Last updated on February 25th, 2022 at 01:58 pm
Share schemes and share options are a complicated area with a lot of statutory regulations, case law and taxation issues impacting on them (mainly relating to the government trying to curb tax avoidance). However, options are simpler and more flexible to deal with than shares, have no initial cost to the individuals issued with them, and employees (not freelancers though) can be issued with tax efficient HMRC approved Enterprise Management Incentive (EMI) options (freelancers can only get ‘unapproved’ share options). With options you can more easily deal with leaving (the options can be forfeited) and performance conditions and can make the options exercisable only in the event you sell the company and other such restricted circumstances. The idea being that without losing any control over the company per se you can motivate employees and freelancers to stay with the business and help build it for the duration of its lifetime and be rewarded at exit with a capital gain (when the options will be exercised and convert into shares just before the company is acquired).
Normally the pre-set price that the option can be exercised for is the market value of the shares at the time the option is granted, although sometimes the exercise price is greater or less than the market value at that time. Therefore the share options can be very valuable as when the share price rises above the exercise price the holder can make a profit if he exercises the option and then sells the shares because he has been able to buy the shares for much less than they are worth at the time of exercise. Options usually cannot be transferred and will lapse automatically if the employee tries to transfer them or uses them as security or encumbers them in any other way.
Options can either be granted as part of an employee share option plan (for employees and full time directors) or by separate deed for self-employed consultants, non-executive directors and freelancers. The particular issues to consider when granting options are to ensure that you have complied with the relevant exclusions and exemptions of the Financial Services and Markets Act 2000, the main options terms regarding exercise and good / bad leaver provisions are sufficiently clear and workable, your company has received the correct formal consents to grant the options and all the possible tax implications of your option plan have been thoroughly researched and discussed.
As stated, EMI options are a flexible way of incentivising employees and full time directors. Shares acquired on exercise of a qualifying EMI option can now automatically qualify for Business Asset Disposal Relief, the 10% rate of tax on lifetime gains up to £10m, where the exercise is more than a year after the grant and the holder of the shares is a retained officer or employee of the company in the year before the disposal, even where the usual 5% Business Asset Disposal Relief voting and holding requirements in respect of shares are not met. EMI Options can be granted over up to £250,000 worth of shares to each individual, subject to a £3 million overall limit for each company. No advance clearance or approval procedure is required, although it is advisable to obtain HMRC’s agreement of the valuation you reach. However, in order to qualify as EMI options a correct grant notice must be given to HMRC within 92 days of the options being granted. There is also an annual reporting requirement to HMRC using form EMI 40.
a) Self-employed consultants
Those who are not employed by the company can only be issued with unapproved options.
Although there is no specific case law or legislation relating to the taxation of share options granted to non-employees, the case of Abott v Philbin is authority for the proposition (in an employment income context) that an option holder is taxed on the value of the option at grant. If the option is taxed in accordance with the principle in Abbott v Philbin, there is no charge to income tax on exercise and any growth in value after grant is chargeable to capital gains tax when the option shares are disposed of.
Note that valuing share options is a complex and uncertain task. The value will depend on the price paid by arm’s length investors, the rights and obligations attaching to the underlying shares, the fact that the share value may take years to realise and may never be realised, marketability, company performance including dividend yield, comparable companies in the sector, size of shareholding and trading history.
Given the above factors, if a self-employed consultant does declare in their tax return the value of a share option granted then a low value should be justifiable for the share option granted.
For the self-employed there are no PAYE/NIC implications in respect of the options for the company engaging the self-employed contractors (see below for PAYE/NIC treatment of unapproved options for the employed), albeit the self-employed person is subject to capital gains tax through self-assessment when the option is exercised and shares are sold.
A company would do well to consider the allotment of Growth Shares in lieu of share options. This is a model by which a new class of share is created and issued which holds no value at the time it is created – because a nominal value can be attached to it the position is free of tax liability when the shares are received. When the holder disposes of the shares they only take exit proceeds exceeding the value when the shares were created, thus only attracting Capital Gains Tax on the value added to the company since their involvement.
For employees with unapproved options, at exercise of the option income tax is charged on the difference between the market value of the shares at the date of the exercise and the option exercise price (this tax is due even if the shares are then not sold straightaway). If at exercise shares are readily convertible assets, i.e. exercise is around the time of a sale of the company, then NI and PAYE liabilities arise. The NI liability may be transferred to the employee and the employee can obtain income tax credit where this liability is transferred. The overall rate of tax on exercise is now up to 54.59% for additional rate taxpayers and remains 50.28% for higher rate taxpayers where the employee NI liability is transferred. Once the option is exercised and the underlying shares are then sold there is also a charge to capital gains tax on any increase in value of the shares since exercise, subject to applying the capital gains tax annual exemption. When the option is exercised a section 431 election should be signed within 14 days, while there is also an annual reporting requirement to HMRC using form 42.
If you’d like advice and assistance on the legal and tax issues relating to share options and share schemes so that such incentives are optimised and issued correctly please do get in touch and we will provide you with an attractive quote.
Gifting shares to an employee and HMRC valuation