Since September 1, 2013, employees have been able to trade certain employment rights otherwise guaranteed by law for shares in their employer. Such employees will be regarded as having "employee shareholder" status and will be able to receive shares worth at least £2,000 in consideration of becoming an employee shareholder, with gains made on the disposal of such shares potentially being exempt from capital gains tax ("CGT").

There has been much scepticism about the new scheme since its announcement in October 2012, as the potential tax benefits under the original proposal did not seem to provide a sufficient incentive to employees to surrender their rights. However, the income tax and CGT reliefs introduced under the UK Finance Act 2013 are potentially extremely valuable, given that they can deliver a tax-free acquisition and disposal of shares worth up to £50,000 (valued at the date of acquisition).

As a result, the scheme will be of particular interest to private equity and other investors looking to incentivise management in start-up or growth businesses. It is unlikely to be of interest to larger organisations, however, because of the administrative hurdles and costs of implementation introduced by the employment rights safeguards described below.

Employment rights. Employee shareholders will have the same rights and will be afforded the same protections as employees who are not employee shareholders, with the exception of certain statutory employment rights which they will be required to surrender. Employee shareholders will have:

  • no right to request time off for study or training;
  • no right to make a flexible working request, aside from those employee shareholders returning from parental leave, who will be restricted to making a formal request for flexible working to the period of 14 days beginning with their return to work;
  • no right not to be unfairly dismissed (except in health and safety cases, automatically unfair cases or cases where the dismissal is discriminatory under the UK Equality Act 2010);
  • no right to a statutory redundancy payment; and
  • to give 16 weeks' notice if they want to return early from statutory maternity, adoption or additional paternity leave.

Following the Chancellor of the Exchequer's original announcement of the proposed employee shareholder status in October 2012, concerns were raised about the potential effect on employee rights and protections. In recognition of some of the concerns that were raised, the new regime has been introduced subject to a number of safeguards, including:

  • protection against dismissal or other detrimental treatment for employees who refuse to become "employee shareholders";
  • a statement contained in the offer of employee shareholder status explaining the employment rights that would be sacrificed if the terms of employment and the rights attaching to the shares were accepted;
  • a requirement for employees to receive independent legal advice on the offer of employee shareholder status with the reasonable costs incurred in receiving this advice being borne by the employer (regardless of whether the offer is accepted); and
  • individuals agreeing to the offer will be entitled to a seven-day "cooling off" period from the day on which the legal advice is received (i.e. entitling them to withdraw their acceptance of the offer).

Tax treatment. In broad terms, the market value of the employee shareholder shares acquired will be taxable as earnings and therefore subject to income tax. However, subject to satisfaction of certain conditions, an employee shareholder will be entitled to deduct "deemed consideration" of up to £2,000 from taxable earnings. In other words, where there is deemed consideration, there will be no income tax or national insurance contributions ("NICs") on the first £2,000 of value as the employee will be treated, for tax purposes, as paying £2,000 for the relevant shares. Any value in excess of £2,000 will, however, be subject to income tax under pay as you earn withholding and NICs on acquisition. No other consideration other than the agreement to become an employee shareholder can be given by the employee shareholder for the shares.

However, it should be noted that the income tax benefits of deemed consideration will not be available if either the employee shareholder or any connected individuals have a material interest (broadly, a 25 percent interest) in the employer or a relevant parent undertaking, or had such an interest for the period of one year ending on the date of acquisition.

In relation to capital gains tax, a subsequent disposal of the shares will be exempt from CGT only if, immediately after the acquisition by the employee shareholder, the total value of that employee's shares is £50,000 or less (as at the date of acquisition) but more than £2,000. There is a mechanism for pro-rating this allowance where the value of the shares exceeds £50,000. The CGT exemption will not be available where the employee shareholder or any connected individuals have a material interest (broadly, a 25 percent interest) in the employer or a relevant parent undertaking at the time the shares are acquired, or had such an interest in the period of one year ending on the date of acquisition.

A corporation tax deduction will not be available in respect of the deemed consideration. However, the corporation tax deduction rules will apply in the usual way where any additional value was subject to income tax and NICs on acquisition.

Where employers and employees are considering employee shareholder status, it will be very important to ensure that the tax incentives designed to compensate employee shareholders for the loss of employment rights and protections will be available. The most obvious concern will be to ascertain the value of shares to be awarded because the CGT exemption will not be available if the market value of the shares is below £2,000 on acquisition and will be pro-rated if the market value of the shares is greater than £50,000 at that time.

An effective incentive? The scheme was originally introduced to promote a new class of entrepreneurial employees who take a stake in their companies in exchange for surrendering certain rights (part of the "aspiration nation" manifesto of the current government). Unfortunately, the safeguards introduced to the scheme, not least the requirement to obtain independent legal advice, are likely to render the scheme unattractive to certain employers, especially those with a large number of lower paid employees.

The potential tax benefits are, however, substantial, and investors are likely to see the scheme as an effective way to incentivise management and other senior employees where the potential benefits are more likely to outweigh the costs of implementation.

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.