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Recruitment Watch

Employees opt to swap employment rights for shares
Recruitment Watch

Recruitment Watch

Author
Stephen Diosi
Date
24 September 2015

"Employee shareholder" status offers potentially valuable capital gains tax relief to employees prepared to give up key employment rights.


Employees opt to swap employment rights for shares

"Employee shareholder" status offers potentially valuable capital gains tax relief to employees prepared to give up key employment rights. At the time of its introduction in September 2013 it was greeted with heavy criticism, yet over two years on it is proving attractive in certain circumstances. It is of interest to entrepreneurial companies with high growth ambitions who are committed to incentivising employees through shared ownership and to the senior employees within these companies.

With few conditions attached, employee shareholder status confers a complete exemption from capital gains tax on shares worth up to £50,000 on acquisition.  It has consequently become a regular feature in private equity backed companies because it offers the potential for management to benefit from growth in equity tax free.

Whether you are an employee contemplating taking an equity stake in a company or a company/investor wishing to align the interests of the staff with those of other shareholders, employee shareholder status is worth considering.

What does it mean to become an employee shareholder?

Under the employee shareholder scheme, employees must receive at least £2,000 worth of shares in their employer company, or its parent, in return for giving up specified employment rights - outlined below. The shares must be allotted or issued to the employees fully paid - the employee may not pay for them as the only permissible consideration is giving up the relevant employment rights. The employees eligible can be existing or new employees, or both. There is no maximum number of shares that can be issued, although capital gains tax relief will be available only on the first £50,000 worth of shares on grant. Employee shares can be combined with other share incentive arrangements such as growth share schemes. This combination may be particularly attractive either where the proposed incentive is a classic ratchet arrangement (i.e. designed to increase the amount of equity held by managers where certain performance targets are met) or as a method to come within the financial parameters of £2,000 and £50,000.

Which employment rights are given up?

When an individual agrees to become an employee shareholder, he/she agrees to give up the right to:

  • receive statutory redundancy pay;
  • not be unfairly dismissed, except in certain circumstances, such as whistleblowing;
  • make a statutory request for time off for training or study;
  • make a statutory request for flexible working - except that a request may be made within 14 days of returning from parental leave;
  • return to work earlier than anticipated from maternity, paternity, or adoption leave by giving eight weeks' notice.  Instead, he/she will need to give 16 weeks' notice.

Employees need to weigh up the value of these rights and the value of the shares on offer.

What are the potential tax benefits and conditions?

Capital gains tax: Up to £50,000 worth of employee shareholder shares valued on the date they were acquired and ignoring any restrictions which may apply to the shares for example on transfer - are exempt for capital gains tax when the shares are disposed of.
Income tax/NICs on allotment of the shares: No income tax or NICs will be payable by the employee for the first £2,000 of any share award. However, any award above £2,000 will be subject to an immediate income tax charge and potentially employee NICs on the value over £2,000 - the employee cannot pay for the shares in any way. The £2,000 is valued taking account of any restrictions on the shares, such as share transfer restrictions which may be found in the company's articles. In addition, because the company and employee may be concerned that an income tax charge may later apply e.g. on sale and otherwise potentially wipe out any capital gains tax benefits, an individual employee may also elect to pay up front any income tax on the difference between the value of the shares on an unrestricted basis and their restricted value - a so-called "section 431" election.
Exclusions: The capital gains tax and income tax reliefs will not be available – i.e. the shares will not be "exempt employee shares" - if the employee or any of his connected persons holds, has rights to hold or, in the previous year, held a "material interest" - broadly, 25% or more - in the employing company or parent.

What happens when an employee shareholder leaves?

Aside from any express provisions in a company's constitution, an employee who is also a shareholder will retain his or her shares on leaving. However, a company would normally wish to include leaver provisions in its articles to allow the company to require the compulsory purchase of an employee's shares. The price at which those shares are purchased will be a matter for negotiation and typically depend on the reason for cessation of employment and/or length of service - so-called "good or bad leaver" provisions. If the company buys back "exempt employee shares" (see "what are the potential tax benefits and conditions?" above) the shares will not be liable to income tax as distributions.

