Gifting Shares to Employees
This blog post focuses on how to gift shares to employees in a private limited UK company, including how HMRC value such shares and how to fill in the P11D form.
Why would you want to do this?
A company may decide to gift shares to an employee (or employees) for a multitude of different reasons. For example, you may wish to reward a particular employee’s recent performance or continued loyalty to your company, or you may do this with more corporate / commercial reasons in mind such as wanting to incentivise and motivate employees to invest their time and skills in helping to grow and build the company’s business.
Statistics show that companies which gift employees shares outperform other companies, and so clearly there is a benefit to rewarding employees in this way. On 18 June 2018, HMRC published a report which evaluated the impact of Enterprise Management Incentives (“EMI”) on small and medium enterprises. The report concluded that there is substantial evidence that EMI is fulfilling its core aims of improving recruitment and retention prospects for small and medium enterprises and supporting their future growth.
Employees will be keen to accept shares in the company as a gift due to the tax benefits. Rather than any profits made on the sale of such shares being subject to income tax and national insurance contributions, the gifted shares attract capital gains tax given that the gain on any sale/transfer of the shares by the employee is taxed as capital which involves lower deductions on any profit gained on a sale or transfer of the shares. Capital gains tax will be payable at the applicable rate which is lower than income tax – 20% or lowered to 10% if entrepreneurs’ relief applies. The liability to pay the tax will rest with the employee, not the employer.
How to gift shares to your employees
When a company is contemplating gifting shares to its employees, there are various ways it could go about doing this.
The company could decide to issue completely new shares or ask shareholders to transfer existing shares already owned by them to the employees. Unfortunately, the latter constitutes a disposal for capital gains tax purposes, and ultimately the attractiveness of transferring existing shares over issuing new shares depends on the capital gains tax bill resulting from the transfer.
In terms of price, the board of the company could determine a value for the shares or the employees could be given the shares completely free or at some discounted value.
If shareholders agree to transfer some of their existing shareholding as gifts to employees, they should be informed that the employees would then receive dividends at the same rate as the shareholder who gifted the shares.
Existing shareholders may prefer to gift some of their existing shareholding to the employees as using existing shares means that other shareholders do not suffer from any dilution (which would be the case if new shares were issued in the company and gifted to the employees).
Issuing new shares has benefits in that no capital gains tax will arise or be charged for the existing shareholder and also, the company could create a new class of shares for the employees receiving the gifted shares. This may help to keep existing shareholders happy as it would mean that the company could give the employee shares a lower dividend rate when compared to the existing shareholders’ dividend rate.
As above, it is worth noting that issuing new shares and gifting those to your employees would have the effect of diluting existing shareholders’ percentage holdings in the company, which they may not welcome or consent to.
Our recommendation is to gift shares to your employees via the implementation of an EMI share option scheme.
Since its launch in 2000, implementing an EMI share option scheme has become by far and away the most popular HMRC tax favoured share incentive plan adopted by companies for UK employees. Employee share incentive plans provide employers with a tax-efficient way to remunerate their employees, which can often help reduce employment costs (given that employees are more incentivised to stay with a company if they own shares in it). EMI schemes are can be used to recruit and retain employees and to also improve staff performance.
Share incentives can also help to align the interests of the company’s owners and its employees as both will be more united in wanting to build long-term shareholder value through growing the business in the expectation that everyone will eventually benefit from an exit event. They can also help private companies with succession or exit planning.
Qualifying companies can set up an EMI scheme whereby options are granted over shares (worth up to £250,000 per employee up to a cap of £3 million for the company) to eligible employees.
Particularly for start-ups, share options can be an important part of the package in attracting high calibre employees who can be persuaded to join a company for a lower cash salary when they see the potential for realising a significant capital gain in the future (i.e. on an exit event when their EMI options will commonly be exercised).
The company and the employee receiving the gift of shares will also need to meet HMRC reporting obligations. As mentioned, employees are responsible for paying any tax arising in respect of shares gifted to them by their employer and must report the gift of shares to HMRC on their tax return (deadlines will apply). Employers have to report the award of shares to employees by 6 July each year following the award, and reporting is done via the PAYE reporting portal.
A number of statutory requirements must be met in order for a company to qualify to grant EMI options. In particular, a company must be an independent trading company with gross assets of no more than £30 million and fewer than 250 full-time employees. Certain trading activities will not qualify and there are detailed rules relating to the independence requirement, the trading requirement and the shares that can be used (which are not detailed in this blog post).
The shares granted to employees under an EMI share option scheme must meet certain requirements, including that the shares must be fully paid up, ordinary shares.
