sale or a flotation in sight, or possibly a part sale to an investor, is a prime candidate. If there is no such "exit" in view, then you will need to think about how the employee is going to sell his shares. Would existing shareholders want to buy? Probably not as they already own the company. One is therefore probably looking at a share buy-back or the use of a trust to create a market. Creating a trust adds to the task, but may prove a boon to current shareholders who wish to sell part of their holding.

As a general rule, share schemes in subsidiaries are frowned on by both institutional investors and the Inland Revenue and one should be looking at the parent company in a group.

If you can make arrangements for the shares to be bought, are there other issues? The ideal company from the point of view of share incentives is one with the hope of a significant increase in share values. The reason for this is that capital gains are currently subject to extremely low rates of tax.

Even if growth is not a major prospect, shares may entitle the employee to dividends or simply be a means of his owning a share in the company.

The next step is to work out what the company is out to achieve. Some motives are easy. Shares may be essential for recruitment, for example, when the best candidate for a senior role insists on sharing in what he hopes will be his achievements.

Share schemes can undoubtedly assist in staff retention by putting a cost on an individual leaving. Typically, this is done by granting options which are only exercisable if the employee stays with the company for a number of years. Providing there is a continual feed of options dependent on, say, three years’ service, the employee knows that he will lose two years’ worth of options if he leaves at any time. In such a case, options become effective (or "vest") if the employee stays in service for given periods of time. Curiously, if one were to suggest to staff that part of their pay in a given year would be withheld and only paid if they were still with the company two years later, there would probably be a protest. Yet achieving the same affect through options seems to be wholly acceptable.

As to whether share incentives increase productivity, the position is less clear. There is some evidence that companies with share schemes are more productive, but is this more a result of their having good management which in turn has caused the share scheme?

Pure tax saving is not the best of motives. While some schemes are tax-advantaged they should not simply be regarded as a way of putting cash into employees’ hands without tax.

Options are usually a good starting point. Typically, the employee is given the right to buy shares in the future at today’s price. So if the value of the shares goes up, he makes a profit. This arrangement probably suits the employee better than buying shares because if the price falls, he will not lose money. From the employer’s point of view, these are also benefits, the employee does not rank as a shareholder and, if he leaves, one does not have to buy the shares back.

First prize must go to the Enterprise Management Incentive Scheme ("EMI"). In its simplest form, if the company grants options so that employees can buy shares at market value at the time of grant, and sell immediately after exercise, then the only tax payable is Capital Gains Tax when the shares are sold. After two years with taper relief, this is as low as 5% for a lower rate taxpayer or 10% for a higher rate taxpayer and, with the annual exemption, very often there will be no tax at all. Some industries will be excluded and some companies may be too large, but a vast range of companies will qualify. If there is a reasonable prospect of a growth in share values, this scheme is highly attractive.

Next comes the Company Share Option Plan. Again, options are granted and the gain is subject only to Capital Gains Tax. But if shares are sold immediately after exercise, then taper relief will not be available, although the annual exemption still will be. This may not be material as the initial value of shares which may be put under option is limited to £30,000. This arrangement is really only suitable if you do not qualify for EMI.

Unapproved options, i.e. not falling into any Inland Revenue-approved arrangement, are very much a last resort. No tax benefit is available so profits are generally taxed as income and there may be National Insurance if there is a market for the shares.

As to share purchase arrangements, the Share Incentive Plan is an Inland Revenue-approved scheme which enables shares to be allocated to employees free of tax, and also allows employees to purchase shares with special reliefs. The disadvantage is that only £3,000 of free shares may be allocated to each employee in any year and the shares have to be held by trustees. Given the need for approval and a trust, this is the most expensive scheme to set up and run, but could yield good benefits if one puts in the effort. A disadvantage is that it cannot be focused on particular individuals, broadly everyone should be allowed to participate. Overall, it has not proved hugely popular.

Unapproved share purchase arrangements, however, have a lot to recommend them, if one accepts that share acquisition is the answer. The employee suffers the risk of buying shares only to see their price go down, but should, with a little care, only pay Capital Gains Tax on any profit. The main problem is that share purchase schemes seem to be regarded with suspicion by the Inland Revenue with the result that gains, in given circumstances, could be taxed as income. To make matters worse, if the shares are marketable, there may be National Insurance where there is an Income Tax charge, which is a cost on the employer although there are proposals to modify this. The days when one could just issue shares are gone but, with planning in advance, one should be able to manage the tax risk.

Overall, share schemes seem to be coming back to life and, if your company is suitable, could be a major incentive.

© RadcliffesLeBrasseur

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.