Radical changes are in prospect for the tax treatment of employee shares schemes.
The Office of Tax Simplification (the “OTS”) has issued its recommendations to the Chancellor for the simplification of the tax rules applying to so-called ‘unapproved’ employee share schemes. Much deliberation has gone into the formulation of these recommendations (as the writer, having been a member of the committee assisting the OTS, is only too well aware) and the changes now proposed are radical. If implemented in full, they should result not only in a simplification of the legislation, but also in affording a clearly defined path which, if followed, will allow companies to establish and operate one or more employees share plan, using an employees’ trust, without falling foul of the complex, but necessary, anti-avoidance rules intended to curb abuse by those companies simply seeking to avoid tax on remuneration.
The two key recommendations are :
1. a fundamental change to the basis on which an acquisition of shares by an employee is charged to income tax; and
2. that provision be made for a form of ‘safe-harbour’ vehicle (in practice a trust, but not thus far referred to as such because of the disfavour with which the term ‘employees’ trust’ is currently viewed within HMRC following recently well-publicised cases of what, in HMRC’s view, has been the abusive use of such trusts) which, if used in an approved manner, would afford shelter from penal or unexpected charges to income tax, NICs, stamp duties, capital gains tax and inheritance tax.
Other recommendations relate to the tax treatment of internationally mobile employees, securing HMRC agreement on share valuations and changes to simplify the administration of share plans.
The basis of charging employee share acquisitions
The fact that under existing rules employees who acquire shares for no payment, or at an undervalue, can suffer charges to income tax (and, if the shares are ‘readily convertible assets’, NICs) notwithstanding that such shares cannot immediately be sold (whether or not the employee wishes or is allowed to do so) can result in a ‘dry’ tax charge: that is, a charge to tax with no means of funding the tax out of the proceeds of sale of the shares acquired. In extreme situations this can mean that, for example, an employee holding an exercisable share option over non-marketable shares cannot afford to exercise it and acquire the shares as this would result in an immediate and substantial unfunded charge to tax. If the shares are, or are deemed to be, RCAs, the tax is due under PAYE and must, to avoid additional penal charges, be ‘made good’ to the employer within 90 days.
Many such practical difficulties would be side-stepped if, as now recommended, the time when income tax is charged on the value of shares acquired (less any amount paid for them) is the time when they first become ‘marketable securities’ – that is, when they are in fact first able to be sold for an amount not substantially less than their ‘unrestricted market value’. If the shares acquired are not ‘marketable securities’, unless the employee otherwise elects within a limited time after acquisition, no tax is charged. Instead, a charge will arise, when the shares first become ‘marketable securities, on the full unrestricted value of the shares i.e the amount for which they could in fact be sold at that time, assuming the employee is then able or willing to do so. In the meantime, and to prevent avoidance, any dividends or other benefits received from, or in respect of, the shares would fall to be charged to income tax (and NICs) as earned income on receipt.
If an election is made at the time of acquisition, the employee would then be charged to income tax (and NICs) under PAYE on the full unrestricted market value of the shares (or, if different, the actual consideration received on a sale within 14 days of the charge arising). Thereafter, any growth in value of the employee-related securities would fall to be charged to CGT.
It is worth noting that, in our opinion, such an election should be allowed to be made at any time after, not only at, the time of acquisition but this idea was rejected by the OTS – although their reasoning on the point is unclear.
In the case of unquoted shares for which there are no arrangements in place to allow the value of the shares to be realised, there need be no liability to tax on the value of the shares until the first opportunity to realise their current value. Whilst the amount on which tax is charged could then be significantly greater than if tax had been charged on acquisition, it can at least be funded by realising the value of some, if not all of the shares : a ‘dry’ tax charge is avoided.
If, being ‘marketable securities’, the shares are subject to a short-term ‘risk of forfeiture’ when they are acquired or if, when they become so ‘marketable’, they are subject to a ‘short-term risk of forfeiture’, in the absence of a election being made, the time when tax is charged would be deferred until the risk of forfeiture falls away (e.g. because a performance target is met) or the shares are sold.
If the recommendation is accepted, much of the detail remains to be settled. That said, the result would, in our view, clearly be an improvement upon, and result in a simplification of, the existing rules and, perhaps more importantly, the general understanding of how tax is charged on the acquisition of employee shares in unquoted companies.
By way of interim solutions, the OTS also recommends:
(a) a clearer definition of “readily convertible assets” with, for example, the omission of the words “trading arrangements … are likely to come into existence”, and the inclusion of a retrospective test whereby if (eg in the run up to an IPO) shares do not in fact become RCAs within a 90-day period, they are deemed not to have been RCAs at the earlier time. Conversely, if they do become ‘marketable’ (see above) within 90 days of sale, they would retrospectively be deemed to be RCAs;
(b) that a ‘tax-free rollover’ be permitted upon an exchange of restricted/forfeitable shares and nil/partly-paid shares if such a tax-free rollover would then also be available to holders of share options;
(c) that corporation tax relief be allowed for employee share acquisitions following a takeover by an unlisted company.
