•Income tax applies where employees acquire shares for less than they are worth
•HMRC valuations of employee shares may be higher than anticipated
•Shares in unlisted companies are usually not liable to PAYE/NIC
•A corporation tax deduction may be available
•EMI share options may be worth consideration
•Exit strategy to be given consideration
•Dividends may be taxable as remuneration in some situations
“I want to give a senior employee some shares”, will be a familiar opening to a conversation between many company owners and their accountants or tax practitioners. It sounds simple enough but where tax is concerned things are rarely as simple as they seem. There are a number of practical and technical issues which must be considered. The technical side can get very complicated indeed as it may involve the onerous ‘employment related securities’ (ERS) legislation (ITEPA 2003, Pt 7) which is basically anti-avoidance legislation designed to ensure that any otherwise untaxed benefit received by an employee in relation to ERS is subject to income tax.
This article aims to cover some of the practicalities of employee share awards.
The starting point is that if an employee acquires shares in his employer and pays less than the shares are worth, as will usually be the case, they are taxable on the difference between the value of the shares and any consideration given. This rule has long been established in tax case law (e.g. Weight v Salmon HL 1935, 19 TC 174; Ede v Wilson, KB 1945, 26 TC 381).
If an income tax charge arises on acquisition of shares it does not in fact arise from the ERS legislation but from the general rules for taxing employment income i.e. as ‘earnings’ which includes any receipt in money or ‘money’s worth’ e.g. the ‘money’s worth’ value of a suit provided to an employee was held to be its second-hand value in one famous tax case. In practice the ‘open market’ method of valuation used for other tax purposes produces a similar result. For a trading company the valuation would traditionally be based upon a multiple of the company’s ‘maintainable earnings’ and then discounted by (say) 80% or more for small minority holdings.
It may thus be expected that very small percentage shareholdings will have negligible market value. In practice the approach of HMRC Shares and Assets Valuation ‘team’ (SAV) seems to be to ‘talk up’ these valuations by taking the ‘price-earnings ratio’ of a comparable quoted company and then discounting for lack of marketability, etc. The resulting valuation is often much higher than an open market valuation on traditional lines.
Tax on acquisition
It is often assumed that any income tax liability of an employee on receipt of shares is payable via PAYE. For unlisted company shares, PAYE (and National Insurance contributions (NIC)) is only payable if the shares are ‘readily convertible assets’ (RCAs), as defined in ITEPA 2003, s 702. Unlisted company shares are not RCAs unless ‘trading arrangements’ are in existence or likely to come into existence. For example if when the shares were acquired negotiations for the sale of the company had reached an advanced stage or arrangements for the flotation of the company were in progress, trading arrangements would be in existence or likely to come into existence and the shares would be RCAs. In that case the company must apply PAYE and NIC based upon the estimated value of the shares. The employee is obliged to enter the value of the shares on his tax return for the tax year in which the shares were acquired (in the ‘additional information’ section). It is possible to agree a value with SAV for these purposes, but not until the shares have been awarded.
Corporation tax deduction
A company will often be able to claim a corporation tax (CT) deduction where shares are acquired by an employee on which the employee is liable to income tax. The deduction is usually the difference between the market value of the shares and what, if anything, the employee pays for them.
The CT deduction is available whether the shares were issued by the company or transferred from a shareholder, provided the employee is subject to an income tax charge (or potentially so) on acquisition.
Payment of PAYE/NICs
As explained, unlisted company shares will not usually be RCAs, and therefore no PAYE/NIC should be payable on the award of shares. If, exceptionally, the shares are RCAs, obviously PAYE cannot be deducted from an award of shares, in which case the employee must reimburse the company for the PAYE within 90 days of acquisition; otherwise, the PAYE is treated as a benefit in kind (ITEPA 2003, s 222).
Enterprise management incentives (EMI) share options enjoy certain tax advantages and may be considered as an alternative to an outright share award, where the employee may suffer an income tax charge on acquisition without receiving any funds with which to pay it.
The effect of EMI options is that income tax is not payable until the option is exercised and then only on the market value when the option was granted less the option price (unlike ‘unapproved’ share options where the employee is taxable by reference to the market value at the time of exercise).
For disposals prior to 6 April 2013, shares acquired though EMI may not have qualified for CGT entrepreneurs’ relief (ER) on disposal (a) if the holding was less than 5% of the company’s equity and (b) because EMI options are typically not exercised until shortly before the sale of the company and so may not have met the 12 month ownership requirement for ER. Under changes in Finance Bill 2013, relief will apply for disposals after 5 April 2013 for shares acquired after 5 April 2012 where the option had been granted at least 12 months before disposal.
Given the lack of marketability of private company shares, to provide a real incentive consideration must be given to how the employee will realise the shares in due course.
Often the exit route will be the anticipated sale of the company and so the employee will benefit from a share of the sale proceeds. In the case of, say, a family company where no sale of the company is in prospect, careful consideration should be given to appropriate transfer restrictions and pre-emption rights requiring the employee to transfer the shares on termination of the employment at valuation - e.g. ‘fair’ value in the case of a ‘good leaver, or par value in the case of a ‘bad leaver’.
Disguised remuneration issues
Earlier this year a company (PA Holdings Ltd) abandoned its appeal to the Supreme Court over whether dividends paid to employees under a complex, artificial tax avoidance scheme were, in effect, disguised remuneration and therefore subject to PAYE and NIC. The earlier decision of the Court of Appeal (HMRC v PA Holdings Ltd CA  EWCA Civ 1414) now stands and other companies with similar arrangements whose appeals remained open pending the outcome of the case may now face substantial tax bills. HMRC have indicated that there has been no change of policy on owner-managed companies.
Therefore while the status quo holds (for now) as regards most shareholder-directors who draw dividends instead of remuneration, a company share structure which involves anything other than a ‘plain vanilla’ single class of shares with full rights to equity, etc. may prompt an enquiry. Where shares of a different class (or classes) are issued which enjoy few rights other than to dividends and particularly if differential rates of dividend are paid which may be linked to individual performance or part of a reward package (in which case the arrangements could simply be a ‘sham’) must be regarded as high risk.
Practical Tip :
As noted at the beginning of this article while the award of shares to employees may seem straightforward it is in fact quite a complex area and appropriate professional advice needs to be taken both as regards the taxation issues and in drafting any documentation (e.g. shareholders’ agreement, EMI options, etc).
It should also be remembered that the acquisition of the shares by the employee will usually require to be reported to HMRC on ‘Form 42’ (or ‘Form 40’ in the case of shares acquired under EMI options), by 6 July following the year in which the shares were acquired.