A joint share ownership plan (or JSOP) is based on the following central features:
- Ordinary Shares are owned jointly by the employee concerned and a third party which is usually a trust
- JSOPs use Ordinary Shares and do not require the creation of a new class of shares as is necessary for growth shares.
- The employee’s interest in the jointly owned shares (the “JSOP interest”) is in the value of the shares above a specified threshold, usually the market value of the shares at the date of inception of the JSOP, increased by a percentage “carry charge”.
- The employee normally pays market value to acquire their JSOP interest, but if the employee paid less than the market value of their JSOP interest income tax and usually PAYE and NICs would be applicable on any excess of the market value over the amount paid.
- The employee’s holding would usually be subject to vesting terms and would be forfeited if vesting did not happen.
- On realisation of the employee’s JSOP interest there would be no income tax or NIC charges but instead capital gains tax on any gain made by the employee.
Having summarised the key structural points, there are many questions to be addressed when establishing and implementing a plan.
Valuation and Setting Carry Charge
A central feature of any JSOP is the calculation of the market value of the employee JSOP on inception of the JSOP.
This has a number of aspects.
(i) There needs to be clarity on the market value of the Ordinary Share itself so that the value of the employee’s JSOP interest in that Ordinary Share can be calculated (see below).
(ii) The employee will participate in value above the threshold; the value of which on a disposal of a jointly owned share is retained by the co-owner.
(iii) However, that threshold is not static. It will increase by a carry charge set at the date the employee acquires the interest.
(iv) The carry charge will typically reflect a fixed percentage amount for a specified period of the lesser of the time the employee holds his/her interest and three years from the date of inception. The setting of the amount of the carry charge is central to the design of the plan, the incentive for the employee and the assessment of the market value of the JSOP interest.
HMRC will no longer agree to post transaction or best estimate valuation checks whereby they reviewed valuations of shares or share interests shortly after they were acquired by the employee.
This emphasises the importance of valuation not only in the design of the plan but also with demonstrating a robust estimate of that valuation by the Directors of the Company.
The Pett Franklin approach to valuation rests on the Expected Return Methodology. The ERM was established through discussions with HMRC when the JSOP plan was first created and its principles agreed. It has been applied consistently since then which allows for a degree of confidence that valuations derived from the proper application of ERM will be accepted by HMRC.
However, in addition to understanding the valuation parameters for JSOP interests, it is important for Companies to be able to demonstrate at a later date that the Directors of the Company have assessed the valuation, and that in their “best estimate”, reflecting their knowledge of the Company, it reflects the market value of that interest.
This has a number of elements:
(i) PAYE and NICs operate by reference to the best estimate of the Company. In effect, that means the best estimate of the Directors.
(ii) While HMRC may review the valuation through self-assessment returns, this can only apply to the personal tax liability of the individual employee and not to the PAYE compliance or NICs unless HMRC demonstrate that the valuation adopted did not reflect the Directors’ best estimate.
(iii) In practice, this would be difficult if the Directors can demonstrate a robust and contemporaneous review of their decision making process.
(iv) This implies a benefit in completing detailed records, including board minutes, of the review and assessment of valuation by the Directors at the time that awards are made.
Sourcing of Shares
Often the shares used to create the joint interest are newly issued, with the Trustee subscribing for the shares in conjunction with the employee.
This does not have to be the structure and JSOPs can operate by way of the employee and the co-owner acquiring shares jointly from other shareholders or, if the co-owner is the Trustee of an Employee Share Ownership Trust, thought the Trustee creating a joint interest with the employee in respect of shares which are already owned by the trust.
Either approach is effective to achieve the intended tax result, but can produce different commercial impacts on other shareholders, particularly if the JSOP is established with private company shares with no ready market for the sale of shares through a listed market.
Particular attention should be paid to the dilution impact on other shareholders, particularly if new shares are issued. It will be important before shares are issued to consider the impact on:
(i) The economic impact on shareholder participation.
(ii) The effect on the control of the Company.
(iii) For a listed company, the views of institutional shareholders.
Role of Trustees
As the co-owner of the shares, the Trustees have multiple facets to consider. These should be reviewed and discussed before the employee acquires their interest in order to ensure that Trustees do not find that they have a conflict of interest between their duties to act in the interests of the employee group, the commercial expectations of the employer and the commitments they accept by way of entering into the joint ownership agreement.
