The much publicised “employee shareholder” status came into effect yesterday, 1 September 2013, offering employers a more flexible way to structure their workforce. The new legislation applies to companies of all sizes, but is specifically targeted at high-growth, low-value companies that want a flexible workforce.
The starting point is straightforward. Employers can choose to offer shares of a minimum value of £2,000 in their employer or a parent company in exchange for the employee waiving certain employment rights, such as unfair dismissal or the right to receive a redundancy payment. Some rights however, such as the right to claim discrimination, cannot be waived.
The employee will receive certain tax advantages on the shares that he or she acquires. The first £2,000 worth of employee shareholder shares are free of income tax and national insurance contributions (NICs). No capital gains tax (CGT) will be charged on any gain on a subsequent disposal of the first £50,000 of the shares.
Relinquished Employment Rights
Provided the necessary formalities are complied with, employee shareholders will have no right to claim for ordinary unfair dismissal, a redundancy payment, or request flexible working or leave to undertake study or training.
In addition, an employee shareholder will be required to give a minimum of 16 weeks’ notice of early return from maternity or additional paternity leave, rather than the standard eight and six week requirement.
In order for these rights to be effectively waived, there are a number of criteria that must be met:
The individual must be an employee of a company, which can be a non-UK company, provided it has share capital.
The individual must receive a written statement of the particulars of their employee shareholder status, specifying the employment rights that he or she must forgo and detailing the rights, restrictions and other conditions attached to the shares.
The individual must receive independent legal advice on the terms and effect of entering into the employee shareholder agreement. This advice can be sought from a “relevant independent adviser”, which includes a solicitor or a barrister.
The individual has seven days to consider the offer and the legal advice and must then expressly agree with the company that he or she will become an employee shareholder.
The individual must not give any consideration other than entering into the agreement to become an employee shareholder.
The company must issue or allot to the individual fully paid-up shares in the employer or its parent company with a minimum value on the day of issue or allotment of £2,000.
The employer will need to cover the cost of the provision of independent legal advice to the prospective employee shareholder, even if the individual does not ultimately become an employee shareholder. This is effectively an advance settlement agreement and the procedural requirements will be familiar to the HR department. Any potential income tax charge on the value of the advice is prevented by an express exemption.
The only requirement relating to the shares is that they are fully paid-up to the value of at least £2,000 on the date of issue or allotment to the employee. This appears to give the employer considerable scope to dictate and dilute the terms on which they are offered. For example, the shares could be redeemable shares, could carry limited (or no) voting rights or rights to dividends or distributions on a winding-up, could have transferability restrictions and could be subject to “bad leaver” provisions.
However, the shares must be valued on a restricted basis for income tax purposes which means any restrictions on, amongst other things, their use and/or disposal will affect their value. Any restrictions on the shares will therefore need to be counteracted by an increase in the number of shares transferred.
Employers will need to ensure the accuracy of valuations. For private companies, this is typically done by an expert valuation firm. Whilst these issues will be nothing new for larger employers with share option and other employee ownership mechanisms already in place, for smaller companies the cost may well be disproportionately high.
Income Tax and NICs: General Rules for Employment-Related Securities
In principle, the receipt of shares in connection with an office or employment is a taxable event for income tax purposes. An employee receiving employment-related securities can therefore face a “money’s worth” general earnings charge up front, as well as a charge in respect of “specific employment income” on later specified events such as the variation or lifting of a restriction. In addition, employment-related securities that are “readily-convertible assets” will give rise to primary and secondary Class 1 NICs liabilities when they are acquired by an employee.
In practice, it is common for individuals receiving employment-related securities that are, or may be, subject to restrictions to make a 431 election to be subject to income tax up front on the difference between the price paid to acquire the shares and their unrestricted market value (the market price of the shares without the restrictions that depress their value).
The key benefit of making a 431 election is that any future growth in the value of the shares is then within the CGT regime. If a 431 election is not made, a proportion of any future growth (the portion of the share value at acquisition that was not paid for or subject to income tax) could remain within the income tax regime. The principal disadvantage of making a 431 election is that it brings forward a tax liability on a profit that the individual may never realise, e.g., if the shares are eventually forfeited and there is no mechanism for the individual to recover the tax paid in consequence of the election.
Income Tax and NICs: Overview of Rules for Employee Shareholder Shares
There is a specific money’s worth charge applicable to the receipt of employee shareholder shares, which are not subject to the money’s worth general earnings charge described above. This charge does not, however, apply to the first £2,000 of shares issued or allotted to an employee shareholder. There is, therefore, no income tax charge on the first £2,000 of shares and there is a corresponding NICs exemption to the same value.
Although there is no maximum value on the shares that can be given to individuals, any value in excess of £2,000 will give rise to an immediate income tax and NIC exposure, which could act as a disincentive for lower-paid employees.
