Share acquisition arrangements
Shares may be given to employees without any restriction, although this is unusual – the shares are normally subject to some restriction, for example forfeiture on cessation of employment and/or restrictions on transfer.
The shares that are awarded are usually shares in the participant’s employing company or a parent company and where the shares are subject to restrictions they often “vest” (ie some or all of the restrictions are lifted) over a period of years. For example, restricted shares may vest over three years in equal portions on the first, second and third anniversaries of the date of award.
Employees may pay market value for their shares or the shares may be provided at a discount to market value or for free and the shares may be subject to specific performance targets before restrictions are lifted.
From a tax perspective, the basic principle is that the employee will be subject to employment income tax on the value of any benefit conferred on them unless there is a specific exemption:
- For “unrestricted” share awards this normally means that employment income tax is payable on the amount by which the market value of the shares at the time of acquisition exceeds any amount paid by the employee for the shares. Once employees have acquired shares and either paid market value for them or paid tax by reference to their market value, any future increase in value is normally treated as a capital gain.
- “Restricted shares” are subject to complex rules, but the most common employee share award structures mean that shares are not subject to employment income tax on acquisition unless the employee and employer elect to pay tax and in the absence of an election, employment income tax charges usually arise on vesting.
- However, where restricted shares are awarded under one of the tax favoured arrangements permitted by the UK’s tax legislation, income tax relief is available when the share is awarded and/or on vesting and capital gains tax is normally assessed on the sale of the shares.
Restricted Stock and Contingent Awards under Long Term Incentive Plans
Awards of shares to directors and senior employees are often made as Contingent Awards under a Long Term Incentive Plan (LTIP). “LTIP” is an “umbrella” term which is used to describe various award structures. The vesting of LTIP awards is often linked to individual or company performance.
More broad based awards and deferred bonus awards are often made under Restricted Stock Plans, which operate in similar ways to LTIPs, although vesting may not be directly linked to individual or company performance.
Under these awards an employee acquires shares which are subject to restrictions for a period of time. During the restricted period, the employee holds the legal and beneficial interest in the shares but is unable to sell, transfer or otherwise deal with the shares. Often, the shares are subject to forfeiture if the employee’s employment ceases before the end of the restricted period. The restrictions on the shares may lift when specified time periods elapse and/or on the achievement of corporate performance targets. An employee may be entitled to dividends and voting rights during the vesting period.
The most common scenario is for employees to acquire shares which are subject to forfeiture restrictions which are not capable of lasting for more than five years after the date of acquisition. In these circumstances, no liability to employment income tax or NICs arises on the acquisition of the shares unless the employee and employer elect to pay tax should the “unrestricted” market value of the shares at that time under section 431 of ITEPA (which prevents any further gain in the value of the shares being subject to an income tax and NICs charge). Where no election is made, a liability to income tax and NICs arises at the time the restrictions cease to apply or on an earlier sale of the shares by reference to the amount by which the market value of the shares at the time the restrictions cease exceeds any amount paid by the employee for the shares.
The employing company is normally entitled to claim a corporation tax deduction equal to the amount by which the market value of the shares on vesting (or acquisition if a section 431 election is signed) exceeds any amount paid by the employee for the shares.
Growth Share Plans
There are many ways in which growth share structures can work. Broadly, employees acquire a separate class of restricted shares which have little or no value until specific hurdles or targets are met at which time they can be sold for a predetermined value or a value calculated according to a formula. The value of the shares at acquisition should be heavily discounted as a result of the hurdles/targets, meaning that employees can more easily afford to pay market value for the shares or elect to pay tax by reference to the market value at the time of acquisition.
Assuming employees pay market value for the shares or elect to pay employment income tax by reference to the unrestricted market value at the time of acquisition, any increase in value of the shares should be treated as a capital gain.
