Shares for Rights (UK) Introduction The so called "shares for rights" legislation came into force in the UK in September 2013. The tax breaks are very generous as they allow employees to achieve tax free gains on share sales. The conditions are not onerous and allow employee incentive arrangements to be structured very flexibly to meet most commercial requirements. Unlisted companies and even AIM traded companies should consider offering shares for rights. Key Conditions Employees can sacrifice certain employment rights for at least 2,000 worth of free shares. Participants must: give no consideration for the shares; be an employee or about to become one; be given prescribed information about the statutory employment rights they are required to surrender and the rights attaching to the free shares; wait at least 7 days after receiving independent advice before the shares are issued. Employees who have a "material interest" (see below) can sacrifice employment rights in exchange for free shares but will not qualify for tax reliefs. The shares: must be new issue and fully paid up; must be shares in the employer or an associated company; may be subject to any vesting / forfeiture conditions; may be any class (so, for example, non-voting growth shares are permitted). Share valuations may be agreed with HMRC in advance so, for example, it is possible to ensure the minimum 2,000 value requirement is met by creating a new class of growth shares with sufficient intrinsic value and agreeing that is the case with HMRC in advance. The shares must be issued fully paid. Companies with sufficient distributable reserves will be able to use these to pay up the shares whereas companies with insufficient distributable reserves will usually be able to take view the rights surrendered constitute sufficient "money's worth" for the shares to be fully paid.
The Tax Reliefs Employees are deemed to give consideration of 2,000 so are only subject to income tax and NIC in so far as the value of the shares exceeds 2,000 on issue. The first 50,000 worth of shares (measured by reference to the unrestricted market value of the shares on issue) are exempt from capital gains tax on disposal. So an employee could acquire 2,000 worth of growth shares income tax free and later sell them for 1 million, the sale would be CGT free (as they were worth less than 50,000 on issue). Shares for rights is more generous than entrepreneurs' relief as there is: no minimum holding period for the shares; no minimum 5% nominal value and 5% voting requirement; no requirement to remain in employment; no need for the company to be a trading company; no cap on the amount of the relief. Qualifying shares can even be bought back by the issuing company and cancelled tax free after cessation of employment (the normal distribution rules on share buy-backs do not apply to employee shareholder shares sold in these circumstances). The CGT reliefs make shares for rights considerably more attractive than entrepreneurs' relief (which has itself been extremely popular). The income tax and capital gains tax reliefs are not available to employees who have (or have had within the previous 12 months) a material interest (at least 25% of voting rights, or if the company is a close company, entitlement to at least 25% of assets on a winding-up) in the employing company or its parent. The employing company qualifies for a statutory corporation tax deduction equal to the amount assessed to income tax in the hands of participants (ignoring the 2,000 which is deemed to be given as consideration) if the shares are in an "independent" company and certain other conditions are met. What Rights Are Surrendered? The rights which an employee is required to surrender are: unfair dismissal rights (apart from the automatically unfair reasons, where dismissal is based on discriminatory grounds and in relation to health and safety); rights to statutory redundancy pay; the statutory right to request flexible working except in the 2 week period after a return from parental leave; certain statutory rights to request time off to train. In addition, an employee shareholder must give 16 weeks' notice to their employer if they intend to return early from maternity, additional paternity or adoption leave. An employer may choose to offer a contractual "make good" to compensate for the loss of statutory rights if they wish. In our experience most employers offer a make good to re-assure participants the purpose of the plan is to provide tax efficient incentives.
Shares for Rights in Practice All companies (whether listed or unlisted) can offer ordinary shares worth at least 2,000 tax free to their employees and prospective employees. This is most clearly what the legislation was intended to allow but arrangements of this sort have not been offered in practice as feedback suggests most employees would not agree to sacrifice their employment rights so cheaply. We look at three possible situations in which companies are more likely to want to use shares for rights but would stress the application to these situations very much depends on the facts. Alternative to Options Unlisted Companies Many unlisted companies that do not meet the conditions for enterprise management incentives ("EMI") can structure incentives tax efficiently instead using a new class of "growth shares" which are issued in exchange for the surrender of certain employment rights. Suppose Company A is controlled by a venture capital investor and it is intended to grant equity awards to three managers over 10%, 5% and 2.5% of the issued share capital respectively. Company A does not qualify for EMI as it is not an "independent" company. The incentives could be structured instead by creating a new class of growth shares which have no rights other than to participate in exit consideration (or distributions on a winding-up) with ordinary shares but only after ordinary shares have received a "hurdle amount" specified by the board on issue. The hurdle can be different for each employee so as to ensure the minimum 2,000 value condition is met whilst minimising the up-front value which is subject to income tax. The minimum 2,000 value requirement is measured by reference to the CGT market value taking restrictions attaching to the shares into account and is referred to as the actual market value ("AMV") Suppose Company A has 100,000 ordinary shares in issue worth 10 each. The growth share hurdles for each participant would be: Manager 1: 10,000 growth shares with a 9.80 hurdle with an AMV of 20p each (10,000 x 20p = 2,000 in total). Manager 2: 5,000 growth shares with a 9.60 hurdle with an AMV of 40p each (5,000 x 40p = 2,00o in total). Manager 3: 2,500 growth shares with a 9.20 hurdle with an AMV of 80p each (2,500 x 80p = 2,000 in total). It is possible to impose any vesting and forfeiture conditions so Company A could be given a call option to purchase unvested growth shares for a nominal amount on cessation of employment or on failure to meet performance conditions. After valuations have been agreed with HMRC the growth shares can be offered to each manager in exchange for the surrender of their statutory employment rights, the shares cannot be issued until at least 7 days after the receipt of independent advice. Each manager will be required to make an election under section 431(1) ITEPA 2003 to pay income tax on the unrestricted market value ("UMV") of the growth shares within 14 days of acquisition. The UMV is the CGT market value ignoring any restrictions attaching to the shares. The election is necessary to ensure the tax point arises on acquisition and that (absent the application of certain anti-avoidance rules) future gains on sale are taxed as capital. HMRC will usually agree the UMV is 10% higher than the AMV. These valuations can be agreed in advance with HMRC.