In order to benefit from the exemption, the individual must not have a “material interest” (broadly a 25 per cent interest in votes or assets available for distribution) in the employer or parent undertaking, either directly or through connected persons. The test is also applied to the 12 months immediately prior to the issue or allotment.
It will still be possible to make a 431 election in connection with the receipt of employee shareholder shares to ensure future gains in respect of the shares are within the CGT regime, rather than the “specific employment income” regime described above. Regardless of whether or not such an election is made however, the £2,000 valuation is determined by reference to the restricted market value of the shares (the value of the shares, taking any restrictions into account).
This means that where an employee shareholder receives restricted shares worth exactly £2,000 (taking the restrictions into account) and makes a 431 election, he or she will still face at least a minimal income tax charge, because the £2,000 exemption will already have been used up.
HMRC has indicated that it will give valuations for employee shareholder purposes through its Shares and Assets Valuation division.
If the employee shareholder shares are acquired under a securities option, there is no up front earnings charge as a matter of general law. The £2,000 income tax and NICs exemption (if available) is instead applied to the acquisition of the underlying shares on a later exercise of the option.
Employers must make annual returns to HMRC identifying the issue or allotment of employee shareholder shares. The returns should be made on Form 42.
Gains on the disposal of the first £50,000 worth of shares acquired by an employee shareholder will be exempt from CGT. For these purposes, the shares are valued on an unrestricted basis. If the value of the original award exceeded £50,000, the exemption is restricted to the first £50,000.
As with the income tax and NICs exemption, the CGT exemption is only available where the individual (directly or through connected persons) does not have a material interest in the employer or parent undertaking. Where relevant, the base cost of the shares is increased by any amount subject to income tax on issue or allotment. The basis of valuation for CGT purposes is the unrestricted market value of the shares.
Where an income tax charge arises in connection with the issue or allotment of employee shareholder shares, the employer company should be entitled to corporation tax relief under Part 12 CTA 2009.
From an employer perspective, it is vital to ensure that the shares are valued correctly. If shares are, for example, overvalued and in reality are worth less than £2,000 when issued or allotted, it may be possible that the employee will both obtain the shares and also retain the employment law protections.
Employees need to be aware that it is possible for an individual to become an employee shareholder and relinquish their employment rights without also obtaining the beneficial tax treatment of employee shareholder status. This could happen if the procedural requirements are correctly complied with, but the individual in question controls 30 per cent of the voting rights in his employer.
Employers will also need to consider whether or not offering employees the opportunity to waive valuable employment protections could reflect badly on their reputation as a workforce-focused employer. The provisions have the potential to create a two-tier workforce of employee shareholders and non-employee shareholders. The former could be potentially subject to less favourable treatment and at higher risk of selection for redundancy as they have waived their right to claims for redundancy payments or unfair dismissal.
Moreover, does the relinquishing of employment rights really provide employers with the flexibility it claims to offer? Employees do not accrue the right to protection for unfair dismissal until they have been in continuous service for two years and, as such, employers already have quite significant flexibility to organise their workforce until those service requirements have been met. The employment rights that cannot be waived under the new system, such as automatically unfair dismissal, including whistleblowing, or discrimination or detriment claims, require no continuous service requirement at all. It is therefore entirely possible that employers will simply face an increase in discrimination claims brought by disgruntled employee shareholders, instead of unfair dismissal claims.
It may well be, therefore, that the true value of employee shareholder status lies in the potential to offer tax savings to senior employees as part of their remuneration packages. Typically, senior executives will be less concerned about claims for unfair dismissal (capped at the lower of a year’s salary or £74,200) and more concerned with securing high value contractual remuneration packages, particularly as most exits at that level are part of a negotiated settlement. Such individuals are also more likely to be paying CGT than lower-paid employees, who would most likely have their annual CGT exemption available to them.
Employee shareholder status is unlikely to see extensive take-up amongst small and medium-sized enterprises. Indeed, of the 184 respondents to the consultation, only three said they would consider implementing employee shareholder status.
It could, however, be of benefit to employers who have sufficient resources to put in place proper procedures to ensure that the administrative costs are minimised each time shares are issued. In particular, where shares are intended to be offered on the same or similar terms to a number of employees, a standard statement of terms can be used and tailored as required.
Employers who already offer equity incentives to some or all of their employees will be well versed in the requirements of valuation. Most HR departments will be aware of the requirements of a settlement agreement and, by extension, the “advance” settlement agreement required by the employee shareholder legislation.
For the majority of businesses, the new regime simply means employers have an additional tax efficient method of structuring remuneration packages for senior employees, with the added nuance of waiver of claims as a the benefit for the employer. It is, however, unlikely that employee shareholder status will eclipse enterprise management incentives as the favoured method for small companies to deliver shares to their employees in a tax-efficient manner.