To be eligible to be granted an EMI option, an employee must work for the company for at least 25 hours per week, or if less, 75% of their working time. Employees cannot be granted EMI options if they, or their “associates”, have a “material interest” in the company whose shares are used for the scheme, or in certain related companies. EMI options can only be granted to employees and cannot be granted to non-executive directors or consultants (although you can choose to grant non-qualifying options to such employees).
The legislation which governs EMI options is known as the EMI code. The EMI code requires that EMI options must be capable of being exercised within ten years of the date of grant, and options can only be exercised within a period of 12 months after the option holder’s death (although usually employers decide that the option holder’s death shall cause that individual’s option to lapse).
Otherwise, there are no restrictions on the exercise provisions that can apply to EMI options, and this flexibility means that they can be used for exit-only arrangements (which is the most common EMI share structure on which we advise, whereby an option can only be exercised on an exit event, such as a share sale or listing), as well as for options exercisable at the end of a performance or vesting period.
It is best practice for EMI option agreements to specify exactly when options will lapse, particularly at the end of a window period for exercise. Often, the EMI option agreement will provide that options will lapse on leaving employment, although early exercise may be permitted in certain circumstances. The EMI option agreement will generally also provide that options lapse if the option holder becomes bankrupt, or tries to assign the options or use them as security.
In the Spring 2020 Budget Spring 2020 Budget, the government announced that it will review the EMI code to see how effectively it meets the objective of enabling smaller companies to recruit and retain staff. This may lead to a relaxation of the qualification criteria (which have been briefly mentioned above) so as to enable more companies to benefit.
What are the risks?
Gifting shares to employees involves an element of risk and therefore it is always advisable to seek professional advice when wishing to do this and to make sure that the company’s articles of association and any shareholders’ agreement include provisions to protect the company’s shareholders.
One of the risks for the company gifting shares is that the employee they gift the shares to may ultimately cease working for the company (note that this will usually result in the options lapsing). If the employee was a valued member of staff, the directors may not want that employee to have to relinquish their shareholding in the company just because they are no longer an employee. On the other hand, the directors may want certain employees to relinquish their shares in the company and not continue to benefit from the prosperity of the company because of the circumstances surrounding the termination of their employment.
It is possible (and common in practice) to address these risks attaching to the gifting of shares to employees through good leaver and bad leaver provisions in a shareholders’ agreement or within the legal documentation governing the EMI share option scheme. An employee will usually be classed as a good leaver if they leave employment on the grounds of death or disability. Alternatively, the existing management / directors may view an employee as a good leaver because they have worked for the company for a significant amount of time and therefore want that employee to continue to benefit despite no longer being an employee of the company.
A bad leaver is usually defined as any employee that does not come within the good leaver definition. An employee will also often be determined to be a bad leaver if they leave in circumstances justifying dismissal (e.g. gross misconduct).
Another risk when gifting shares to employees is that the situation may arise whereby some shareholders wish to sell their shares on an exit event, but others do not. This risk can be addressed by inserting drag along rights into the company’s articles of association. A drag along right means that if a majority of the shareholders wish to transfer all (but not some only) of their shares to a bona fide purchaser on arm’s length terms, this majority can require all other minority shareholders to sell and transfer all of their shares to the proposed buyer as well.
HMRC have wide-ranging powers at their disposal when it comes to a company gifting shares to its employees.
Post-exercise, should an employee subsequently sell / transfer the shares on to a third party at a profit, the employee will then be liable to pay capital gains tax as they will be in receipt of a capital gain. Alternatively, instead of holding on to the gifted shares at all, the employee could decide to sell or transfer the gifted shares straight away. This sale or transfer will attract CGT, yes, but CGT rates are notoriously lower when compared to income tax and national insurance rates.
If the employee finds that they are liable to pay CGT in relation to the gifted shares, they should consider whether they qualify for entrepreneurs’ relief, which would bring the CGT rate down to 10% (from the usual 20% rate).
If the employer was so inclined, they could choose to reduce their corporation tax bill by issuing the relevant employee a bonus which the employee could then use to meet any income tax / national insurance liability in relation to the gifted shares. It is worth noting that any bonus payments made by the company will also attract income tax liability and national insurance contributions, however this may be offset by the fact that the bonus payments will help to decrease the company’s corporation tax liabilities.
If the company wishes to change the rights attaching to the shares once they have been gifted and the initial payment of tax has occurred, they should be aware that this may attract further tax liabilities.
For example, the company could choose to pay the employee that owns the shares a dividend rather than a salary. This is because dividends are more tax efficient when compared to salaries and also dividends will not attract employer’s or employee’s national insurance. If a company chooses to do this, however, it should always seek professional advice beforehand because if HMRC decides that the dividends are just disguised remuneration, then the tax advantage of receiving dividends will be diluted.
