If Enterprise Management Incentives (EMI) and the Company Share Option Plan (CSOP) are the “Gold Standard” for employee equity participation, what are the alternatives when those HMRC-approved routes are unsuitable?
In this article, Chris Riley, explores why approved share schemes may not work for some insurance intermediaries and the alternative structures that, if put in place with care and correctly structured, can minimise initial cashflows while preserving Capital Gains Tax (“CGT”) treatment, most commonly partly paid shares and growth shares.
For reference, in Tom Golding’s recent article Tax implications of employee equity incentives for brokers, he consideres the tax implications of awarding shares to staff, and focussed on two key tax advantaged schemes available for many insurance intermediaries that wish to incentivise staff through equity participation, Enterprise Management Incentives (EMI) and the Company Share Option Plan (CSOP).
In many ways, these schemes are the “Gold Standard” in terms of employee equity participation. Both schemes fix the value of the shares for employment tax purposes at the date of award of the option, and because it is options that are awarded – any cash flow considerations for the employee are deferred until the point of exercise, which is also typically the point of sale of the business. Therefore there is likely to be cash available to the employee when it is required. Also, if an individual leaves the organisation, it is far easier to resolve an unexercised option than to buy back shares.
However, sometimes these routes are not suitable for insurance intermediaries, either for the organisation as a whole, or for specific employees for reason such as:
- The intermediary group may breach relevant size limits for the EMI scheme. While these have been significantly increased recently, there remain many groups that breach the limit for the number of employees in the group, or the gross assets threshold (due to client money balances).
- Equally many (particularly MGA groups) will hold an interest in an insurance carrier, or plan to in the future. If this represents a significant part of the group activities, it may mean that EMIs for the group fail under the excluded activities definition, which blocks insurance companies from participating in the scheme.
- Or, the value of the shares of the group at the time of award may be such that the value limits on the scheme (£60,000 per person for CSOP or £250,000 for EMI) mean that the group can’t achieve its intentions for specific (senior) individuals, or for the population as a whole (if the company limits for EMI would be exceeded).
- In addition, as shares under option must be in the ultimate parent of the group, this can inhibit targeted incentives for specific business units.
In such cases, consideration may revert to either an outright issue of shares (potentially very cashflow intensive in respect of funding the immediate subscription or tax costs of the award) or issuing Unapproved Share Options (which would be primarily, if not wholly subject to employment taxes in respect of any value gain) again both discussed in Tom’s article. Neither are ideal for an established business where the shares have value.
There are however a number of alternative structures that are used by groups (including those in the insurance intermediary market) that if put in place with care and correctly structured can minimise initial cashflows, while preserving Capital Gains Tax (“CGT”) treatment. Two of the most commonly seen are as follows.
Partly Paid Shares
In this scenario, the shares are issued at full market value to the employee, but only a small element is paid up front in cash terms (typically, the nominal value of the shares). In respect of the balance of the share value, the employee has a legal obligation to pay this balance, which in practical terms, would ordinarily be settled from post-tax dividend income from the shares, and any balance from the proceeds in any sale event.
As the shares are issued at full value, and assuming s431 elections are entered into, any disposal gain should be solely within CGT. However, there are various risks that must be navigated.
- The legal obligation to pay must be binding. This means that if the shares fall in value, the employee may make an absolute loss. And if the group were to ever enter into an insolvency position, any amounts that remained outstanding would be claimed by a liquidator from the employee.
- There are both Employment Tax considerations in respect of loans made to employees (Beneficial Loan Interest) and for Corporation Tax in respect of loans to shareholders (Loans to Participators). Whether these apply depends on the nature of the company itself, and the structure of any legal obligation to pay. However, if that obligation were ever later waived (in whole or part) this would be a PAYE event to the value of the waiver in any circumstance.
As partly paid shares are likely to involve shares that hold significant value, the tax and wider financial obligations should things go badly are significant, so it is fundamental that both the employer, and employee are fully aware of the potential consequences, and take steps to mitigate these through careful planning at the outset.
Growth Shares
Growth shares come in many forms, and with many different names. However, the principle is consistent – a new class of shares is created in the company which do not participate in the value of the company that has been created prior to the issuance of the shares – they only participate in a share of future growth of the company over a defined “hurdle” value.
Again the shares are issued at their full market value, meaning that gains should be taxed under CGT. However, because the current value of the company is not reflected in the new share class, the value per share is significantly lower than ordinary shares of the same class. Again however, careful consideration needs to be given to the structure.
- The valuation position for the growth shares is more involved than for “normal shares”. The value of the company must first be determined (as with any share incentive) to determine that baseline “current value”. A secondary valuation must then be carried out in respect of the value of the new share class based on the returns that it is expected will arise. It is not the case that a growth share has no value on issuance because there is no economic entitlement at the date of issuance.
- Typically the hurdle value will be set at a higher value than the current value of the business. This ensures that the economic benefit that passes to the growth shareholders arises only from value created above that which could already be reasonably expected. This further reduces (but again not to nil) the issue value of the growth share. Growth shares will often not have rights to vote or receive dividends, as these complicate the valuation position.
- It is fundamentally important that the factors which are applied in considering the initial valuation of the shares on issue are maintained through to the exit. Fundamentally changing the business in a way that artificially transfers value to the shares will give rise to PAYE exposures, as would applying higher returns to the shares on exit than the share rights are entitled to.
- If further awards of growth shares are likely (for example when new teams join the business) then an element of futureproofing will be required in the structure to consider the order of return to growth shareholders by reference to their specific hurdles (future issuances would be expected to have a different baseline value).
It can be seen that growth share structures require detailed consideration, not just of the position today, but how the future may look. That consideration and the planned structure needs to be carefully documented, and reflected in the Company Articles, to be effective.
In Summary
If the main HMRC approved schemes are not available to an insurance intermediary, either because they do not qualify, or the objectives cannot be fulfilled within the limitations of the approved schemes, all is not lost, there are other routes available.
While neither a partly paid or growth share structure is an HMRC approved scheme, HMRC are aware of their existence, and accept that they are appropriate if applied correctly as part of a commercially based incentive structure. If used for purely tax avoidance purposes, or if valuations are not reasonable and supportable, they remain subject to challenge – either by HMRC, or by advisors in an exit due diligence process. Therefore taking care, and time, to document and stress-test any such arrangement is critical to their successful operation.
To discuss anything raised in the article in more detail, please contact: Chris Riley, Tax Partner.
