Employee share schemes: incentivising talent though equity

Mike Hayes explains how UK employers can offer top performers share incentives in a tax-effective way

The general consensus is that UK businesses need to continue to attract top talent from around the world if the country’s economy is to thrive. There are many uncertainties, among them the unknown outcome of Brexit and the impact of tax changes for non-domiciliaries. One frequently overlooked area is the incentivisation of key talent through equity. Being able to participate in some form of capital can be key to attracting skilled people.  

In most countries where shares are passed to employees and they don’t pay for them, or they pay less than the market value, the shortfall compared to market value is liable to income tax. In the UK that would mean employees being liable to income tax of up to 45 per cent and, in certain circumstances, employee’s and employer’s national insurance contributions (NIC). These rules also apply where an option is involved and the income tax charge is calculated by reference to the value of the shares at the time the option is exercised.

However, the UK has share schemes that are structured so that the impact of income tax is less, and more of the overall ‘profit’ on a share incentive is taxed as a capital gain; capital gains are taxed at lower rates than income. Also, more of the tax arises when there is an actual sale, so there is cash to pay the tax.

For example, the enterprise management incentive (EMI) in the UK has a £250,000 limit per option holder and the company can obtain a corporation tax deduction for the ‘gain’. EMI is the share incentive of choice for most UK SME businesses. Not all trades qualify, and there are limits on the number of employees (250 full-time equivalent employees) and the gross assets of the company (£30m).

Capitals gains

The advantage of EMI is that if the option price is correctly set – ie it is not less than market value as at the date of grant – the only tax that is involved is capital gains. Capital gains tax (CGT) is 20 per cent at the moment, so an EMI option is much more attractive than one that is fully liable to income tax and NIC, which could give an overall tax rate of more than 54 per cent.

And the news gets even better – it is likely that an EMI option will also qualify for entrepreneurs' relief if there is a gap of at least one year between the grant of the option and the sale of the shares. This brings the CGT rate down to 10 per cent.

There are other ‘tax approved’ shares schemes in the UK – such as company share ownership plans, share incentive plans and others. Few countries have such tax-advantaged share schemes.

Two other points worth noting:

  1. In the UK, the employing company can obtain a corporation tax deduction for any ‘gain’ on the option. Where the option is exercised on a sale this gives rise to a significant deduction as the market value of the shares at that point will be the sales price.
  2. The UK has a buoyant market for companies being acquired and sold, particularly in the tech and media sectors – to which overseas talent is drawn. This means there is a real opportunity to realise a capital sum should share incentives be put in place.

In uncertain times, employers should remember that share incentives attract staff.

Mike Hayes is a partner at Kingston Smith