A Guide to the Taxation of Share Plans in the UK

Share plans are a powerful mechanism for companies to recruit, retain and motivate talent. By taking a stake in the business they work for, employees can align their interests with the company's long-term goals.

Over time, UK governments have recognised the value of share plans and encouraged employee participation through several tax-advantaged plans including the Company Share Option Plan, Enterprise Management Incentives, Save-As-You-Earn schemes and Share Incentive Plans. While these plans can provide tax benefits for employers and employees, they are not suitable for, or available to, every business. Even when a company implements a tax-advantaged plan, there are occasions when the tax benefits are unavailable because the required conditions haven't been met.

Taxable share plans therefore offer a practical alternative when the company or employees do not qualify for the tax-advantaged plans. They can also supplement existing tax-advantaged arrangements by providing additional benefits to employees.

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What Types of Taxable Share Plans are available?

As taxable plans are not governed by strict statutory rules, there is a great deal of flexibility over how they work and they can take a number of different forms. Some involve giving participants an interest in shares from the outset whereas others offer a right to acquire shares at a future date.

Overall, there is no "one size fits all" approach to share plans. Companies can tailor or combine both taxable and tax-advantaged plans to achieve the best results for the business and their employees. Each method should be considered in light of the company's commercial objectives, the regulatory requirements and tax implications.

Share Ownership Arrangements

Structured carefully, share ownership arrangements have the advantage of delivering capital gains (as opposed to income) tax treatment on any growth in value. Capital gains are charged at a lower rate (currently 24%) than the top rates of income tax and are not accompanied by social security charges (National Insurance contributions or "NICs"). However, they are not without risk for participants who could lose any investment they make to acquire the shares if the company under performs. The main types of taxable share ownership arrangement are as follows:

Share Offer: This is a straightforward way of encouraging participation in the company's future and involves giving employees the opportunity to acquire shares at a set price. This is often an amount equal to the unrestricted market value of the shares (UMV) although companies may offer them at a discount. It is usually recommended that the participant enters into a s.431 Tax Election (Tax Election) which they must do within 14 days of acquiring their shares (see section 2 below for further information on the consequences of doing this). For ease of administration, it is usual for the legal interest in the shares to be held by a nominee, such as a trustee of the company's employee benefit trust (EBT), on the employee's behalf. Participants can be given the benefit of any rights attaching to their shares (which might include dividends and voting rights) but will usually be required to offer them for sale when they leave. A share offer might be made to a wide range of employees or be limited to senior management (often known as a management incentive plan or MIP).

Joint Share Ownership Plan (JSOP): In a JSOP, participants own the shares jointly with a third party known as the 'co-owner' (who is often a trustee of an EBT). Over time, the individual's interest increases, usually dependent on the value of the shares reaching a pre-determined threshold or "hurdle". The co-owner receives value up to the hurdle, and the participant receives value (if any) above the hurdle. Participants will typically pay UMV for their JSOP interest (although this amount is usually a lot lower than the UMV a whole share due to the existence of the hurdle). A Tax Election is also recommended.

Growth Shares: Typically, these are a class of shares with limited economic rights until a specified value threshold or hurdle is met. They work in a similar way to JSOPs with the key difference being that the shares are owned by the employee outright and are made available under a share offer. They are suitable for companies that can issue a range of classes of shares with different rights attaching to them. As with shares or JSOPs, participants will typically pay UMV for their growth shares and a Tax Election is recommended.

Funding: The acquisition of shares or JSOP interests can be funded out of an employee's net of tax salary or bonus, personal funds and/or a loan provided to the employee by their employer. If loans are used, the employer will need to consider any regulatory obligations it might have (for example in relation to consumer credit protections) as well as the tax implications (see section 2 below for further details of these). Usually, loans will be offered on a full recourse basis, which means employees must repay the loans even if the value of their shares falls. Limited recourse loans against the value of the shares are also possible, if structured correctly, but any future write-off will be taxable.

Share Options

Rather than issue shares to employees from the outset, companies may prefer to grant them options to acquire shares in the future. This has the advantage of not immediately diluting the interests of existing shareholders and does not require shares to be available at the time of grant. For participants, options are lower risk than shares because they can simply choose not to exercise them if they cease to have value. The exercise of an option will, however, trigger a charge to income tax (currently at a marginal rate of 45% for higher earners) and (in most cases) employee and employer's National Insurance contributions ("NICs") (currently at marginal rates of 2% for higher earners and 15% respectively). See section 2 below for further details on the taxation of share options.