A ‘safe harbour’ employee shareholding vehicle
The use of an employees’ trust as a vehicle for holding shares pending their acquisition by employees pursuant to a bona fide “employees’ share scheme” is currently fraught with traps for the unwary. Examples include:
- inheritance tax charges on contributions made, transfers out, and at 10-yearly intervals, if the specific requirements of certain exemptions are not met;
- a penal charge to tax if a loan is made by a close company to fund the acquisition of shares by a shareholding trust;
- the risk of double taxation (in certain circumstances) if the trust is UK resident and shares with accrued gains are acquired by employees from the trust;
- liabilities to stamp duty (or SDRT) on purchases and sales of shares by the trustee;
- the application of the ‘transactions in securities’ rules to a sale of shares to the trust funded by the company;
- the potential application of the ‘disguised remuneration’ rules to any earmarking or award of shares, given that the trust is a ‘relevant third person’ for those purposes.
The OTS recommends “the creation of a set of model rules for a vehicle which would provide a marketplace and/or warehouse for shares held on behalf of employees”. This, of course, is a diplomatic way of describing a ‘safe harbour employees’ trust’, without using the discredited term “employees’ trust”! In practice, the vehicle in question would be a trust … however else it might be described. Such a vehicle would be UK tax resident, but otherwise should be in a form which will enable existing employee trusts used for bona fide purposes to be repatriated and qualify as such a safe harbour vehicle without too much cost or complexity and the need to establish a new ‘vehicle’ (to use the politically neutral term adopted).
The use of such a vehicle for bona fide commercial activities in relation to an employees’ share scheme would qualify for the disapplication of some, though not all, of the penal and unexpected charges which might otherwise apply, such as the first five of those listed above and certain of the ‘disguised remuneration’ charges such as the ‘earmarking’ charge as it applies to shares held in the vehicle.
Further, and by way of a nod to the ‘Nuttall Review’, such a vehicle holding a controlling interest in a company would still be eligible to operate HMRC tax-advantaged schemes such as EMI and CSOPs.
Insofar as the vehicle did not confine its activities to dealing only with fully-paid non-redeemable ordinary shares in the sponsoring company (or its holding company) for an ‘allowable purpose’, exemptions from the various tax charges noted above would cease to apply.
In our view, legislative provision for such a ‘safe harbour’ employees’ trust would result in a major simplification for many companies by providing a clear path for those wishing to operate bona fide employee share schemes and internal markets in a manner which will give confidence as to the tax treatment of the company, the vehicle and participating employees and would reduce significantly the professional costs of such bona fide commercial arrangements.
Internationally mobile employees
The OTS has recommended that the tax treatment of international assignees be aligned with the general earnings charge (section 62 ITEPA 2003). This is intended to bring to an end the widespread difficulty in determining the appropriate UK tax treatment of employee share awards made in subtly different forms (eg contingent share awards, share options, forfeitable share awards and phantom options). It would also bring to an end the inconsistency in treatment of awards made before arrival in the UK, and those made to an employee when he is in the UK but which vest or are exercised after he has left the UK. There should also be closer alignment of the charge to NICs with the charge to income tax in relation to awards made to internationally mobile employees.
It is also recommended that a corporation tax deduction be allowed in relation to the acquisition of shares by employees seconded to work for UK companies if the employee is charged to UK income tax.
As regards the valuation for tax purposes of employee shares, the OTS has recommended:
(a) that additional resources be made available by HMRC to provide pre-transaction valuations for unapproved schemes in the following situations:
- if a valuation is to be agreed for the purposes of EMI, CSOP, SAYE or SIP, then agreement could extend to unapproved awards made at the same time;
- if a company wishes to use an EMI valuation for other purposes, provision should be made for the company to indicate this so that HMRC SAV may perform a more rigorous risk assessment of the valuation;
- if a further valuation is sought but no significant changes have occurred since the last agreement, fresh agreement could be sought on the basis of a “black-lined” comparison of the methodology;
- if a company has undergone a recent arm’s length transaction and wishes to agree a value broadly equal to that transaction;
- if the situation is straightforward (eg offer of shares in a start-up);
- if the company has followed an outline valuation methodology set out in published guidance; and
- if the situation is straightforward and involves an offer of shares to all employees (a service which HMRC SAV currently provides informally);
(b) that for both pre- and post-transaction valuations, HMRC should provide outline valuation methodologies, checklists of information acquired and standard procedures for dealing with applications for valuation agreements;
(c) in the case of shares dealt in on AIM and other non-recognised stock exchanges, an automatic acceptance that the closing price on the day preceding the date of award or grant is the market value of a share;
(d) in the case of listed company shares, a move to using the closing price on the day of trading, rather than the ‘quarter up’ basis of valuation.
Other ‘administrative’ recommendations
The OTS has also recommended:
(a) online filing of Form 42 – a medium-term goal – but that, until then, there be no change to the process for submission of Form 42 to HMRC each year;
(b) that Form 42 be released at the beginning of the year;
(c) once online filing is established, that a process of ‘intelligent filing’ be adopted (ie with better targeting of specific information requests);
(d) in the longer term, that the information on Form 42 be integrated into RTI reporting;
(e) that the statutory deadline for reporting employment-related securities income under RTI be extended to 60 days after the end of the tax month;
(f) the removal of employment-related securities from the scope of the penal charge to income tax under section 222 ITEPA 2003 if the tax is in fact made good to the employer.
The Final Report in full
The text of the OTS ‘Review of unapproved employee share schemes: Final report’ is available here.
The next step is for HMRC to respond and consult on the recommendations with a view to those which are accepted by the Chancellor being implemented in 2014, or in some cases, 2015 and beyond.