Restricted eligibility criteria are preventing nearly two-thirds of employers from setting up employee share schemes, according to recent research by CCH.In an exclusive extract from his book, Employee Share Schemes, Chantrey Vellacott DFK partner, Philip Fisher, presents an introduction to the evolution of share-based remuneration in the UK, and the role the tax regime has played up to this point.

It is often said that cricket mirrors the society in which it exists. The Australians are hard-nosed and want to win at all costs, the Indians are mystical, West Indians are exuberant entertainers who lack discipline, and the English have changed from imperialist oppressors to a bunch of duffers who are too polite to deal the killer blow – at least prior to last years’ Ashes.

It could be argued that in the UK there is a similar process at work in the world of employee share schemes.
Until the 1950s and 1960s, the concept of employee share schemes hardly existed. Britain had a paternalistic society that almost replicated cricket’s amateurs and professionals, with employees shut out of ownership.

Things began to develop as some johnny-come-lately nouveau riche types began to pay themselves and their best friends in shares, often on the basis that they could escape the worst excesses of a rather nasty tax regime by doing so.
The first great legislative developments in this area took place in the 1970s and early 1980s as the regime for taxing payments by way of shares developed and, as a corollary, three approved share schemes were introduced with the support of the Government and what was then the Inland Revenue.

There were no more major changes until the mid-1990s, when there was a backlash against those who had taken what was seen at too great an advantage of tax-aided assistance. The best of the schemes had its wings clipped when it became apparent that it was making too many people multi-millionaires at the expense of the taxpayer. So much for the idea of the free market and an enterprise society.

The balance was somewhat redressed in the early years of the third millennium as two different forces got to work.
First, there was a push by the government to legislate in a way that would provide more opportunities for companies to operate in a controlled environment using schemes that the Government could control and monitor.

Second, there was a massive authoritarian clamp-down, occassioning an assault on overly inventive tax advisers and arguably greedy executives.

Finally, the legislative changes that took place in the budget of 2003 introduced hundreds of pages of new legislation.

Employee Share Scheme – what to choose

The first stage in the process of deciding what kind of employee share schemes will be appropriate for any company and its employees is to look at the types of share scheme that are available. While there are potentially an almost infinite number of ways of offering shares to employees, in most cases only two or three will be appropriate for any one company. Philip Fisher gives a brief overview of the types of share scheme available and the kinds of companies or groups that might wish to implement each.

Share Incentive Plans
Share Incentive Plans were introduced in the Finance Act 2000 under the original name of the All Employee Share Ownership Plan were designed to replace the Approved Profit Sharing Scheme and, as such, are all-employee plans based on the appropriation of shares into trust for a period of time, usually five years.

The plan operates by allowing shares of various types worth up to £7,500 per annum to be appropriated into a trust for three to five years. The shares will then be held there on behalf of specific employees. At the end of the period, the employee receives the shares, generally on favourable terms from a tax viewpoint.

The attraction is that the employer can offer employees free shares, can allow employees to buy shares from untaxed pay, or can even offer the kind of buy-one-get-one-free plans that have been popular for many years. For those who wish to put the icing on the cake, they can also allow the chance to reinvest dividends tax-free into yet more shares.

HM Revenue and Customs (HMRC) regard all-employee Share Incentive Plans are the dream ticket for almost all companies, whatever their size. However, because they require the creation of a separate Share Incentive Plan Trust, the set up and administration cost of implementing even the simplest Share Incentive Plan can be prohibitive. For an organisation with up to 50 people, they are never likely to be cost-efficient.

However, it is possible to take a small element of the overall legislation and utilise that on a stand-alone basis. This has enabled some smaller companies to consider giving employees up to £3,000 of free shares without the need for massive administrative back-up.

Enterprise Management Incentives
When Chancellor Gordon Brown announced his initial proposals for Enterprise Management Incentives in his 1999 Budget speech, they sounded almost too good to be true. Here was an employee share scheme where the employers could write their own rules with only a few guidelines as to what was not going to be permissible.

The scheme is geared to assist any qualifying smaller company with maximum gross assets at the date of any grant of options of £30 million and carrying on a qualifying trade. Service companies and companies that are heavily property-backed are excluded. There is also an overall limit of £3 million on the total value of shares that can be held under option at any time for each company (or group).

