Employee share schemes allow employees of both quoted and private companies to share in the success of that company.
Evidence suggests that by incentivising the workforce through share schemes, employees are more likely to be motivated to work harder. They are used to attract new employees as well as retain and motivate existing members of staff. There are also tax advantages for both employer and employee and they have gained popularity during the recent recession due to their cost effective nature.
The Finance Bill 2014 (Finance Bill), which is due to become law in April 2014, will make substantial changes to the operation of various share schemes, including introducing self-certification for tax advantaged schemes and online filing of annual returns. These changes will be looked at in detail in a future blog. However, we will focus on the two schemes that crop up most frequently for our clients here at Waterfront: Enterprise Management Incentives; and Company Share Option plans.
Enterprise Management Incentives (EMI)
EMI schemes are designed for start up companies and SMEs due to their low cost as well as the tax advantages on offer. In order to qualify, a company must have less than 250 employees and gross assets of £30million or less. There is no limit on the number of participating employees but the maximum value of awards permitted under the scheme is £120,000 per employee and £3million per company. These can be granted under a set of general plan rules or a stand alone option agreement. Legislation requires that any EMI option takes the form of a written agreement between the option holder and the grantor so it is not possible for an EMI option to be dealt with on an informal basis.
There are certain categories of companies which will not qualify for EMI but technology based firms are able to use them. Despite several changes being proposed in the Finance Bill, an EMI option that is granted will still need to be filed with HMRC 92 days after it has been granted.
In order to meet the eligibility requirements, an employee must work for the company for at least 25 hours a week or, if less, 75% of his working time. Employees cannot be granted EMI options if they, or their associates, have a “material interest” in the company whose shares are used for the scheme. In this case, “material interest” means if they have beneficial ownership of, or the ability to control directly or indirectly, more than 30% of the ordinary share capital of the company.
EMI legislation requires that the options must be capable of being exercised within ten years of the date of grant, and that they can only be exercised within a period of 12 months after the option holder’s death. Companies often incorporate vesting conditions into an EMI scheme, which means that the options can be linked to performance or length of service. This means that employees will not automatically be granted options, thereby encouraging their ongoing performance in their role.
A key feature of EMI is its tax treatment which is linked to the value of the shares. On the grant of the option, there is no income tax or National Insurance. Upon the exercise of the option, there is no income tax or NIC if the exercise price on grant was equal to the market value of the shares. On a disposal of the option shares, Capital Gains Tax may be payable on any gain over the market value at grant.
Company Share Option Plans (CSOP)
A CSOP is normally used when EMI is not available to companies, whether as a result of being a non qualifying business or exceeding the employees and assets thresholds set out above.
Significant changes are to be made to CSOP following the publication of the Finance Bill. Unlike the current position, new schemes will have to be self certified and registered with HMRC rather than requiring prior approval. Similarly, the value of the price payable for the shares will no longer be agreed in advance with HMRC and instead, guidance will be published of the various valuation methodologies. Similar to EMI options, the maximum value of shares (valued at the date of the grant of option) that any one person can hold under unexercised CSOP options is £30,000 and this will remain the case.
Although a company retains discretion over which employees can participate, CSOP options can only be granted to full time employees and directors. As is the case with EMI, employees cannot participate in a CSOP if they, or their associates, have a material interest in the company whose shares are used for the scheme.
The key feature of such a scheme is that the price payable for shares on the exercise of a CSOP option must not be less than their market value at the time of grant. Generally, a CSOP can specify that exercise of the option can take place at any time. However, it has become the norm for the option not to be exercised before the third anniversary of the grant as this obtains a significant tax benefit. The rules of the CSOP should specify exactly when options lapse but it is usually when the individual leaves employment.
Employee share schemes are considered to be a cost effective and tax efficient means of recruiting, retaining and motivating employees. Several studies have shown that the productivity of employees can be improved through a minimal cash cost to the employer. Furthermore, the schemes are hugely important for companies who may otherwise find it difficult to attract the best talent to their developing business. EMI options in particular are tailor made for start up companies who may not be able to afford large salaries or cash bonuses. From the perspective of employees, they provide an opportunity to acquire a stake in their employer at no extra cost to them which may result in significant financial gains in the long run.
Granting options raise the possibility existing shareholders suffering equity dilution. A way to combat this is to impose limits on the number of shares that can be used for employee incentives. From the point of view of the employee, much depends upon the growth of the company otherwise the shares may not be worth very much when they come to be exercised. Schemes also tend to come with good and bad leaver provisions which, depending on how they are drafted, may not be advantageous to employees.
Although undergoing legislative tinkering on a yearly basis, employee share schemes are rapidly becoming standard provisions in service agreements, particularly among more senior members of staff. They are governed by complex regulations so it is important to get them right. Consulting your lawyers and accountants will help to ensure that the documentation is correct and no nasty surprises are waiting for either the Company or employee.
If your company is looking to set up an employee share scheme, please contact Matt Cunningham or Patrick Peake in the Corporate team on 020 7234 0200.