We look at how unlisted companies should structure employee share based remuneration to secure capital gains tax treatment.
The tax hikes announced in the budget on 22 April 2009 make it more important than ever for unlisted companies to structure employee share based remuneration tax-efficiently.
1. EMI options
The starting point should be to establish whether it is possible for a company to grant EMI options. If the conditions can be met the tax treatment is very favourable:
- No income tax on grant;
- No income tax on exercise (unless the option was granted at a discount and then only the amount of the discount on grant is taxed on exercise); and
- CGT on the sale of the plan shares.
In addition, the UK employing company will qualify for a statutory corporation tax deduction equal to the gain on the exercise of the option (i.e. market value on exercise less the exercise price).
The corporation tax deduction gives EMI the edge over the other arrangements discussed below. If options are exercised on an exit, the deduction will typically appear as a deferred tax asset in completion statements and it is often possible to persuade purchasers to give selling shareholders credit in negotiations.
Options are easier to operate in that generally no separate class of shares is required and leavers can be dealt with more easily by allowing their options to lapse (thereby avoiding the need to put in place arrangements to buy their shares).
To meet the conditions companies must have:
- gross assets of less than £30 million;
- only “qualifying subsidiaries”;
- less than 250 full-time (or full-time equivalent) employees;
- be independent; and
- satisfy the other conditions, for a full description of these click here
The requirement that a company must have only “qualifying subsidiaries” can cause problems where joint venture holdings are 50:50 creating deadlock but we may be able to help in difficult cases.
Limits and eligibility
There is an individual limit of £120,000 worth of shares which may be subject to unexercised EMI options.
Participants must be employees within the group and must work at least 25 hours per week (or 75% of their working time, if less). There are various other conditions (e.g. reporting, type of shares which may be used etc.) but listed companies are likely to meet these.
2. Growth shares
If the EMI conditions cannot be met (or the limits are exceeded) an alternative we often favour is to create a new class of shares which only participate on an exit on gains in excess of market value on the date of acquisition.
If performance conditions are required, these can be built into the articles thereby further reducing the up front value of the shares.
Employees subscribe for the shares at par and elect to pay income tax on the unrestricted market value ("UMV") of the shares at the outset. Gains thereafter are taxed as capital. The up front value is likely to be no more than par in many cases so the initial cash employees are required to fund is not too onerous.
3. Nil paid shares
If it is not possible to create a new class of shares another possibility is for employees to subscribe for shares nil paid. The amount payable for the shares is the estimated UMV but it is not payable until called by the company.
Employees elect to pay income tax on the UMV of the shares on acquisition. If the amount payable when called is at least equal to UMV, no income tax will be payable on acquisition and subsequent gains are taxed as capital.
The amount left uncalled is taxed as a “notional loan” unless the employee would be eligible for interest relief under section 393 ITA 2007 on borrowings to buy shares. Relief is available if the company is closed and either the individual is actively involved in the "actual management or conduct" of a business or he acquires more than 5% of the issued share capital.
A more recent possibility is co-ownership arrangements. These have been possible since HMRC confirmed they accept these arrangements are tax effective in a meeting with the Share Plan Lawyers Group on 12 January 2009.
The arrangement does not require a separate class of shares but it does require the company to establish an employee share ownership plan trust (“ESOP”) to acquire the shares and for the participant to acquire a co-interest which entitles them to the increase in the value of the shares in excess of the cost to the trustee. As for growth shares, the employee elects to pay tax on the UMV of the co-interest. The arrangement is described in more detail in our article for listed companies on structuring share plans tax efficiently.
We recently advised the venture capital arm of an exploration company to structure carried interests for management using co-ownership arrangements. Whilst more complicated than growth shares or nil paid shares, co-ownership interests are much less complex than traditional carried interest arrangements using limited partnerships and can be more flexible by rewarding management for the performance on individual investments rather than on a pooled basis.