What are unapproved / non-tax advantaged share option schemes and how are they used?
What is an unapproved / non-tax advantaged share option scheme?
An unapproved share option scheme (which is now increasingly referred to as a non-tax advantaged share option scheme) provides the right, but not obligation to acquire a given number of shares from a company at a future date for a fixed price.
For the purposes of this article, we will continue to refer to these schemes as “unapproved” schemes because this is how many people still refer to them. Many industrial professionals, however, have adopted the term “non-tax advantaged” in place of “unapproved”.
The term “unapproved” merely means a share option which is not generated under any of the statutory tax advantaged schemes (EMI, CSOP or SAYE) and therefore has not received approval from HMRC for option holders to benefit from tax breaks.
An unapproved option scheme can either be used on its own, or it can be used alongside statutory tax advantaged scheme as a way of providing additional benefits in excess of the caps prescribed by legislation for the tax-advantaged schemes. However, the most common use of an unapproved share option scheme is for companies that do not meet the tax-advantage scheme criteria to be able to incentivise their employees or for those companies that do meet the criteria but want to grant options to officers/employees who do not qualify under the tax advantaged rules.
Possibly the most common use for an unapproved option scheme is to incentivise employees to work towards an exit (such as a sale or listing); indeed, many private company unapproved options are only exercisable on an exit.
How do unapproved share option schemes work in practice?
For the Employer
As these schemes do not need to be approved by governmental or regulatory bodies, there are no legislative requirements for the setting up or running of such a scheme, thus resulting in more flexibility and a myriad of benefits.
Examples of such flexibility are as follows;
- options can be offered to a much broader range of employees, such as consultants, non-executive directors and employees residing outside of the UK;
- there is no limit on the number or value of options that can be granted;
- option schemes can be discretionary and do not need to be offered to all employees; and
- option schemes do not provide the holder with any voting rights prior to the exercise of the option (despite the underlying option potentially having voting rights), this ensures any existing shareholders are protected from dilution.
The introduction of a scheme like this can be used alongside certain conditions in order to motivate employees to be more productive, for example target hitting or staying within the company for an agreed time, therefore boosting the productivity of a business.
Assuming all other criteria are met under the Corporation Tax Act 2009 (“CTA 2009”), the corporation tax deduction following an option exercise can have positive benefits for a company financially.
While unapproved share option schemes offer few tax benefits in comparison to a statutory approved scheme, there are still benefits for employees, examples of which are set out below:
- employees are able to share in the success of the business, this helps them to feel like they have some “skin in the game” and have a genuine reason for wanting to work hard to attain performance targets/generally drive the success of the company;
- there is little to no financial risk for employees – if the market value of the option is less than the exercise price, the employees do not have to exercise the option; and
- there are no restraints on who can participate (unless the company wishes to impose some).
What are the tax implications?
The below information is intended as a summary only, and we recommend seeking separate tax advice for further clarification.
For the Employer
The granting of the option is not a taxable event itself, however following exercise of the option and if the option is ‘readily convertible’, the employers national insurance contribution (“NIC”) will fall due.
Corporation Tax relief is available to the company when an employee exercises their option under Part 12 of the CTA 2009. This is based on the Gross Gain (the value provided to the employee following exercise), plus the employers NIC arising.
The receipt of the option is not a taxable event, however there are differing tax implications depending on when the option is exercised.
Options not exercised immediately before an exit event
The employee will be subject to income tax on the difference between the market value of the shares they receive on the date of exercise, and the amount that they pay to exercise the option.
This income tax charge is usually dealt with as an employee benefit in kind and therefore the employee will usually need not to pay or do anything.
When the employee disposes of the shares, capitals gains tax will become payable. This is the difference between the disposal proceeds and the price paid, or the market value (whichever is greater).
Options exercised immediately before an exit event
A pending exit event makes shares held by the employee ‘readily convertible’.
When shares are readily convertible, PAYE and NICs become due. The employer should deduct PAYE and employee NIC from the sale proceeds paid to the employee and the employee will also have to pay the employer’s NICs.
The sale proceeds paid to the employee will be the sale price per share, less the exercise price due to the company.
Note that despite the employer initially deducting/paying the PAYE and NICs, the liability remains with the employee. As such, if the employer did not recover this from the employee, then HMRC will deem this as a separate benefit, which will become taxable.
No capital gains tax liability arises.
How to implement an unapproved share option scheme?
While there are no legislative requirements to implement an unapproved share option scheme, it is important that the terms of the options are set out in an option agreement. This will also set out any vesting periods, conditions to be met and leaver conditions.
At the Jonathan Lea Network, we regularly support and advise companies with regards to share options, both approved and unapproved. If you would like advice and assistance on this please send an email to firstname.lastname@example.org or complete this form to arrange a free 20-minute consultation.
This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited 2023.