A large number of businesses use equity as a way of incentivising and rewarding their employees. In this article Corporate Tax Partner Catherine Heyes looks at different mechanisms for equity incentivisation and some common pitfalls.
The most common types of equity incentivisation schemes used by our international and UK clients include: the Enterprise Management Incentive (EMI) options, outright awards of equity, growth shares and unapproved options.
EMI options are by far the most popular mechanism for using equity to incentivise employees in the UK. There are a number of qualifying conditions and if met, EMI enables the growth in value of the option to be taken free from tax. There are also relaxations to the Capital Gains Tax rules meaning it is easier to secure a 10% rate on exit.
Unlike an option, with an outright award of equity the legal title of the equity passes on day one. However, it is possible to structure the equity with restrictions such that it is forfeited if the employee leaves. The taxing points of this award can be either at award, or on vesting, depending on how it is structured and if any elections are made.
Growth shares are one of the more complex plans to implement. However, if done properly, a new class of share is created which derives a right to the future value of the company above a hurdle, rather than any existing value. This should mean that the growth in value attracts Capital Gains Tax.
Unapproved Options are known as a tax inefficient option. The growth in value of the option between strike price and exercise will be liable to tax, either as income tax or PAYE. This means for an exit only option, there would be no access to Capital Gains Tax.
All of the above have different commercial and tax drivers, so it is important to understand what they are at the outset and ensure any plan is appropriately implemented.
Equity awards come with complications for the un-prepared, which can create tax difficulties for employees. The most common errors are identified and explained below:
- Don’t assume that a tax efficient award scheme for your non-UK based employees, will attract the same benefits for your UK tax resident employees. For example, an ISO (Incentive Stock Option) which confers tax favourable status for US based employees, will not have the same taxing profile in the UK and will lead to a tax inefficient UK position.
- Track your globally mobile employees and advise them of the interaction between the home and host jurisdictions’ taxing positions in respect of their equity awards. It is often thought that the home taxing position applies, but this is not the case and claims for Double Taxation Relief may be required.
- Accurately value the awards of equity and appropriately communicate this to employees. Whilst different schemes have different taxing points, the key message is that if an employee receives something of value for free, there will be a tax consequence. For privately owned companies, valuations can be a complex area and specialist advice should always be sought.
- Comply with all of the requirements of the EMI Scheme or other tax advantageous schemes. Not complying with some of the requirements can lead to a situation where you have communicated to employees that they are receiving a tax favourable option, which may turn out not to be the case.
- Be aware of the impact that elections can have on any taxing position, which can potentially result in a significantly more unfavourable tax position than expected.
- Don’t fail to notify HMRC appropriately in respect of any form of equity award. HMRC requires this to be done by 6 July annually otherwise penalties will be incurred.
One thing is clear, not only will these potential issues inevitably give rise to additional costs, they will also cause difficulties for employees, souring the relationship and somewhat defeating the purpose of the award.
If you would like more information about any of the issues covered by this article, please contact Catherine Heyes.
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