Employee Shares – What Are The ‘Options’?

There are a number of ways in which shares can be awarded to employees but the choices can be confusing, especially if the basic principles are not understood. This article explains some key concepts and summarises the ‘bare bones’ of some of the tax-advantaged and non-tax-advantaged arrangements.

A successful employer’s thoughts often turn to ways of giving key employees in particular more of a stake in the business, both as a reward and an incentive. When considering employee share awards there are a couple of basic issues, which operate rather like a two-edged sword in a private company context. 

The first is that shares are in effect earnings. The employee is taxable on the market value of the shares less what they pay for the shares (if anything). This is nothing to do with the employment-related securities (ERS) rules (in ITEPA 2003, Pt 7). The precedent was set by case law in the 1930s (e.g. Weight v Salmon HL 1935, 19 TC 174). The other issue is that private company shares are not, by their nature, freely transferable. The employee may be happy to be awarded shares but shares are not ‘pound notes’ and the employee will have to fund any income tax on such ‘earnings’ out of their own pocket. Not only that, they cannot ‘cash in’ the shares when they choose to, and so where is the incentive?

The immediate cash-flow issue may be ameliorated by an interest-free loan from the company, although this will give rise to a benefit-in-kind if the de minimis threshold of £10,000 is exceeded. The second issue is trickier. If there is a realistic possibility that the company will be floated or sold in the foreseeable future, that would provide an exit route. Otherwise, it would not normally be commercially acceptable for the employee to sell the shares outside the company or to retain the shares on ceasing employment. At that point, the company’s articles may bind the employee to offer the shares to other shareholders for a price calculated in accordance with the articles. This will often be market value or ‘fair’ market value if the employee is a ‘good leaver’ or a lower value or whatever the employee paid for the shares if they are a ‘bad leaver’. A good leaver will usually be a retiree and a bad leaver may be an employee who takes another job.

Alternatively, the company may set up an employee benefit trust (EBT), which may award and buy back shares from employees on such terms as meet the company’s objectives in awarding the shares. Awards of private company shares are not usually liable to National Insurance contributions (NIC) because they are not ‘readily convertible assets’ as the shares are not marketable. But the existence of an EBT means that there is a market for the shares and employees’ and employers’ NIC may be payable based on the market value when the shares are awarded; and income tax and NIC liabilities may arise on disposal under ERS rules in some circumstances.

A company may also of course purchase its own shares (CA 2006, s 690) but it cannot guarantee to do so as this depends upon the reserves available at the time. ‘Capital treatment’ may be available if certain requirements (in CTA 2010, ss 1033–1043) are met, but that is beyond the scope of this article. 

An outright share award is taxed as outlined above. Sometimes shares are offered ‘nil paid’ at market value, which helps to avoid a charge on acquisition, but the employee remains liable for the ‘call’ on the shares. The amount unpaid is excepted from the benefit-in-kind rules because the ‘loan’ is to buy shares in a private company, although an income tax charge will arise if the outstanding call is ultimately waived.

Share options granted otherwise than through a ‘tax-advantaged’ scheme are not tax-efficient, but might still be commercially expedient. There is no tax charge on the grant of an ERS option, but when exercised the employee is taxable on the market value of the shares received. If that is shortly before the sale of the company, the employee might not benefit from capital gains tax (CGT) entrepreneurs’ relief (ER) even if the ‘personal company’ test (i.e. broadly owning 5% of the ordinary share capital/voting rights) is met, because there is unlikely to be a capital gain since all or most of the value of the shares is liable to income tax.

Enterprise management incentives (EMI) share options are often the first port of call when considering employee share awards, and can be offered to selected employees only. As long as the option price is not less than the market value of the shares at the time of grant there is no charge on exercise of the option. The growth in value in the meantime is subject only to CGT when the shares are sold. Moreover, the ‘personal company’ requirements are relaxed in the case of shares acquired under EMI options. There is no minimum percentage requirement and, provided that the option was granted at least a year before disposal of the option shares, ER is available (so the option might be exercisable just before the sale of the company). The employee cannot hold options over shares with a market value (at grant) of more than £250,000 and there are various other requirements and stipulations over the size of the company. 

If the options are granted at a discount, the discount is taxable on exercise, but EMI options are often partnered with ‘growth shares’ which have a low value on acquisition as they usually have no dividend or other rights, and therefore can only benefit from future capital growth.

A company share ownership plan (CSOP) also allows the company to be selective as to which employees are granted options. The limit on the market value of the shares under option is only £30,000, which is obviously much lower than the EMI limit. But there are fewer limitations over the size of the company, and what really matters is what the shares may be worth in future. If the company is expected to grow rapidly a CSOP may be attractive, even for private companies. The option price must, however, not be ‘manifestly less’ than the market value of the shares on grant, and unlike shares acquired under EMI options there is no relaxation of the ER rules for shares acquired under CSOP options. 

‘Employee shareholder’ is an employment status: for giving up certain employment rights (e.g. unfair dismissal, redundancy, etc.) the employee is awarded shares with a minimum value of £2,000. Any value in excess of £2,000 is taxable. For shares issued before 17 March 2016, provided the market value of the shares was not more than £50,000, the gain on disposal was exempt from CGT whatever the amount. Finance Bill 2016 limits the exempt gain to £100,000 for shares issued on or after that date. Employee shareholder shares could take the form of growth shares (see above), and so one can certainly envisage circumstances where employees might find the arrangement attractive, possibly as an alternative to EMI, albeit that this does involve giving up certain valuable rights.