What are the pros and cons for an employee?

General

Pro

Potential for tax free return on exit.

Con

Gives up certain employment rights for shares. Shares can fall in value.

Mitigating factor

N/A

Tax

Pro

Save CGT on exit on shares initially worth up to £50,000.

Con

Could pay some income tax up front.

Mitigating factor

Always consider the individual's particular tax circumstances.

Employment & leavers

Pro

N/A

Con

Loses rights to redundancy pay or rights to some unfair dismissal claims.

Mitigating factor

The employee is still protected by his/her contract of employment and is legally protected by other employment rights, such as a right not to be discriminated against. He/she should check the terms of leaver provisions in articles – at what value will shares be purchased on leaving?

Ceasing to be a shareholder

Pro

The employee should check whether he/she can sell the shares.

Con

If shares can be sold and the employment continues, the renounced employment rights are not reinstated automatically.

Mitigating factor

It is open for the company and employee to agree to reinstate employment rights if shares are sold.

What are the pros and cons for the company?

General

Pro

Employee incentivised to achieve corporate growth.

Con

Employee won't have paid for the shares – no "skin in the game".

Mitigating factor

The manager could subscribe for loan notes (or non-employee shares) in addition to holding employee shares.

Tax

Pro

A corporation tax deduction is normally available for the employer company equal to £2,000 plus the taxable value of the shares on issue.

Con

Company concerned to limit PAYE and NIC exposure.

Mitigating factor

The individual may require the company to enter into a joint s.431 election. The company may require an indemnity in the employee shareholder agreement.

Employment

Pro

There should be a reduced risk of statutory employment claims and no obligation to make a statutory redundancy payment.

Con

The claims risk is not entirely removed as the individual is still protected by their contract of employment and legally has other employment rights, such as a right not to be discriminated against. The individual could also remain a shareholder after leaving.

Mitigating factor

Carefully drafted leaver provisions can require the compulsory purchase of the leaver's shares.

Cost

Pro

The employee should check whether he/she can sell the shares.

Con

The company must pay the reasonable costs of the employee taking independent advice. In addition there will be valuation and legal fees for the company in implementing the employee shareholder scheme.

Mitigating factor

There are a number of professionals that we work with who can give this advice cost effectively. For example, a relatively straightforward valuation would be approx. £1,500 + VAT.

What steps are required?

There are a number of information rights and protections built into the legislation which introduced employee shareholder status, designed to ensure that employees giving up their rights are properly advised.  No case will be exactly the same and there is a need for careful structuring, particularly in relation to share rights.  Additional formalities would be required for a public company, however a typical timetable and documents for a private company would be as follows:

Step 1

Timing

N/A

Action/Document

Decide on the rights and restrictions which attach to the employee shares. Draft any relevant shareholder resolutions and amendments to the articles (which may be passed conditionally or later).

Details

May be part of a wider transaction. Often a new class of shares is created for the employee shares.

Step 2

Timing

No more than 60 days before the share acquisition.

Action/Document

Value the employee shares (on a "restricted" and "unrestricted" basis). Agree with HM Revenue and Customs.

Details

Professional valuation is normally needed.

Step 3

Timing

N/A

Action/Document

The company gives a statement of particulars to the employee & attaches a draft agreement to become an employee shareholder.

Details

The statement sets out the employment rights that will be sacrificed and specified particulars of the rights and restrictions attaching to the shares.

Step 4

Timing

N/A

Action/Document

Independent advice must be given to the employee on the terms and effect of the employee shareholder agreement.

Details

The reasonable cost of this advice is to be paid by the company.

Step 5

Timing

At least 7 days after the independent advice.

Action/Document

The company and employee(s) enter into the employee shareholder agreement(s). The shares are allotted and issued.

Details

N/A

We have relationships with professional valuers who can give a cost effective valuation, and we work with professionals who can give cost effective advice on all these issues.

Please contact Stephen Diosi, Legal Director in Employment, to find out more.