Introduction

One of the most effective ways to incentivise staff, in particular senior employees, is to offer them the opportunity to purchase stock or shares in a group company. U.S. companies often operate stock and other incentive plans that apply the same terms to their international workforce as apply to their U.S. employees, often for good reasons such as consistency and ease of administration. However, care needs to be taken to ensure that specific tax, employment and regulatory rules in the relevant jurisdictions do not impair the effectiveness of the corporation’s incentive arrangements. The use of sub-plans or tailored grant documentation, varying the application of the rules of the overall U.S. plan to reflect the UK law and tax context, may be essential to avoid difficulties arising in a variety of areas.

Restrictive covenants

It is common for U.S. incentive plans to include, as terms applicable to the grant of the relevant incentives, non-compete and other post-termination restrictive covenants. However, it is important to appreciate that non-compete and other post-termination restrictive covenant provisions that are perfectly valid and enforceable in the U.S. – or at least certain states in the U.S. – may not automatically be enforceable in the UK – even where the governing law of the incentive plan in question is stated to be the law of a U.S. state.

Even if, as a matter of the governing law of the relevant plan, a restrictive covenant is enforceable, the courts of England and Wales will not enforce covenants which are unenforceable when judged by the standards of the law of England and Wales as a matter of public policy. The test for the enforceability of non-compete and other post-termination restrictive covenants in English law, to paraphrase, is that they must go no further than is reasonable in scope and duration in protecting the employer’s legitimate business interests in terms of confidential information, goodwill, client connection and a stable workforce. This test is not dissimilar to that applying in those states in the U.S. where restrictive covenants are potentially enforceable.

However, the detailed case law in England and Wales – which often focuses far more particularly on the minutiae of the drafting and operation of a particular covenant in determining its enforceability – can lead to a restrictive covenant being unenforceable whilst the executive remains entitled to retain the benefit of the incentive in question. Drafting issues jeopardising the enforceability of post-termination restrictive covenants by the courts of England and Wales can arise in various ways including the length of the covenant, how its geographical scope is defined and whether the degree of involvement of the restricted executive with the business, employees and clients that the applicable covenants seek to protect is sufficiently narrowly and precisely defined. Careful assessment may be needed of the enforceability of the restrictive covenants contained in a U.S. stock incentive plan and appropriate amendments made to the relevant restrictive covenants to address any concerns.

That said, ideally a corporation granting incentive awards to executives in England and Wales will not rely solely on the rules of the relevant plan for protection by way of post-termination restrictive covenants. As incentive plans operate in tandem with executives’ employment contracts, the corporation may want to ensure that the relevant executives’ employment contracts contain up-to-date and appropriately drafted confidential information, intellectual property and restrictive covenant provisions that achieve its business protection objectives. If an executive’s contractual arrangements need updating, agreement of a revised and updated employment contract may be a condition of grant.

Notice periods and garden leave

The impact of contractual notice periods also needs to be borne in mind in the application of U.S. incentive plans in relation to executives in England and Wales (and indeed other European jurisdictions). The rules of a U.S. incentive plan may specify that an executive’s entitlements lapse immediately on termination of employment. This is consistent with the fact that executives’ employment in the U.S. is typically “at will” and therefore subject to termination without notice being needed from either party. In England and Wales, however, executives are almost without exception entitled to a period of contractual notice which must be served before the executive’s employment terminates. Where an incentive plan provides that their entitlements only terminate on (eventual) termination, their ongoing vesting and potential ability to exercise their options will continue during and until the end of the executive’s notice period. This will be the case even if the executive does not work for the notice period but is placed on “garden leave” whereby, pursuant to an express provision of the executive’s employment contract, the executive is not provided with any work but remains employed by the employer and unable to work elsewhere, thereby keeping the individual out of the market for the notice period. The corporation may not wish the executive to retain his or her ongoing benefits under the incentive plan for the notice period but still wish to hold the executive to his or her notice period.

If the corporation wishes to retain this flexibility and avoid continued vesting and the ability to exercise an incentive award following service of notice of termination, either by the employer or the employee, the rules of the incentive plan (or applicable sub-plan or grant documentation) should specify that the vesting of, and ability to, exercise an incentive award should cease upon the earlier of the giving or receipt of notice of termination of employment and the day the employment actually ceases.

Claims for loss of incentive rights

It is customary in stock option plans operated in England and Wales to include a provision to the effect that the individual’s entitlements under the plan are entirely separate from the individual’s employment contract and that termination of the individual’s employment does not give rise to any claim for loss of entitlements under the plan. Whilst this sort of clause is not effective to prevent claims for loss of stock options in an unfair dismissal or unlawful discrimination claim, it does prevent an executive including loss of stock incentives in a damages claim for breach of contract. Without such a provision, an executive – especially one with a long contractual notice period who is wrongfully dismissed in breach of contract – could claim damages for the loss of the value of incentives that would otherwise have vested and been exercisable during the notice period. U.S. plans do not include such provisions and so it is advisable for them to be included in sub-plans or grant documentation for executives in England and Wales.

Tax-approved share option plans

In general, using an “unapproved” form of option arrangement will be tax inefficient and will subject UK employees to income tax (at up to 45 percent) on the value of the equity received at the time of acquisition less any exercise price paid. Social security liabilities by way of employer and employee National Insurance Contributions (“NICs”) may also arise as discussed further below. In contrast, using a tax-advantaged form of award can potentially achieve a materially better tax capital gains tax outcome for UK employees (with tax payable at 20 percent). Various forms of tax-advantaged incentive are available in the UK, the most common of which is the Enterprise Management Incentive (“EMI”) share option. Although detailed conditions must be satisfied in order to grant EMI options (and other types of tax-advantaged award), for qualifying companies it may be relatively simple to adapt U.S.-style award documentation to conform with UK requirements for EMI share options. Offering tax-advantaged awards to UK employees is significantly likely to increase the attractiveness of the corporation’s overall incentive package.

Social Security Taxes

When a UK employee is subject to income tax in respect of an incentive award, there will often be a corresponding NICs charge for both the employee and employer. The employer charge is equal to 13.8 percent of the amount chargeable to income tax and can therefore constitute a significant additional cost to the employer making the award. When using standard U.S. award documentation, social security contributions will rarely be addressed in sufficient detail for UK purposes and no provision will usually be made in respect of employer NIC. As a matter of English law, it will generally be unlawful to rely on a general tax withholding right to pass such cost to the employee. With appropriate UK review and advice, plan documentation can be amended so that any employer NIC liability can be factored into the value of the award made to UK employees or, in certain scenarios, transferred to the employee.

Tax Point

In the U.S., the vesting date of an award will typically be a taxable event. However, in the UK, the vesting date of a share option-based award will not generally constitute a taxable event. Instead, tax will become due only when the option is exercised. Some adaptation may be required to plan documents to reflect this difference and to ensure that tax withholding can be made at the appropriate time.

Tax Elections

UK employees are often required, as a condition of the receipt of share-based awards, to make tax elections to bring the full unrestricted market value of employment-related shares into tax at the point of acquisition (broadly similar to the U.S. 83(b) election). Making such an election should ensure that the recipient benefits from capital gains tax treatment on future growth and should avoid any additional income tax and, importantly from the employer perspective, NIC arising in the future.

Conclusions

Employers will wish to ensure that their international incentive arrangements are fit for purpose from the employment tax and regulatory perspectives. It is prudent to obtain expert advice at an early stage and to build in flexibility as appropriate into plan design to deal with local law requirements when rolling out U.S. incentive arrangements internationally.