There are strong incentives for companies to introduce such schemes. First, in keeping with some other arrangements, they can obtain corporation tax relief on the value of shares at exercise less sums paid. Employees will not face any tax charge at the time at which options are granted in accordance with the legislation, and, provided that the options are not granted at below their current market value, there will be no tax charge on exercise and there will never be an income tax or NIC charge.

This is completely different from the other approved selective scheme, the Company Share Option Plan (formerly Executive Share Option Scheme). Under the current legislation for those schemes, no option can be granted at any discount to their current market value. The chance to give shares to employees without any charge has been greatly welcomed by many employers especially in start-up situations.

The biggest incentive is with regard to capital gains tax. Business asset taper relief will begin to apply with effect from the date on which options are granted to employees, not the date of share acquisition as would be the case under the normal rules. Employees do not need to own the shares to start the taper relief clock. By definition, all shares that qualify for Enterprise Management Incentives reliefs will also be regarded as qualifying for business asset taper relief.

Under legislation effective from 6 April 2002, the maximum business asset taper relief reduction of 75% of the gain will apply two years from the date on which the options are granted.

Although the massive share price increases that were enjoyed when the scheme was originally introduced seem to be a thing of the past, the fact that a higher-rate employee need only pay tax at an effective rate of 10% or less and a basic-rate taxpayer, 5% or less, on gains on shares in his or her employing company is very attractive.
Options can be offered at any price and with an exercise date the next week should that prove attractive. Further, the arrangements are administratively simple as there is no need to obtain HMRC approval in advance of commencing an agreement.

This means that, at least in theory, a company could draw up an agreement and put an EMI scheme into place on the day that they first thought of it. In practice, it is at least advisable to obtain both an agreed share valuation and clearance that the company is a qualifying company with HMRC before embarking.

This will mean that the large take-up of Enterprise Management Incentives at their inception should continue as smaller, developing companies try to attract and retain employees.

Company Share Option Plans
The Company Share Option Plan (CSOP) has become far less popular since the introduction of EMI. Where EMI cannot be used, however, there are still great attractions in using a CSOP.

CSOPs operate by allowing companies to offer their employees the opportunity to purchase shares between three and ten years from the date of grant. The purchase price is fixed at the shares’ current market value at the time that the options are granted. Note, the limit on the value of options is restricted to no more than £30,000 per individual. This figure has not changed since 1995 and there seems no real political impetus to increase it. This is a shame, as these are good arrangements that are relatively fair to both employers and employees. In addition, they are selective schemes, so do not have to be offered to all of a company’s employees, although in many cases, companies might consider offering these schemes to all of their employees rather than using, for example, a Share Incentive Plan as the set-up costs are so much lower and there is minimal administration. The flexibility given by a selective scheme can also often seem more attractive than the rigidity of a Share Incentive Plan.

Savings-Related Share Option Schemes
These schemes combine a Save-As-You-Earn savings account with a share option, but have not proved particularly popular except with the very largest quoted companies. However, since it is possible to set up and administer a scheme without incurring any external costs, it is surprising that more companies have not used them. In reality, most companies are likely to use lawyers or accountants for the drafting because they will not want totally standard rules, in which case there will be a set-up and possibly also an administration cost.

The lack of popularity might primarily result from the fact that only the very largest quoted companies have a sufficiently large share capital to satisfy likely employee demand. The restrictive criteria for shares to qualify for use in these schemes means that they are generally not suitable for private unlisted companies.

Save-As-You-Earn schemes are offered by many banks and buildings societies. They generally work on the basis that a regular monthly amount, which in the case of schemes linked to share options must be between £5 and £250 per month, is saved and at the end of the fixed period, a bonus equal to several additional months is added tax free. A small number of banks and building societies are willing to operate SAYE schemes on behalf of employers without making any charge either for the creation of the scheme or for administration and running costs. This is generally linked to a requirement to have a minimum monthly value of savings invested. In most cases, if they are not to charge for set up or management, the bank or building society will also insist that a relatively basic type of scheme with simple rules be used.

