A share in the rewards
Share incentive schemes have been part of key employees' remuneration for many years. Historically they've been considered a tax efficient option for both employee and company. But recent changes have brought their potential tax benefits more into line with those applicable to cash. Littlejohn tax partner, Chris Riley, begins a two-part analysis of the pros and cons.
This article deals with an absolute issue of shares to employees. Part 2, in the next edition of Tax Matters, will consider share options and other alternative arrangements.
Why give shares to employees?
There are several reasons:
- the employee gains an immediate interest in the business and can benefit from its value, including any dividends, in the future
- this interest is likely to incentivise the employee to contribute to increasing the business's profitability
- an employee with shares in the company may be more likely to stay longer term
- increasing share ownership by younger generations may help succession planning when the current owners decide to retire
- there are cashflow benefits to the company by rewarding employees in the form of shares, rather than a bonus
What else should you consider?
Holding shares in a company implies a degree of permanence in the employee's relationship with the company, and deliberately so. But this can cause problems if the individual chooses to leave. So it's extremely important to plan for this possibility at the outset. What will happen to the shares? Will they be retained, bought back or forfeited? How will they be valued? Will it vary depending on how the employee leaves? Any conditions which may require the employee to forfeit or sell their shares in the future are considered ‘restrictions'. These can have an impact on the tax position both now and later.
The employee's tax position
An approved Share Incentive Plan may offer tax benefits to employees by avoiding employment income charges if certain conditions are met. But this is an employee scheme that requires HMRC approval, and can only offer shares up to a limited value. Accordingly it may only be suitable for larger companies and is not considered further here.
An employee can acquire shares in the company in two ways; by being awarded the shares outright (at no cost) or by being given the opportunity to buy the shares, possibly at a discount to their market value. Either way, the immediate tax treatment is the same. The employee is generally liable to income tax based on the difference between the market value of the shares when acquired and the amount they have paid for them.
If the shares are issued with any ‘restriction' which does not apply to other shares (for example, the shares cannot be sold), this reduces their value. However, if later on the restrictions cease to apply or the shares are sold, new income tax liabilities may arise because of the deemed increase in ‘employment income'.
One measure may help to resolve this problem, which is to elect to ignore the ‘restriction' in calculating the initial value of the shares and instead pay tax on the higher value. Although this can accelerate a tax charge by implying a higher value to the shares acquired, the employment tax charges over time may be lower - especially for a growing company whose share value increases. For this reason, it's an option worth considering - even though there is a risk that if the shares subsequently fall in value, a higher amount of tax could be paid over time.
If the employee disposes of the shares at a profit, any capital gain will be reduced by amounts already taxed as employment income, and be subject to capital gains tax at a rate of 18% or 28%. For shareholdings of 5% or more, entrepreneurs relief may reduce the rate to 10% if certain conditions are met.
Tax issues for the company
If PAYE applies the company has to account for any income tax and national insurance arising. These sums can be recovered from the employee, but if not recovered within a certain timeframe, they will be regarded as net pay, and further liabilities will arise on that amount. If PAYE is not applicable, then the amount of income will need to be reflected on the employee's self assessment tax return.
A company must make returns to HMRC of any share interests acquired by employees within three months of the end of the tax year, whether tax charges arise or not.
Finally, as a corollary to the income tax charges on this deemed employment income, the company may receive a deduction against their corporation tax liability, relating to shares acquired by employees at a discount.
Making the decision
For a growing company, awarding shares can provide significant long term rewards to employees and, as a long term succession plan, they can be invaluable. The downside is that immediate tax charges may apply. Share option schemes or other alternatives may provide more flexibility, and I'll look at those in the next issue.
To discuss the tax consequences of any aspect of employee remuneration packages, including share schemes, contact our corporate tax partner Chris Riley on 020 7516 2427 or email criley@littlejohnllp.com
