Which option is best for your client?
Scenario
Your client Acom Ltd is a construction and plant hire business. The company is a family business that has grown significantly over the last 20 years, and is looking to open a new branch - which would require further recruitment, including five positions at manager level. There are currently four equal shareholders - a husband and wife and their adult children. It is a single company, with 260 full-time employees and 31 part-time employees in addition to the directors.
The company has had problems with a high level of staff turnover in the past and is looking to rectify this. It has the cash reserves to potentially improve the current bonus scheme; however, several of the managers have indicated that they would be happier in the long term with the opportunity to acquire shares and have a say in running the company.
The directors are unsure about giving away growth, but are open to passing shares to a limited number of key individuals, provided they can retain control. The company has asked for advice on share-based remuneration, and whether this can be done in a tax-efficient way.
Share bonus plans
The first option to consider is free shares. Instead of paying a cash bonus (or to supplement it), the company could issue shares at its discretion as a reward for hitting targets or reaching a number of years’ continuous service.
The shares do not have to carry dividend or voting rights – which might be attractive if the ultimate aim is to sell the company, as the new shareholders would then receive a share of the capital proceeds as a reward for helping to build the company to the point it was sold. The shares could also be of a different class to the existing ones, meaning if dividends were to be paid instead of a salary bonus, this could be done separately to the main shares held by the owner managers.
Tax considerations
On the face of it this might be the simplest option for Acom; however, the arrangement is not tax efficient for either the employee or your employer client. The value of the shares given is deemed to be income of the employment, and so income tax is payable by the employee.
Pro advice. The amount that is chargeable as income should be allowable as a deduction from the company’s taxable profits - putting it in the same position as if a cash bonus had been paid.
If the shares are readily convertible assets (RCAs) - broadly they can be sold easily, e.g. if they are listed - the tax is payable via the PAYE system, and both primary and secondary Class 1 NI would be due. This means the CT deduction is less valuable.
Example. Acom gives the five new managers (higher rate taxpayers) new shares worth £25,000 each, giving a CT deduction of £125,000 x 20% = £25,000. These are held by HMRC to be RCAs, so the company will have to pay £3,450 x 5 = £17,250 in secondary NI, so the actual saving is only £7,750. Each manager will pay at least £10,500 in tax and NI - possibly more if the award pushes them into the additional rate or personal allowance withdrawal.
For guidance on whether shares are RCAs (see Follow up ).
Pro advice. An approved option scheme will usually be a better choice from both a tax and non-tax perspective, unless there is a good reason or one of the HMRC endorsed schemes can’t be used.
Option schemes
Instead of shares, the company could grant options over shares, capable of being exercised at some point in the future but with an exercise price set at the current market value, meaning the shares are paid for, but the price should be lower than the share’s true value.
The upside of this is that the employee isn’t subject to an immediate tax charge - the tax point for anything due is on exercise, not grant. If the scheme is unapproved, however, there will still be a tax charge on the difference between the exercise price and the market value.
The real efficiency comes if the company qualifies for one of the HMRC endorsed option schemes - particularly the enterprise management incentive (EMI) or the company share option plan (CSOP).
We discussed the EMI in yr.2, iss.10. pg.8 (see Follow up ) and that should always be used if your client qualifies. However, Acom will not to be able to use it as it already exceeds the maximum permitted number of employees.
Pro advice. You will notice that most (though not all) of the tax advantages are conferred on the employee and not your employer client. However, you need to have approved schemes in your advisory arsenal as your clients looking at share-based remuneration will want to make it as attractive, hence tax efficient, as possible.
The CSOP
A similar scheme is available under the CSOP which permits options over shares worth up to £30,000 (per employee) to be granted to hand-picked employees, and has far less restrictive conditions. Non-trading companies can use it, for example, as can overseas parent companies looking to grow a subsidiary in the UK (although the shares have to be in the parent company).
The employee can’t exercise the options before the third anniversary of the grant date. This helps to tie them to the company for the medium term and reduce staff turnover - which was the priority for Acom.
Your client can also stipulate additional terms, such as minimum service length, specific sales or profit margin targets etc., which serves to provide a performance incentive. Because shares are paid for, it is growth, not value being gifted.
Tax breaks
So why might Acom’s employees prefer the CSOP scheme to straight gifts of shares? The main reason is that, provided all of HMRC’s conditions (see Follow up ) are met, there will be no income tax charge when the option is exercised, even if the market value exceeds the exercise price. Instead, the increase in the value is taxed when the shares are sold, and are subject to the more favourable CGT regime. Entrepreneurs’ relief might even apply if the circumstances are right. The employer won’t be subject to NI either, which means it can enjoy the full CT deduction on the employees’ gain when the options are exercised.
Example. Instead of shares, Acom provides options over £25,000 worth of shares to each of the five new managers through the CSOP. When the options are exercised, these tranches are valued at £40,000 each. No income tax is payable by the managers, and the company will receive a deduction worth (5 x £15,000) x 20% = £15,000 in tax saved. The amounts of £25,000 each have been paid up too, so in pure cash terms, the company is £132,250 better off than if the shares had been given for nothing. If the managers sold the shares at that valuation, they would be charged to CGT on a gain of £15,000 each, against which the annual allowance of £11,100 can be offset.
Pro advice 1. If the options are being exercised ahead of a sale, your client can loan the required funds, and be repaid from the sales proceeds.
Pro advice 2. The costs of setting up a CSOP - for example your professional fees for the advice - are specifically allowable deductions.
Always bring up the potential of using approved option schemes for your clients if they’re considering share-based remuneration. If a CSOP is to be implemented, it needs to be self-certified as qualifying and registered with HMRC, which provides guidance on how to do this (see Follow up ).
Guidance on readily convertible assets
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CSOP conditions
Registration guidance
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