Structuring share plans tax efficiently – Listed Companies

08 June 2009

Employee Incentives & Benefits Group

Following the income tax hikes announced in the Budget we look at how a helpful announcement by HMRC will enable listed companies to structure employee share plans in the future to secure capital gains tax treatment.

Background

22 April 2009 and 12 January 2009 are two dates which are likely to be etched in the minds of employee incentives lawyers for some time to come.   

On 22 April Alistair Darling announced substantial income tax hikes on top of those already announced in the pre-budget report.  This announcement will open a gap of 33.5% between tax rates on employment income and capital gains and puts the UK at the top end of the range compared to other jurisdictions.   

By a helpful co-incidence, HMRC announced to the Share Plan Lawyers Group on 12 January 2009 that they accept co-ownership plans are effective for tax purposes.  Co-ownership arrangements allow listed companies to structure share plans so participants are taxed on gains as capital. 

These two announcements taken together are likely to alter the way listed companies structure employee share plans in the future.  

How are plans currently structured?

Most listed companies make awards to executives and key employees using long term incentive plans, deferred bonus plans and share option plans in varying combinations. 

These plans should already be structured so as to take advantage of the two discretionary tax advantaged plans, namely:

  • Enterprise management incentives (“EMI”); and

  • Company share option plans (“CSOPs”)

Our fact sheets on LTIPs and deferred bonus plans and share option plans  describe how these plans are typically structured and how to take advantage of EMI and CSOPs. 

EMI and CSOPs remain the most tax-efficient route as they not only allow employees’ gains to be taxed as capital but the employer qualifies for a corporation tax deduction by statute. 

The difficulty with EMI is that it is only available to smaller companies with gross assets of less than £30 million and less than 250 full-time employees, and the individual limit is restricted to £120,000.  For a summary of the conditions click here.

The difficulty with CSOPs is the individual limit is only £30,000 and the plan is inflexible in that options cannot be granted at a discount (so CSOPs are unsuitable for LTIPs and deferred bonus plans which involve free shares). 

The result to date is that many companies use up the EMI / CSOP limits and are then forced to grant the bulk of their awards in a form which does not qualify for tax relief.     

Increases in tax rates

Income tax rates are due to be increased on 5 April 2010 when:

  • the top rate of income tax will rise from 40% to 50% for earnings in excess of £150,000; and

  • individuals with earnings in excess of £100,000 will lose the benefit of the single personal allowance at the rate of £1 for every £2 of income. 

NIC rates are due to increase on 5 April 2011 when:

  • employees’ NIC on earnings above the upper earnings threshold will rise from 1% to 1.5%; and

  • employers’ NIC will rise from 12.8% to 13.3%.

The highest effective marginal rate for participants in employee share plans which are not tax advantaged depends on whether the employer passes on employers NIC costs and will rise as follows:  

























 

2009/10


2010/11


2011/12

Employers’ NIC passed on to employee  

48.68%


57.4%


58.15% 

Employers’ NIC paid by employer 
Employee:  

41%


51%


51.5%

Employer: 

12.8%


12.8%


13.3%

Participants who receive awards in 2009 and beyond are likely to be taxed under the new rates.  If executives have to pay tax at an effective rate of 51.5% when they could have paid 18%, the awards will be less attractive.  Companies should examine the alternatives now to see if the current round of awards can be structured tax efficiently.   

The co-ownership alternative  

Co-ownership plans are available to practically all listed companies without any limit on the size of individual awards.  No deduction is available for corporation tax but the proposed increases in income tax and NIC rates make co-ownership more attractive despite the absence of corporation tax relief (see the example below).
 
Under co-ownership plans:

  • a trustee of the company's employee share ownership plan trust (“ESOP”) buys shares in the market (or subscribes for shares at market value);

  • the participants acquire an interest at the same time in gains made on the sale of the shares in excess of the cost to the ESOP trustee;

  • participants elect to pay income tax on the value of the interest on its acquisition, subsequent gains are taxed as capital;

  • performance targets apply so that participants forfeit the interest to the extent targets are not met after a performance period (usually of three years);

  • once the targets have been met, the participant can require the trustee to sell the shares or have the growth element bought out with shares of an equivalent value. 

These arrangements allow participants to benefit from capital gains tax treatment on gains made in excess of the cost of the shares to the trustee.  After the tax rises on 5 April 2010 and NIC rises on 5 April 2011, on £100 of gain: 
 























 

LTIPs / Deferred Bonus Plans(1)


Co-ownership

Employee pays (2)

£51.50


£18 (3

Employer pays (4)

£13.30


Nil

Employer Corporation tax relief (5)

 (£31.724)


Nil

Net tax cost

£33.076 


£18

                                                                             
Note:
1    Whether structured as nil cost options, RSUs or restricted stock but assuming no election is made to pay tax up front in the case of restricted stock
2    Income tax of 50% assuming earnings in excess of £150,000 and employees NIC of 1.5%
3    Ignoring annual exemptions and losses
4    Assuming employer NIC costs are not passed on to participants
5    Assuming the employer pays corporation tax at the top rate of 28%


In this example the co-ownership plan saves £15.076 per £100 of gain.  The tax savings benefit the employee (who saves £33.50) at the expense of the employer who saves employers NIC but loses out on the corporation tax deduction (the net loss to the employer is £18.424). 

These arrangements only ensure gains in excess of cost to the trustee are taxed as capital.  They replicate “market value” option plans which deliver the same benefit to employees. 

In order to replicate an LTIP or deferred bonus plan fully, it is also necessary to ensure participants receive a benefit equal to the cost of the shares to the ESOP trustee in addition to the gain.  There are a number of ways in which this can be structured which we would be delighted to discuss with you. 

It may be possible to introduce co-ownership without seeking shareholder approval (assuming the plan being replicated contains the usual wording which permits amendments to secure more favourable tax treatment and there are no prior commitments to shareholders).  It makes sense, however, to discuss the position with major institutional shareholders first. 

Please contact us for an initial free meeting to discuss.   

 

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