Long-Term Incentive Plan (LTIP): Under an LTIP, participants are granted an option to acquire shares at a future date. Options can be granted with an exercise price equal to the market value of the underlying shares or at a discount, including at nil or nominal value, without any adverse tax consequences for the participants or their employer. Although they can be offered to any section of the workforce, LTIPs tend to be used for executive directors and senior employees.

There are broadly two types of LTIP; Performance Share Option Plans (PSPs) and Restricted Share Option Plans (RSPs). In a PSP, participants can only exercise their option if specified performance conditions (usually linked to the growth in the company's value or other strategic measures) are met. In private companies, it is common to see "exit based" awards where exercise can only occur when certain events take place such as the company being sold or listed. RSPs are similar to PSPs but do not require the achievement of specific performance targets and are usually over a smaller number of shares to reflect this. Sometimes companies establish "hybrid" plans under which both PSPs and RSPs can be granted.

Non tax-advantaged part of the Company Share Option Plan (CSOP): There is a £60,000 limit on the value of shares an individual can hold as tax-advantaged CSOP options at any time. It is therefore usual for a CSOP to be designed in two parts with the first part structured as a tax-advantaged CSOP and used to grant options up to the £60,000 limit. The company can grant further options under the second part of the plan which is drafted on broadly the same terms but without the restrictions attaching to tax-advantaged CSOPs.

Even a tax-advantaged CSOP option can give rise to income tax and NICs charges in certain circumstances, for example, if the options are exercised within three years from the date of grant unless this is due to certain company events, death, or specified "good leaver" situations.

Conditional Shares

Similar to share options, conditional share arrangements offer employees an opportunity to acquire shares in the company or group that they work for. They have the same advantages as share options and are taxed (broadly) in the same way as share options. The main difference is that settlement takes place automatically, once all the vesting conditions have been satisfied, and the employee does not have a choice as to when to exercise their award and receive the shares.

The main forms of taxable conditional share arrangements are set out below:

Restricted or Performance Stock Units (RSUs/PSUs): Delivered under an LTIP, each unit represents the right to receive 1 share, typically at nil-cost to the participant, at a future date. Although RSUs/PSUs can be offered to any section of the workforce, they tend to be used for executive directors and senior employees. Participants will only receive their shares if vesting conditions are met. In the case of RSUs these are linked to time only (e.g. 3 or 5 years from grant). In the case of PSUs, these are linked both to time and also the performance of the company or the satisfaction of other strategic measures. In private companies, it is common to see "exit based" awards where vesting can only occur when certain events take place such as the company being sold or listed.

Restricted Share Awards (RSAs): Unlike in the US, RSAs, where shares are issued/transferred to an employee on grant subject to restrictions that fall away over time, are not very common in the UK. There are a number of legal, administrative and tax complexities which make them an unattractive alternative to share options or RSUs.

Cash Settled Arrangements

Due to regulatory constraints or other commercial considerations, companies may be unable or unwilling to issue shares or options to employees. In these situations, companies can use "Phantom Options" or awards (sometimes known as "Share Appreciation Rights" or "SARs"), which provide a cash bonus based on the company's share performance. Phantoms are particularly useful for companies with illiquid shares or for overseas employees residing in jurisdictions that restrict foreign shareholdings.

Tax Treatment in the UK

Even where favourable tax treatment is unavailable, there are still ways to achieve tax efficiencies for both the employee and the company when offering share plans in the UK.

Acquisition of shares

Where shares are acquired under a share ownership arrangement, tax and (usually) both employer's and employee's NICs are due on the difference between the market value of the shares and the amount (if any) paid for them. It is unlawful to ask the employee to bear the employer's NICs which therefore becomes a cost to the company.