Areas which have to be considered include:
(i) Determining the employee price paid by the employee to participate.
(ii) Establishing the role of the Trustee should awards lapse.
(iii) Following vesting, establishing the realisation (see below) for the employee to enable the employee to receive appropriate value.
This leads to the treatment of JSOPs on realisation. There needs to be clarity in the original design on a number of features.
Calculation of Realisation Value
There are different issues according to whether the shares are listed or not.
For a listed company, issues include:
The expectation would be that the shares would be sold in the market. In that case, consideration needs to be given to:
(i) Who bears the burden of dealing costs?
(ii) Who bears the risk of price movements if Market Abuse Regulations prevent realisation after vesting?
(iii) Aside from MAR, for a smaller company with an illiquid market, what steps can be taken to allow for realisation without disrupting the market price?
Different questions arise for private companies.
(i) The starting point is to consider how the realisation price is determined.
(ii) If the price is higher than the market value, the excess amount is subject to income tax collected through PAYE and NICs. The objective would therefore be to establish the best estimate of market value at the point of sale. However, this gives rise to the same valuation challenges as with the assessment of market value at the time of award, but with a different context. This may lead to differences in outcome as with, for example, the determination of appropriate discounts for minority interests.
Providing a Market
As important as determining the realisation value is identifying who will provide a market to allow the realisation to occur.
The exit may be provided by other shareholders, but that effectively requires a further investment by those shareholders which might distort commercial relationships between shareholders. This means that a number of other factors become relevant:
(i) How will the acquisition be funded?
(ii) What impact might the acquisition have on the personal tax planning of the shareholders?
(iii) How will the realisation structure interact with (a) Company Articles; and (b) any Shareholders’ Agreement?
If instead, the Company provides funding, which entity will purchase the shares?
The most likely purchaser is an employee share ownership trust (or ESOT) funded by the Company. That provides a flexible vehicle for providing a market for employee shares. There are a number of issues to address with ESOTs, however:
(i) If the company is a “close company” for tax purposes (broadly, controlled by five or fewer shareholders or by shareholders who are directors), loans to the ESOT will give rise to tax charges on the amount of the loan recoverable when the loan is repaid.
(ii) If, instead, the company makes a contribution to the ESOT to fund the purchase, that value cannot be recovered by the Company leading to the value being locked into the ESOT unless used to provide benefits to other employees.
The third potential purchaser would be the Company. This may be suitable but, normally, company purchases of own shares give rise to income tax on the excess of the purchase price over the original subscription price. This is subject to a potential relief for trading companies if the shares have been held for at least five years and a trading purpose can be demonstrated for the Company to acquire its shares.
With a private company, thought should be given on the design of the plan to the effect of a corporate transaction, even if not contemplated at the time of award.
This raises similar questions to those arising for succession planning, and plan terms should consider:
(i) What happens if a major shareholders dies or is incapacitated?
(ii) How are JSOP interests treated on a listing of the Company?
(iii) Are there effective drag and tag provisions to ensure that on a sale to a trade buyer, the employee and co-owner will participate on equivalent terms without having the ability to block a sale.
(iv) How is valuation affected prior to a potential exit?
(v) What happens to unallocated ESOT shares on an exit?
The planning for employee share schemes tends to focus on successful outcomes. The plan should also encompass the treatment of interests if objectives are not met and the awards are forfeited.
This will cover:
(i) Determining when and in what circumstances awards are forfeited.
(ii) Within that, defining what amounts to a Good Leaver.
(iii) Unlike options which can simply be cancelled, JSOP shares exist, leading to the need to determine what happens to them on forfeiture. For instance, should they be transferred to an ESOT or sold to other shareholders?
(iv) Will there be circumstances in which the value of awards might be clawed back after vesting and realisation if, for instance, subsequent events demonstrate serious financial failings?
JSOPs can be effective to provide employee share incentives without excessive income tax and national insurance contribution costs. They have been widely used and are familiar to HMRC.
With careful structuring and planning at an early stage, they can provide the alignment between shareholders and participants with a manageable tax cost, combining the achievement of commercial, legal and tax objectives.
Pett Franklin are experts in employee share schemes, executive incentives and share valuation.