Employees are able to enter into payroll savings arrangements for three, five or seven years, at the end of which the proceeds may be used to exercise a share option granted to the employee at the commencement of the scheme. In the case of a seven-year scheme, the savings period during which sums are deducted from employees’ pay and paid to the savings institution will only be five years, but the total saved after five years can be rolled up for a further two years with a larger bonus.

As an incentive to employees to enter into these schemes, they are permitted to acquire options with an exercise price that can be up to 20% lower than the market value of the shares on the date on which the option was granted, with no adverse tax consequences. This tax-free discount differentiates savings-related share option schemes from the other types of share option schemes approved by HMRC.
In the vast majority of cases, top executives will have the chance to benefit from a separate scheme that may well be unapproved. This could take the form of an option arrangement or a Long-Term Incentive Plan (LTIP).

Savings-Related Share Option Schemes must be made available to all those employees (including part-timers) who have at least five years’ service, although they can be offered to a broader range of employees. Where employers are keen to offer the full range of share schemes, SAYE schemes are a nice added extra bonus for employees, but are only really attractive to those who are intending to stick with their employer for a good number of years.

Unapproved schemes

It is possible to do almost anything with an unapproved scheme, always provided that you stay within the law. Their attraction is the complete flexibility that they offer to employers to write their own scheme for employees. This could involve the use of restricted shares, conditional shares, shares subject to forfeiture or partly paid shares.
More simply the scheme could just offer employees the chance to buy or be given shares immediately or to enter into an option over an unlimited number of shares or securities with no restrictions on exercise periods.
While all of this sounds very attractive, there is a big downside, namely the tax liabilities that the employee will suffer on acquisition of the shares, exercising options or receiving any other benefit. Employees will pay tax at their highest marginal income tax rate, often through the Pay As You Earn scheme, and worst of all for the employer, there could be a National Insurance charge as well.

Following legislation which took effect in April 2003, an NIC charge may impact on employees as well as employers albeit at a much lower rate for those on higher salaries.
It is now possible to enter into a joint election in certain circumstances that will allow the employer to pass on its National Insurance contributions liability to the employee. While this makes things more attractive for the employer, the corollary obviously applies for the employee.

Phantom share schemes
In some cases, existing shareholders are not willing or possibly able to offer any kind of share arrangement to employees. In these circumstances the best alternative can be the use of a phantom share scheme.

This will probably take the form of an option arrangement and can be identical in form to any option arrangement described above. The difference is that no real shares are offered to the employees and what they are really getting is a cash-based bonus scheme, which is quantified based on movements in share price or value.

The taxation treatment is pretty unattractive as these payments are regarded as remuneration and taxed instantly through the Pay As You Earn and National Insurance systems. To be fair, nowadays, this does give pretty much the same tax and NIC treatment as unapproved share options.

Corporation tax relief
The other point to bear in mind for the employer that offers shares to employees is the prospect, in most cases, of obtaining corporation tax relief on the value of shares that employees eventually get. While this may not be the primary moving force behind introducing a share scheme, it is a pretty effective and desirable bonus to reward an employer’s altruism.

Employee share trusts
The use of an employee share trust is independent of any share scheme. However, employee share trusts can augment a share scheme and help it to operate more effectively.
They serve a number of purposes.

Finally, they can create a market in a private company’s shares. This can be of enormous benefit since, without such a market, the shares can be perceived by employees as worthless. If that is the case, the whole point of a share scheme, the motivation of employees, will be negated.
In the past, there could also be some fairly significant tax advantages to companies that utilised employee benefit trusts of various types. Following legislative changes in 2002/2003, these have largely disappeared.

However, it is worth remembering that in certain cases, if someone sells shares back to their employer, they may be regarded as receiving a distribution, which is equivalent to a dividend. By way of contrast, a sale to an employee benefit trust will always be treated as a capital gain. In the current tax climate, that can be a major advantage to the vendor.

Conclusion
For smaller companies, there are a number of questions that should be asked before entering into any kind of share arrangement with employees.

Ultimately, the main thing is to ensure that the employees appreciate what they are being offered and that, as a result, they work harder for the company and stay there longer.

For larger companies, the considerations are generally pretty similar, but they may be constrained by investment and remuneration committees who will have their own ideas about how to protect investors. Quoted companies may also be obliged to follow guidelines laid down by the Association of British Insurers, the National Association of Pension Funds (NAPF) and the Stock Exchange.