Managing reward: Share schemes
Section seven of the Personnel Today Management Resources one stop guide on managing reward, covering share schemes, including: employee share ownership; share scheme currencies; all-employee share plans; executive share schemes; and international perspectives. Other sections .
|
|
Employee share ownership
Whether direct ownership (ie, purchasing and holding shares) or a shareholding interest (eg, through a share option or phantom plan), share scheme participation can prove an effective means of aligning the financial interests of employees with those of investors. Share scheme participation helps employees think and act like owners, focuses attention on longer term business considerations and assists people to identify with their employer in a way which contributes to a sense of engagement.
Approved and Unapproved Share Plans
A growing number of governments around the world are recognising the importance of the above business mindset and behaviour to the creation of wealth and have introduced tax incentives to promote employee 'share ownership'. In the UK this process commenced in 1978, when the Lib-Lab pact gave rise to tax-favoured profit sharing plans where "profits" were distributed in the form of company shares. In the 1980s momentum gathered with the Thatcher Governments initiating new tax incentives to promote investment and share ownership, which were further extended by the Labour Government elected in 1997.
The main forms of tax incentive provided by government are to treat share plan earnings as capital gains rather than employment income, and to extend lower rates of capital gains tax to shares held in a company which employs the shareholder. By extension the company may enjoy a corporation tax deduction for the expense associated with the share plan and may also be exempt from the obligation to pay social security taxes (eg, employer's NIC) on the earnings employees receive from share plans. When such tax favoured status is extended to a share plan it is described as 'approved' and where no special tax incentives exist, the share plan is described as 'unapproved'. The equivalent terms applied by the Internal Revenue Service (IRS) in the US are 'qualified' and 'non-qualified' respectively.
In summary, unapproved share plans will be subject to income tax and national insurance contributions whereas earnings from approved share plans will be treated as capital gains. The rates which apply to share plan gains in 2004-05 for employees are shown in the table below:
In all cases favourable tax treatment is dependent on the company complying with Inland Revenue approved rules, both at the time the plan is first submitting and continuing through its lifecycle.
Share scheme currencies
Share Options
The most commonly used currency in employee share plans is share options. A share option represents a right to buy (or sell) a share at a predetermined price. When used in employee share plans the share option will invariably be a right to buy in the future at a price set today. The right to buy usually 'vests' three years after the date the option is granted (ie, awarded to the employee) and expires ten years after the same date. For example, if Lloyds TSB granted options to employees at £3.00 in March 2003, the earliest date that the option could be 'exercised' (ie, the employee could exercise their right to buy) is March 2006. If the employee has not exercised the option to purchase at £3.00 before March 2013 then the option would expire.
Upon exercise, say at £7.00 in 2008, the (taxable) profit per share would be £4.00. If approved the £4.00 of profit would be treated as a capital gain, or if unapproved, as income tax. The approved gain would be exempt from both employer and employee national insurance contributions, whereas the unapproved gain would incur NI.
Stock Appreciation Rights (SAR)
Stock Appreciation Rights look and feel like share options, but are in effect cash based rather than share plans. An SAR is a unit of cash which tracks or ghosts the appreciation in the actual share price of a real share. To extend the example given above, Lloyds TSB could issue SARs to employees at £3.00 per unit of value and the 'appreciation' achieved in that unit of cash would be £4.00 if the SAR was exercised at the time when the share price had reached £7.00. Profit per "share" is taxed as employment income due to the underlying fact that the SAR is cash based rather than a share or share option scheme. SARs are commonly used in those countries where financial services regulators or exchange controls prohibit or limit the holding of shares or share options in foreign companies. For example, in the US the Securities and Exchange Commission (SEC) limits the number of employees/total value of shares in a company which can be put under option when that business does not have a US stock exchange listing. Historically, India is another country where SARs have had to be used in lieu of share options.
Phantom shares
Phantom shares are units of cash dressed up to look and feel like shares. They are most commonly used in financial services and/or private companies whose shares are not listed on a stock exchange. Unlike a Stock Appreciation Right (SAR) they usually have no face value but operate, pay out and are taxed on a similar basis to SARs. Their main advantage over SARs is their flexibility. Their main disadvantage is that their value is not necessarily aligned to the interests of shareholders. A phantom share could easily be appreciating in value during a period when the actual share price of the business is falling.
Being a cash plan the performance measures used to appreciate or depreciate the value of a phantom can be whatever the organisation chooses, eg, profit improvement, Net Asset Value (NAV) per share, sales growth, the achievement of a predetermined target. An employee would normally be awarded a number of phantom shares, each of which has nil value at the date of award (nb, no tax charge arises at the time of award). After either a prescribed holding period, say two or three years or upon achievement of a certain business goal (eg, turnover hitting a target level) the value which has appreciated in the time since grant will vest and pay out. The earnings received from the phantom pay out will be taxed as ordinary income, in effect just like additional salary.