Loans

As mentioned above, a company might make a loan available to its employees to help them participate in a share plan (for example to fund the purchase or exercise price). It is possible to make these loans on an interest free basis but if the loan to an individual employee exceeds £10,000, the employee will be charged to tax on the difference between the interest paid and the Official Rate of interest (which can change from time to time). The employer will also incur a corresponding employer's NICs charge. The existence of anti-avoidance legislation means that it is uncommon for third parties (such as the trustee of an EBT) to make loans to employees as these can trigger automatic charges to income tax and national insurance contributions at the time the loan is advanced and is non-refundable, even if the loan is repaid.

The write-off of a loan will give rise to an income tax charge on the amount written off together with employer's and employee's NICs.

Grant of an option

No tax or NICs are payable when an option is granted (this is the case whether it is a taxable or tax-advantaged award).

Exercise of an option

Income tax is payable when an option is exercised and is charged on the difference between the market value of the shares at that time and the aggregate price (if any) paid for them. In most cases, there will also be a corresponding charge to both employer's and employee's NICs on the same amount. The exercise of a share option is one of the very few circumstances in which an employee and employer can agree that the employee will bear the employer's NICs. This helps employers manage their costs and employees can claim tax relief for any employer NIC they pay. Therefore, an additional rate taxpayer paying a combined rate of tax and NICs of 47% will have an effective combined tax and NICs rate of 55.25% on their option gain (assuming an employer's NICs rate of 15%).

Payment of Tax and NICs under PAYE

In the majority of cases, the employer is responsible for paying the tax and NICs outlined above through the PAYE collection system. Employees will be asked to agree that the tax and NICs outlined above is deducted from their salary. When exercising a share option, employees will often allow the company to sell some of the shares they acquire to fund their tax and NICs obligations. In the relatively unusual case where no NICs is payable and the tax is not collectable through PAYE, the employee will need to report the event and pay the tax due through self-assessment.

The cash payment made under a Phantom Option is subject to income tax and NICs in the same way as a cash bonus (but note, it is not possible for the employee to bear the employer's NICs under a Phantom Option).

Tax Elections

Shares awarded to employees are often subject to restrictions, such as the risk of forfeiture within a minimum employment period or limitations on when and to whom they can be sold, which have the effect of reducing their market value.

Usually, when an employee acquires shares by reason of their employment, any future growth in value of those shares will be taxed as capital gains rather than income and will not give rise to NICs. However, there is an anti-avoidance regime in the UK which can trigger additional income tax and NICs charges when the shares are sold or the restrictions lifted. Fortunately, it is possible for employers and employees to take themselves out of this regime by entering into what is known as a "section 431 election". The effect of a section 431 election is that the amount on which tax is charged when shares are acquired or an option exercised is calculated by reference to the (higher) unrestricted market value of the shares. However, this should ensure that subsequent increases in value of the employee's shares will be taxable as capital gains. Not only are capital gains taxed at a lower rate than the higher rates of income tax, they are not accompanied by a charge to NICs and employees can also use their annual CGT exemption to further reduce their tax liability.

To be valid, a section 431 election must be entered into by both the employer and the employee within 14 days of acquiring the shares. Under share option plans, it is common practice for employers to ask employees to agree to the election before an option can be exercised or as part of the award grant process.

Corporate Tax

Many companies operating employment share plans can benefit from a statutory UK corporation tax deduction when an employee is subject to an income tax and/or NICs charge. The employing company can deduct both the employer's NICs paid, and the amount on which the employee is assessed to income tax, from the company's taxable profits. The deduction is made in the accounting period during which the shares are acquired by employees, i.e., the same period when income tax becomes chargeable.

Registration and Reporting Obligations

The award of shares and grant of options must be notified to the UK tax authority (HM Revenue & Customs or "HMRC") through the PAYE online system. Before it can file a return, the company needs to register with HMRC however, all activity relating to a company's non-tax advantaged arrangements can be reported under a single reference number. It is important to note that the employer needs to report all acquisitions of shares or options by reason of an individual's employment, even if they do not give rise to a tax charge.

Once it has registered the plan, the company must submit an annual online return by 6 July following the end of the tax year containing details of all the reportable transactions that have taken place during the tax year. As well as the award of shares, grant and exercise of options, other events need to be reported including the exercise of options. If no such transactions have occurred during the tax year, the company is still required to file a 'nil return' with HMRC.

For more information or tailored advice on employee share incentive plans, please contact a member of the Travers Smith Incentives and Remuneration team below.

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