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Navigate the minefield of employee share ownership

Companies often use share ownership to motivate, recruit and retain key staff and to align the interests of employees with those of shareholders.

Issuing shares to employees can also be really useful in high growth or start-up businesses where the business isn’t in a position to pay large salaries or bonuses.

The schemes we advise on are broadly divided into tax-advantaged share schemes and non-tax advantaged (non-approved) share schemes; and we work closely with the business’s tax advisers to structure attractive and efficient share schemes for the benefit of your employees.

The disadvantage of a non-approved share scheme is that employees can be liable to pay income tax and capital gains tax.

EMI share schemes

Enterprise Management Incentives (EMI) share schemes are very popular among owner-managed businesses as they enable an employer to pick and choose which employees are eligible to join the scheme; and they allow the employer to set the exercise criteria. Also, shares are not actually issued; instead the employee has the right to obtain shares if certain conditions are satisfied. The advantage of this is that the company doesn’t have to go through a process of recovering the shares if the employee leaves the business for any reason whatsoever.

EMI schemes are available to businesses which meet the following criteria:

  1. limited by shares
  2. independent (not owned by another company)
  3. gross assets of less than £30million
  4. fewer than 250 employees
  5. involved in an eligible commercial trade (businesses involved in property investment, banking, insurance and professional services are among those who don’t qualify)

Employees are eligible to participate if they work at least 25 hours a week (or they work for more than 75 per cent of their working time). Employees can be granted up to £250,000 of EMI options each; and the total value of shares in a company which may be subject to unexercised EMI options at any time is £3 million.

The options can be exercised either on a sale of the company and/or provided a set of performance criteria are satisfied including factors such as length of service or financial performance; and the options lapse (subject to very limited exceptions) if the employee leaves the company.

The huge advantage of an EMI scheme is that there is no income tax or national insurance to pay when an employee exercises an EMI option and there can also be a reduced rate of capital gains tax.

EMI options need to be properly documented to ensure that they comply with the legislation; and, where the options are exercisable other than on an exit , to ensure that (as companies usually want) if the employee leaves the company the employee is required to transfer the shares.

Share options are still a possibility if the company does not meet the EMI criteria; however, income tax and capital gains tax would, in all likelihood, be payable as the shares will qualify as employment related securities.

Growth shares and hurdle shares

Growth shares and hurdle shares are tax efficient structures to incentivise senior employees or directors, providing the opportunity to invest in the company and participate in future growth with a low initial investment. Even greater efficiency can be achieved by granting EMI options over the growth or hurdle shares.

Growth shares are a separate class of shares designed to allow the holders to benefit only from growth in the value of the company from the time the shares are issued; whereas hurdle shares enable the holders to benefit from growth in the value of the company above a hurdle which exceeds the current value of the company: if the current value of a company is £1 million then the hurdle shares may only participate in growth over a sum in excess of that amount, such as £1.5 million.

Typically, growth shares have the following characteristics which will be set out in the articles of association of the company:

  • On a return of capital (either from the proceeds of sale or on winding up) they don’t get to participate until a certain amount (usually linked to the threshold value at the time the shares were issued) has been distributed to the holders of ordinary shares;
  • Rights to dividend are either excluded entirely or based on the proportion of value which the growth shares as a class represent to the value of the company as a whole; and
  • Voting rights are often excluded.

In the event of an employee holding growth shares leaving the company, there is usually an obligation on the shareholder to offer the shares for sale; and the price payable for those shares can vary depending upon whether the leaver is a good or bad leaver.

The principal reason for introducing growth shares is to enable employees/directors to invest in the company without having to pay for a share at its current value. Provided that the proposed shareholder either pays the full unrestricted market value for the shares, as determined at the time they are acquired, and/or enters into a joint s431 election, then the risk of a subsequent income tax charge on a proportion of the subsequent growth in value can be avoided.

Unfortunately, unless the growth shares are being issued in combination with an EMI scheme, it is not possible to obtain HMRC confirmation of the unrestricted market value; so it is important that the determination of the valuation is properly documented at the time of issue, in case it is subsequently questioned by HMRC.

Employee Ownership Trusts (EOTs)

It is generally accepted that employee-owned companies have greater productivity, reduced staff turnover levels and better long-term planning. In recognition of this the government introduced legislation in 2014 to encourage employee ownership including a capital gains tax exemption when an owner sells a controlling interest in their business to an EOT; along with a potential annual income tax windfall for employees as companies controlled by EOTs are able to pay tax-free cash bonuses to their employees of up to £3,600 per employee per year.

An EOT enables a company to become owned by its employees. It’s far simpler than creating employee ownership by allocating all the shares to employees individually. An EOT can be set up by a company’s existing owners, maybe as part of their exit or succession planning; or by founders starting a new enterprise which they want to be employee-owned.

Basically, an EOT is a form of employee benefit trust. This structure works particularly well for niche creative or technical owner-managed businesses where a trade sale isn’t necessarily available and the founder may be looking to retire or step back from day-to-day management. An EOT is particularly suitable for situations where there is a skilled senior management team and the business generates enough profit to fund its own purchase; or where a third party funder is prepared to lend to the company to facilitate the sale.

The legislation sets out key tax relief requirements which must be satisfied in order to qualify for both income tax and capital gains tax relief:

  • The trust must hold a controlling interest with reference to: the percentage of the ordinary share capital; a majority of the voting rights; entitlement to profit; and to assets on a winding up;
  • The company must either be a trading company or the principal company of a trading group (the Trading Requirement);
  • All eligible employees must benefit equally under the terms of the trust and the eligible employees are all employees subject to very limited exceptions;
  • Any distribution from the trust fund, or payment under a bonus scheme that qualifies for relief, must be for the benefit of all eligible employees on the same terms; although it is possible to determine the size of awards by reference to remuneration, length of service and hours worked.

If a sale to an EOT is being considered it is essential to work out what the payment will be; how it will be funded; and - if the payment is on deferred terms - how the deferred element will be protected. In setting up the trust it is also key to ensure that the directors of the company are responsible for the day-to-day management, whereas the trustees have oversight as shareholders and their decisions reflect their obligations to the employees and to the terms of the trust deed.

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