Ordinary or common shares
In 2000, the Government introduced favourable changes in the tax treatment of company shares held directly by employees. In effect, the capital gains tax rate applied to such shares fell from 23% after a 10 year holding period to a 10% tax rate after a two year holding period. The change has generated interest in share schemes, particularly executive share schemes, which require the employee to purchase shares in their employing company. Sometimes this will simply be presented as an expected or target holding (often expressed as a percentage of salary) or more increasingly in the UK on the basis of some form of matching from the employer. The COLT plc executive share scheme is an example of the latter approach. On the positive side, there can be no better way of aligning managers interests with those of shareholders, including dividend income, than by requiring them to become shareholders. However, from a negative perspective requiring employees to invest substantial sums of money in the same company which already provides them with employment income and pension heightens risk to a point which is unacceptable to many.
All-employee share plans
Sharesave (Save As You Earn)
Sharesave remains the most popular form of all employee or 'broad-based' share plan. This plan, introduced by the Government in the 1980s, can be used by companies listed on the stock exchange and must be made available to all employees in order to secure 'approved' status. There is some flexibility in the detailed design of the plan but in all circumstances it must be submitted to the Inland Revenue for formal approval. The introduction of Sharesave, or any other form of employee share plan (whether approved or unapproved) must also be approved by the company's shareholders at an annual general meeting.
The main features of Sharesave are listed below:
An employee can save up to £250 per month with a bank or building society. After three or five years, total savings plus tax-free interest can be used to buy shares in their employing company
Price paid for the shares upon exercise of their option to buy the shares is the option price set at the date they commenced their commitment to save
The option price may be discounted by up to 20 per cent of the market price of the shares as an added incentive to employees to participate.
By way of example, an employee responds to an invitation to participate in Sharesave by agreeing to save £100 per month for three years, at a time when the share price is £2.50.
Total savings = £3750 (£100 x 36 months plus interest)
Option price = £2.00 (£2.50 less 20% discount)
Number of options granted = 1875 (£3750/£2.00)
If the share price had grown 10 per cent pa and was standing at £3.30 three years later then the employee would purchase 1,875 shares at a total cost of £3,750, yet own shares which were currently valued at £6,188. In this example the profit of £2438 would be received tax-free if the shares were immediately sold in the market place. (This is because the first £9,000 or so of capital gains tax per annum is tax-free - in effect, a personal allowance similar in principle to the personal allowance which applies to income). Alternatively an employee could retain their shares and experience either further growth or depreciation, plus any dividend income, on the same basis as other shareholders.
The pros and cons of Sharesave
Advantages
Popular, proven and well established
Relatively straightforward to explain compared to other schemes
The employee is not exposed to significant investment risk
In a worse case scenario (ie, the share price falls below the option price) the employee can have their savings back with tax-free interest
Travels well - for companies which want to extend all employee share plans internationally
Disadvantages
Is not available to unlisted companies
Oversubscribed invitations have to be reigned back
Despite the relatively straightforward design it remains a complex scheme.
Share Incentive Plan (SIP)
Originally entitled All Employee Share Ownership Plans (AESOP) when launched by the Government in July 2000, this plan was quickly re-branded SIP. The SIP is a very flexible vehicle in the sense that it permits a company to offer tax favoured acquisition of shares via three methods:
Free shares
Partnership shares
Dividend shares.
Free shares, as the name suggests, offer the company the ability to gift up to £3,000 pa of shares to employees without the gift being treated as a taxable event. After a required holding period shares are released from a Trust and may be sold without an income tax or national insurance charge being applied. If released early, income tax is payable by the employee and national insurance contributions will be due from both the employer and employee.
Partnership shares are awards to employees in return for their purchasing shares for themselves. One of the key features of the SIP is that employees are permitted to purchase shares via payroll deduction pre-tax. In other words, the expense of purchasing the shares does not count towards taxable income while preserving pensionable pay for the purposes of Inland Revenue limits.
Sometimes referred to as matching shares the company may match shares purchased based on a formula determined by the company and subject to a maximum of two shares from the company for every one purchased by the employee. The 2:1 limit is set by the Inland Revenue and is further capped by the employee only being permitted to have shares with a maximum value of £1,500 pa (£125 per month) matched by their employer. The minimum payroll deduction for the purchase of partnership shares is set at £10 per month.
Dividend shares are shares given to employees in lieu of dividends which cannot be received directly, due to the shares being held in trust. The cash dividend is in effect used to purchase additional 'dividend' shares, which eventually transfer to the employee.
Advantages
Available to unlisted (ie, private) companies
Highly attractive, even generous, tax incentives
Employee purchases shares out of 'pre-tax' earnings
Disadvantages
Employees invest their own money in partnership shares from day one
Participants are exposed to a level of investment risk which is often inappropriate to their circumstances
Encouraging people to buy shares and then the share price falls is a recipe for negative employee relations (eg, Enron)
Executive share schemes
Company Share Option Plan (CSOP)
A Company Share Option Plan (CSOP) permits approved options to be awarded to individuals, subject to the face value of the options not exceeding £30,000. Other than favourable tax treatment (ie, earnings are treated as capital rather than income) share options awarded under a CSOP are like any other share option in the way they operate (see above).