From the employee’s viewpoint, the tax treatment of an EMI qualifying option is as follows:
- At the point of grant, there is no income tax liability.
- At the point of exercise, there is no income tax liability if the exercise price was at least equal to the market value of the shares at grant. If the exercise price was less than the market value of the shares at grant, then income tax is due on the difference between the exercise price and the market value at grant.
- On a sale/disposal of the option shares, capital gains tax may be payable on any gain over the market value at grant (that is, the difference between the sale proceeds and the market value of the shares at grant). As above, shares acquired on the exercise of EMI options qualify for entrepreneurs’ relief, provided that conditions are met.
How do HMRC value the shares?
The exercise price of an EMI option can be set at any value (and can be nil, if option shares are not newly issued). Setting an exercise price that is less than market value at grant has consequences for the tax treatment of the EMI option on exercise (as mentioned above). The exercise price is usually agreed with HMRC at the outset before the options are granted.
The Shares and Assets Valuations (“SAV”) team is the specialist department within HMRC that will value, amongst other things, unquoted shares for tax purposes.
As there is no active market for most of the assets considered by the SAV, the department gets most of its guidance on valuations from court decisions and case law. With that being said, the SAV must be sure to carry out valuations for tax purposes on the basis of ‘market value’ as defined in the relevant statute.
The definition of market value for Capital Gains Tax can be found in section 272(1) of the Taxation of Chargeable Gains Act 1992, which provides as follows: “In this Act “market value” in relation to any assets means the price which those assets might reasonably be expected to fetch on a sale in the open market”.
Where the market value is being assessed because you have gained or sold assets, the valuation date is the date a binding contract was entered into (i.e. the date the relevant EMI option scheme documentation was signed by the parties or the date of grant of the EMI options).
As part of the valuation process, you will most likely be required to prepare and submit a valuation of assets to HMRC’s SAV team. When the valuation relates to unquoted shares (i.e. shares that do not have a quotation on a recognised Stock Exchange anywhere in the world), the SAV will require you to provide the following information:
- company performance and financial status (the SAV team will want to see accounts for the three years preceding the valuation, if available, and any other information normally available to the company’s shareholders)
- size of the shareholding and shareholder rights (this can impact whether it’s necessary to agree the value of all the company’s assets or gather more information about company performance and prospects than is in the published accounts, for example, if the holding is one that would give control of a company)
- the company’s dividend policy
- appropriate yields and price earning ratios of comparable companies or sectors
- the commercial and economic background at the valuation date
- your suggested value and how you have calculated it, this includes:
- the valuation approach adopted, such as earnings, assets, dividend yield or industry specific valuation method;
- any assumptions or adjustments made; and
- all the supporting evidence used
It is also advisable to include any other factors you think are relevant for the purposes of the valuation.
This form must be completed and sent to HMRC if you are an employer and need to report end-of-year expenses and benefits for employees and directors. You must submit a P11D form for each employee that you have provided with expenses or benefits (i.e. shares).
For further information on how to complete the P11D form, please consult HMRC’s guidance.
What we can do to help you
We offer in the first instance a 20-minute no cost, no obligation call to discuss your requirements and gain some background information on you and your business. We will then send you our tried and tested EMI option scheme checklist and questionnaire which will form the basis of the legal/contractual documentation governing your scheme. Completing our checklist/questionnaire at the outset will help us better understand how you envisage your scheme being structured and ensures that we can put in place well-considered and bespoke documentation to govern the scheme.
Our checklist/questionnaire can be downloaded for free by clicking this link and navigating to the “Free checklist” subheading.
We work alongside an accountancy practice which is well versed in consistently agreeing low valuations with HMRC for the purposes of granting EMI qualifying options. Our contact usually charges a fixed fee of £1,500 plus VAT (£1,800) for carrying out the initial tax and valuation work.
Given the prevailing economic circumstances resulting from the Covid-19 outbreak, there is an opportunity to agree a low valuation with HMRC for the purposes of granting EMI qualifying options to your employees, giving such employees the opportunity to acquire shares in the company at a low price.
We then charge a time-capped fixed fee of £1,500 plus VAT (£1,800) for advising on and producing the legal/contractual documentation to govern your EMI share option scheme.
If you would like our assistance with implementing an EMI share option scheme, please send an email to firstname.lastname@example.org or call our office on 01444 708 640 and we will be delighted to assist.
For further information, please see our more detailed blog post called “What Are EMI Option Schemes And How Do They Work“