8th July saw the first Conservative Budget since the days of Kenneth Clarke with hush puppies and whisky at the dispatch box. The attention this time was on the policies and changes on the tax rules. Little change was expected in the area of employee shares schemes and incentives but there were still some announcements which will have important impacts.
Dividend tax changes and employee share incentives
The government has announced that from April 2016, the current system of dividend tax credits will be removed. Instead, a new tax-free Dividend Allowance of £5,000 per year will be created for all taxpayers, above which dividends will be taxed as income at the rate of 7.5% for basic rate taxpayers, 32.5% for higher rate taxpayers and 38.1% for additional rate taxpayers.
While the details of how this change is to be implemented are as yet unpublished, the government has stated that it expects ordinary investors to see no change to their tax liability, but that some investors who receive significant dividend income may pay more in tax. Reference to this is made in the Fact Sheet issued on 17th August (Dividend Allowance Factsheet) These changes will have a significant impact on small owner-managed businesses, and the government has stated that reducing the incentive to incorporate is one of its goals in making this change.
Share Incentive Plans
Participants in a statutory Share Incentive Plan (“SIP”) may choose to reinvest dividends paid on their SIP shares in purchasing “Dividend Shares”. If they choose to do so, they will not be required to pay any tax on such dividends at the time they are paid. Only if participants leave employment within three years of receiving the dividend will they be charged to tax, which will be on the amount of the dividend originally reinvested to acquire the shares.
What impact will the Dividend Allowance have on SIPs? The result may be that some leavers no longer have to pay any tax on their Dividend Shares when they leave. But in other cases, a significant minority of SIP participants may have received more than £5,000 worth of Dividend Shares within the past three years (and some participants may have other dividend income from different sources), with the result that tax will be payable.
The removal of the 10% dividend tax credit therefore means that some basic rate tax payers may have to pay tax who would not have in the past. We also note that this change could also require more taxpayers to complete self-assessment returns, potentially in many cases because of a requirement to pay quite small amounts of tax on income over the £5,000 threshold; it remains to be seen how HMRC will deal with this change in practice.
A boost for employee share ownership?
Companies who are willing and able to encourage their employees to acquire shares may therefore, by paying a dividend on the shares, be able to boost the tax-free income of such employees by up to £5,000 per year. The opportunity for tax free dividends should increase the attractiveness of SIP shares for dividend paying companies, particularly when compared with the costs of rewarding employees through employment. For an illustration of the potential equivalent costs of a £1,000 dividend, go to Pett Franklin Share Schemes at a Glance.
For independent private companies in particular, by using a SIP, the company might issue and award to all eligible employees shares of a special class (“Employees’ Shares”) which, for example, carry an obligation to forfeit such shares on leaving employment with the company or group. The unrestricted market value of such shares awarded to each eligible employee in a tax year must not exceed the annual limit of £3,600, but the acquisition of such Employees’ Shares, upon and subject to the rules of the SIP, would be free of income tax and NICs.
From next April, participants in such a SIP would, in common with all other individual shareholders, then be able to receive dividend income of up to £5,000 per tax year free of income tax (assuming they have no other dividend income save, perhaps, on shares in an ISA).
The idea of allowing employees to acquire a special class of restricted shares in a tax-efficient manner would not work in relation to CSOP or SAYE share options as the legislation governing such schemes includes an additional requirement that the shares used must be either “employee-control” shares or “open market shares”. The acquisition of shares through the grant and exercise of EMI options, similarly, only affords relief from income tax and NICs on the growth in value of the shares over the option period. It is only by using a SIP that shares may be acquired by employees entirely free of tax.
For listed companies, while offering shares of a separate class may not be feasible, it will still be possible to make tax-free share awards under a SIP which are subject to forfeiture if an employee leaves. Employees may then be paid tax-free dividends on the same basis as all other shareholders.
Taxation of pensions – a new role for employee share ownership?
The total amount an individual can save into a pension plan in a given year without triggering a tax charge is limited to the “annual allowance”. Originally set at £215,000 when first introduced in 2006, this has since been substantially reduced and is currently set at £40,000 per tax year for 2015/16.
This allowance is now set to be reduced even further for high earners. This reduction will apply on a tapered basis, reducing by £1 for every £2 by which the individual’s income exceeds £150,000, so that individuals earning £210,000 or more will be limited to an allowance of £10,000 per tax year which they may contribute to their pension each year without incurring tax charges.
Many high earners are likely to find this level of pension contribution insufficient and the challenge for employers is therefore how to respond. It may be that the new pension limits should encourage the introduction of different forms of employee share plan – similar to those more often seen in the US and consistently with the pressures from regulators and investors, particularly in financial services, to encourage significantly longer term shareholdings – where share awards are made with an expectation that shares will continue to be held in the long term, with the employee receiving the cash value only on retirement.
Carried interest – changes to taxation of rewards for private equity fund managers
From 8 July 2015, private equity executives will no longer be entitled to the “base cost shift” for carried interest.
Historically, the tax treatment of carried interest – executives’ right to a share of the profits received from a fund’s investments – has been such that the interest is both taxed as a capital gain and executives have been entitled to deduct part of the base costs that the investors paid for the fund’s investments, reducing the executives’ gain for tax purposes. This effectively reduces the tax payable by executives without any tax consequences or costs to the executives themselves.
Going forwards, this may indicate that the government is now looking more closely at the taxation of the private equity industry and we may see future measures designed to raise the rate of effective tax paid by fund managers as the government continues to look for ways to increase tax revenue in the future.