Stephen Woodhouse, Partner at Pett Franklin, has published an article entitled “The Demise of Employee Shareholder Shares” on Lexis®PSL. This article provides some background to the now defunct employee shareholder arrangements and considers how they have been replaced.
Measures set out in the Income Tax and Capital Gains Tax: employee shareholder status policy paper remove the income tax reliefs on the receipt or buy-back of shares issued to an employee under an employee shareholder agreement made on or after 1 December 2016. The new policy also aims to remove the capital gains tax (CGT) exemption relating to shares received as consideration for entering into an employee shareholder agreement on or after the same date.
What is the background to the demise of employee shareholder shares (ESS)?
To answer this question, it is necessary to start with the reliefs introduced and their background.
Relief for ESS was introduced by the previous Chancellor, George Osborne, in 2013. The relief had not been subject to any consultation process and was driven by policies to encourage the growth of small companies and to encourage them to recruit more vigorously.
The theory was that such companies were constrained from recruiting by the risks of incurring cost should it subsequently become necessary to reduce the workforce due to the various statutory employment protection rights.
In order to overcome this, the basic structure of the legislation was to offer tax incentives to employees in return for the surrender of specified statutory employment rights. In particular:
- tax and National Insurance Contributions (NICs) were not payable to the extent that the value of the shares being acquired was no more than £2k. If the shares had a higher value, tax and NICs were only charged on the excess
- under the initial rules, no CGT was payable on gains realised in respect of ESS acquired with an initial value of up to £50,000
- subsequently, the tax relief on sale was restricted to gains of £100,000
As originally conceived, with awards being made in respect of ordinary shares of the same class as other shareholders, the value of the reliefs would have been limited in most cases. However, that is not the context in which most ESS were issued.
Which type of companies used to use these arrangements and what was the main reasons for their use?
ESS relief was designed for small, typically owner managed, businesses. The legislation provided for great flexibility in relation to the types of company concerned—eg allowing for shares in subsidiaries—and the structure of shares, compared with the normal rules for tax advantaged plans.
This flexibility reflected what was thought to be the intended target of the tax relief—ie relatively small levels of awards to facilitate recruitment by smaller businesses. In practice, the relief was more typically used to support awards with a low initial value but the potential for large gains for a limited number of senior executives.
The structure varied from company to company and award to award. Frequently, though, it involved the use of growth shares. These are shares which do not participate to a significant degree in the current value of the company in which the awards are made at the date of award. Rather, they share in value above a threshold specified in the share rights when they are issued.
Such shares offer the potential for substantial but uncertain returns where a company has significant potential for value growth.
This was seen in several contexts of which two concerned arrangements with subsidiary companies and companies backed by private equity investment.
The ESS relief fitted naturally the form of equity incentive plans already used for typical private equity management equity plans. Further, growth shares are well suited for the financial structure of many private equity investments.
The reason relates to the nature of private equity investment. Often, companies will be highly leveraged. If the company performs in accordance with the targets set on the initial acquisition happening, the debt will be repaid over a relatively short timescale and on repayment of the debt, the equity value increases substantially.
This creates a scenario where growth shares will have no realisation value until the debt is repaid—with the attendant risks should that not happen—but substantial and rapid growth once repayment occurs.
This offers an attractive tax treatment without the application of ESS relief. Where ESS relief was available, there could be nil tax for substantial gains—potentially millions of pounds—due to the shares having low initial value (well below the £50,000 threshold) and, until the introduction of the £100,000 cap, no limit on the amount of gains exempted from tax.
Subsidiary share schemes
Another use of ESS was for companies in respect of which it was difficult to use growth shares in the parent company—eg listed companies—where, due to the flexibility of the ESS rules, shares in subsidiary companies could be used instead.
That subsidiary might be an operating company or a service company with intra-group charging arrangements designed to allow value created within the group to flow into the service company, thereby increasing the worth of the shares created leading to capital gains which were excluded from tax under the ESS regime.
What are these companies using now that ESS can no longer be put in place?
The conditions for ESS relief to apply were not linked to the nature of the shares as such. As a result, the form of shares for which the relief applied continue to be available and attract a beneficial tax treatment—namely CGT chargeable to tax at 20% (or 10% if entrepreneurs’ relief is available).
Consequently, in many cases, the same forms of shares continue to be applied. Equally, other types of plan are available with beneficial tax treatments.
- Joint Share Ownership Plans (“JSOPs”) – this is a form of growth interest where no separate class of shares is created but the participation in the growth in value of the company arises through splitting the ownership of the shares between a third party (eg the trustees of an employee share ownership trust) and the employee.
- Enterprise Management Incentives (“EMI”) – EMI plans, where the relevant conditions are satisfied, offer substantial benefits with CGT on value growth, extended availability of entrepreneurs’ relief and potentially corporation tax relief on the exercise of options on the inherent gain in the options at the date of exercise.
This article was first published in Lexis®PSL Employment on 9 May 2017. Click for a free trial of Lexis®PSL.
Pett Franklin are experts in the design and implementation of employee share schemes, and provide a full end to end service including share valuations. To find out more about how we can help you or your client, get in touch today.