Although such schemes have their origin in executive share schemes (nb, the £30,000 limit only dates from July 1995) a number of companies have used a CSOP as an all employee plan, eg, by awarding a number of options to all employees on equal terms.
Unapproved executive share schemes
The most frequently deployed management and executive incentive share scheme currency is unapproved share options. Unapproved (non-qualified in the US) options are commonly used to reward past performance, to incentivise higher performance or to promote retention (ie, by delivering a compelling financial reason not to look for alternative employment). They are rarely awarded as an entitlement (eg, based on grade), though managers or executives will normally be aware that they are 'eligible' to be considered for an annual award of options.
UK companies have historically made awards based on a percentage of salary, whereas US Corporations tend to prefer to express awards as a given number of shares. In the UK, the vesting of these shares is generally dependent on the achievement of a performance target such as growth in earnings per share. Historically, US shareholders have not required corporations to use performance targets - preferring simple time-based vesting.
In the UK, companies will generally utilise the tax planning technique of awarding the first £30,000 of any award under the CSOP umbrella. For example, an executive with a salary of £100,000 who receives an award of shares with a face value equal to 100 per cent of salary would receive the first £30,000 of value via an approved option, the balancing £70,000 as an unapproved option.
Following the Greenbury Report in 1995 a large number of companies developed alternative or supplementary long-term incentive plans, often based on a share currency. In particular there was a rapid expansion of 'restricted' (or 'performance') share plans whereby shares are placed in trust and then released to the individual contingent on performance. The performance measure used is frequently a relative measure, eg, total shareholder return (TSR) relative to a comparator group of companies with broadly similar industrial characteristics. Opportunities to achieve efficient tax planning of such long-term incentive plans are very limited, ie shares will normally be subject to income tax and NI upon release from the trust.
Enterprise Management Incentive (EMI)
An EMI is a share incentive scheme available to companies with gross assets of less than £30m, using share options as the plan currency. As a result they are a feature of small companies only and are often set up to incentivise one or a handful of key individuals.
When introduced in July 2000, EMI participation was restricted to a maximum of 15 'key employees', but the rules were subsequently relaxed to permit participation of any number of employees on the condition that no employee is granted an EMI share option with a face value of more than £100,000. There is an aggregate limit, that shares under option in the company EMI must not exceed £3m.
Providing that the scheme rules are complied with no income tax or national insurance contributions are due from the employee or employer on grant or exercise. Furthermore, capital gains tax taper relief accrues from the date that the option is granted and not from the date of exercise. In simple terms this means that a 10 per cent capital gains tax rate is achieved in an EMI two years after the date of grant. For other approved share option plans (whether Executive/CSOP, SAYE or SIP) capital gains tax relief only commences upon exercise. As the period between grant and exercise is normally three years, a 10 per cent capital gains tax rate will take five years to be reached in non-EMI approved share schemes.
Perhaps the most restrictive feature of the EMI is that they operate in companies where there is little liquidity, ie, they are unlisted companies with few buyers or sellers of the shares available to other buyers and sellers. As a result the achievement of performance measures (if any) applied to vesting, may be academic as a means of realising value, where no purchaser exists to turn that share value into cash. The practical consequence is that value might only be realised 'on exit' such as sale or listing of the company. Finally, the valuation of shares in unlisted companies is a notoriously difficult and relatively expensive exercise.
International perspective
During the past 20 years, the UK has become, arguably, the most favourable environment in the world for employee share schemes
Contrary to popular perception the percentage of employees participating in share schemes in the UK is more than twice as high as the percentage of employees in US companies. (Setting aside company shares held in a 401K - see section 6 ).
The US Internal Revenue Service permits tax favoured (qualified) Employee Share Purchase Plans (ESPP) under Section 423. Section 423 plans typically deliver share purchase opportunities with a 15% discount to market price - the discount being exempt from taxation.
An ever increasing number of UK companies are extending their share schemes internationally and are adopting intelligent tax planning techniques to tailor schemes to local tax environments. For example, integrating an SAYE Sharesave Plan with a Plan d'Epargne d'Entreprise (PEE) in France.
|
Share plan type |
Income tax |
National Insurance |
Capital gains |
|
Unapproved |
Up to 40% |
Up to 12.8% |
n/a |
|
Approved |
Exempt |
Exempt |
First £8,750 tax-free 10% tax after 2-year holding period |
The Dos and Don'ts of share plans
|
Do |
Do not |
|
Consider cost to company as well as net value to employees |
Overlook earnings dilution, administration, corporation tax and accounting |
|
Take account of investment risk when promoting a share plan |
Allow the company secretary alone to design your share plan |
|
Plan carefully and take expert tax and legal advice |
Underestimate the value of share plans in helping to make your organisation an "employer of choice" |
|
Section two: Job evaluation and grading Section three: Base pay and salary structures Section seven: Share schemes Section eight: International assignments Section ten: Resources/ jargon buster
|
