Tax Efficient Share Incentive Schemes

Accountancy Best PracticeCorporate StrategyHuman Resources
Written By Misha Patel

Employee Share Incentive Schemes - Tax savings for UK SMEs

As any experienced founder or entrepreneur knows, if you try and do everything yourself in a business, two things will happen - you’ll hit a glass ceiling of growth and you’ll burn out trying to break through on your own. 

It’s for this reason that attracting and retaining an outstanding team is so essential. Often, we look to share schemes to incentivize and secure superstar employees over the long term. This way, we can reward individuals for their contribution to the growth of the business, motivating them to increase the value of their share of the business and give them a sense of ownership.  

However, if not carefully considered, there can be significant tax implications for the employee which can dramatically reduce the attractiveness of a share scheme and owners could find themselves giving away more of their company than they are comfortable with. 

Therefore, in this post we take a look at three of the most common share incentive schemes and their advantages and disadvantages.

1 - EMPLOYMENT MANAGEMENT INCENTIVE (EMI) SCHEME

Mechanics

  • An option is granted to buy a share at a set ‘exercise’ price, often the market value of the share at grant. If the market value of the share increases, then the original ‘exercise’ price is still retained.

  • So long as the exercise price is not lower than the market value of the share at grant, then no income tax is paid on the exercise of the shares.

  • Capital gains tax is paid on the sale of the shares on the difference between proceeds and the amount paid for the shares less any amount which was captured by income tax. However, EMI qualifies for Entrepreneur’s Relief so this can be taxed at 10%.

  • Generally, these are useful when a company is aiming for a sale and the exercise is likely to be at the sale event.

Advantages

  • Very tax-efficient. Generally, EMI results in the employee only paying tax @ 10% of the growth of the value of the shares from grant to sale.

  • Very flexible – the only limit is that exercise is within 10 years of grant.

Disadvantages

  • Can not be awarded to non-employees. Employees also must work 25 hours per week for that company or 75% of their working time.

  • Require formal valuation by HMRC because of reliance on the market value at grant.

  • There are several eligibility criteria for the company, for example the company must be small (under £30m assets and 250 employees) and there are ineligible industries such as professional services.

2 - UNAPPROVED OPTIONS

Mechanics

  • An option is granted to buy a share at a set ‘exercise’ price.

  • Income tax will be paid by reference to the market value at exercise less the amount paid for the shares.

  • Capital gains tax is then paid on the sale of the shares if the market value has increased further between exercise and sale. These do not automatically qualify for Entrepreneur’s Relief, so the tax is likely to be at 20% unless over 5% of the company is held for over two years.

Advantages

  • Simple, common, very flexible – can be employees, contractors, anyone.

  • Do not need approval from HMRC

  • Provides an alternative if a company is ineligible for EMI

Disadvantages

  • Not very tax efficient. Unless there has been no growth in company value between grant and exercise, there will always be an income tax charge to pay at exercise which can be up to 45%.

  • If the shares are readily convertible to cash at the point of exercise then the national insurance is also due. As exercise is often at the point of sale (otherwise how does the individual pay for the share?) then the entire growth between grant and sale is captured under the higher rates of income tax.

3 - GROWTH SHARES

Mechanics

  • A base value is set, and individuals can enjoy a % share of any growth over that base value.

  • These shares are issued upfront, generally as a new class of shares that has no voting or dividend rights.

Advantages

  • There is generally no tax charge on the issue of the shares because they only obtain value when the company grows from that point. The lack of voting and dividend rights also helps to ensure they have no value to be taxed on. All the value is future growth/hope value which is not taxable.

  • Very flexible, as this is not an HMRC scheme they can be designed however you want for whoever you want.

  • Generally, the only benefit of growth shares is to enjoy participation on exit, so taxes are at capital gains tax rates of 20% or 10% if qualifying for Entrepreneur’s Relief by satisfying the normal Entrepreneur’s Relief conditions.

  • Minimises dilution on current shareholders and holds back base value for them to enjoy

Disadvantages

  • Slightly legally complex and therefore can be expensive to set up.

  • Value of the growth shares can’t be agreed upon in advance with HMRC.

If you are considering setting up a share incentive scheme and would benefit from bespoke advice to make sure you hit the right balance, our ranges of services across accountancy, legal and HR are perfect. We have extensive experience helping small businesses put fit-for-purpose share incentive schemes in place.

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