Partly Paid Share Plans
Under partly paid share plans, employees acquire shares for full market value, but pay only a nominal amount, with the rest of the purchase price remaining outstanding between the employee and the company. The shares can be subject to forfeiture if the employee leaves employment within a specified period. Participants may be permitted to vote and receive dividends in respect of the shares that they hold and the outstanding purchase price is normally repaid from the proceeds of sale of the shares and/or deducted from any dividends payable to the employees.
As the employees acquire the shares for market value, they are normally not subject to employment income tax on acquisition. On sale of the shares, any increase in value of the shares above the market value as at the date of acquisition should be treated as a capital gain.
While a participant holds partly paid shares, the outstanding purchase price is normally treated as a beneficial loan for employment income tax purposes (although there are some exemptions that may apply). Where a "deemed loan" arises, income tax is charged annually on notional interest in respect of the outstanding share purchase price. The tax is payable through the individual's self-assessment tax return and Class 1A (employer's) NICs are payable in respect of the taxable benefit. However, if for any reason the loan is written off, the amount written off is normally subject to PAYE income tax and employee's and employer's NICs.
Joint Share Ownership Plans
Joint Share Ownership Plans operate in conjunction with an employee benefit trust. The employee and the trustees become joint owners of the shares, agreeing at the outset how the eventual proceeds of sale of the shares will be divided between them. The participants’ share rights can be forfeitable in the event of cessation of employment and can carry shared voting rights and/or shared rights to dividends. Usually the employees pay a nominal amount for an entitlement to any growth in value of the shares over a set hurdle while the trustees pay most of the share value, which they recover when the shares are sold.
The employees elect to pay employment income tax on any amount by which the unrestricted market value of their interest in the shares at the time of acquisition exceeds the amount (if any) that they pay for the share interest. The market value of the employees’ share interests should be quite low. Using these ownership rights could, therefore, reduce the up-front cost of paying full value for the rights or paying tax by reference to that value at the time of acquisition.
Any growth in value of the employees’ share rights after acquisition should be treated as a capital gain.
Share Incentive Plan (SIP)
A SIP is a tax-favoured “all employee” arrangement under which employees can be awarded or purchase shares which, in each case, are held by a trust. Contributions are required from the company to fund the award of free shares to employees. A SIP must meet certain legal requirements for tax favoured treatment to apply which are set out in Schedule 2 to ITEPA. The main features are as follows:
- up to £3,600 of free shares per tax year per employee can be awarded by the company - the award can be based on performance targets
- employees can purchase partnership shares from pre-tax salary up to an annual limit of the lesser of £1,800 or 10% of total salary for the tax year
- matching shares can be awarded by the company to a participant up to a maximum ratio of 2:1 for every partnership share purchased
- free and matching shares must be subject to a retention period of between three and five years
- the company may allow dividends payable in respect of shares awarded or purchased under a SIP to be reinvested in further shares (subject to a limit if the company wishes to impose one)
- there is limited discretion in selecting participants – broadly, all UK employees who have completed a specified period (if any) of service of up to 18 months must be eligible to participate
- shares may be forfeited on a participant ceasing to be an employee of the company for a reason other than a “good leaver” reason, depending on how long the shares have been held in the trust, and
- SIP shares must be ordinary shares in a company that is listed on a recognised stock exchange, is controlled by a company listed on a recognised stock exchange, is not under the control of another company or is controlled by an employee ownership trust.
No income tax or NICs liability will arise at the time an employee purchases or is awarded shares under a SIP.
The tax treatment of awards varies according to the type of shares held and when the shares are removed from the trust, but the shares will be tax-free if held by the trust for five years or more. In addition, shares may be removed from the trust prior to the expiry of five years without attracting a tax liability where an employee leaves the company in certain limited “good leaver” circumstances or following a corporate event.
The employing company is normally entitled to claim a corporation tax deduction equal to the value of free or matching shares at the time they cease to be restricted (subject to certain qualifying conditions).
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.