Employees are deemed to give consideration of 2,000 for the growth shares so the section 431 elections will result in a small amount being assessed to income tax for the tax year the shares are acquired as follows: Manager 1: 10,000 x 22p - 2,000 = 200 Manager 2: 5,000 x 44p - 2,000 = 200 Manager 3: 2,500 x 88p - 2,000 = 200 Another method of achieving the same result would be to issue growth shares with one hurdle (of 10 in this example) and to issue a separate share worth 2,000 to each participant. This method avoids the need for different hurdles but requires an additional class of shares to be created with no rights other than to be sold for 2,000. Note: This example assumes HMRC will agree AMV and UMV by deducting the hurdle from the value of ordinary shares to establish the value of the growth shares. Some inspectors, however, take the view that growth shares have a "hope" value over and above the "intrinsic" value when compared to ordinary shares. If so it may be necessary to agree the growth shares have a higher value (resulting in a higher up-front tax charge) than illustrated in this example. Alternative to Options AIM Listed Companies Suppose Company B is traded on AIM and wishes to grant market value options to its executives and key employees. As an alternative to EMI it could create a new class of non-voting growth shares in an intermediate holding company which is wholly owned by Company B. The economic rights of the growth shares would be pegged to the value of the listed shares in Company B. For example, if the listed shares trade at 10p each when the growth shares are issued, the growth shares would be entitled to distributions on a winding-up or to exit consideration equal to the listed price at the time in excess of a hurdle of (say) 10p per share. After HMRC have agreed the value of the growth shares participants would surrender their employment rights in exchange for the issue of growth shares worth at least 2,000. Vesting and forfeiture conditions could be imposed by giving Company B a call option to purchase unvested growth shares for a nominal amount on cessation of employment or on failure to meet performance conditions. Once the growth shares have vested, participants would be entitled to put the growth shares on Company B in exchange for listed shares of the same value (which can be sold in the market immediately). The put would be exercisable at any time until the tenth anniversary of the issue of the growth shares (so as to replicate an option plan). The exchange is a disposal for CGT purposes and would be tax free, the listed shares have a base cost equal to the consideration given for them so the immediate sale would also be tax free. This sort of arrangement is more likely to be used by AIM companies than by companies on the full list of the London Stock Exchange for two reasons. First, the rules of the full list require prior shareholder approval for any plan involving new shares in any group company whereas the AIM rules do not. Second, the guidelines of the Investment Association do not approve the use of subsidiary shares, these guidelines apply to companies on the full list but not to AIM companies. Note: HMRC will invariably take the view growth shares in a subsidiary of a listed company have a "hope value" over and above the intrinsic value arrived at by deducting the hurdle from the listed share price at the time of issue. If the listed share price is volatile this can have an exponential effect on the value of the growth shares so some modelling is required at the feasibility stage to ensure the likely values are acceptable. University Spin-Outs Special rules apply to help university research teams to establish spin-out companies. The rules can be combined with shares for rights to produce very tax efficient incentives.
The value of the intellectual property transferred to the spin-out is ignored for income tax purposes if the spin-out conditions are met. Broadly the research team have to acquire shares in the spin-out before or within 183 days after the transfer of the IP from the university to the spin-out and they have to have acquired their shares in the spin-out by virtue of being employees of either the university or the spin-out. The rule which allows the value of the IP to be ignored for income tax purposes extends to shares acquired pursuant to shares for rights. So it is often possible to structure share awards to university research teams so they acquire ordinary shares in the spin-out with a significant initial value but at an insignificant up-front tax cost. The shares can later be sold tax free if offered through shares for rights. The research team need to be employees of the spin-out in addition to being involved in related research carried out by the university in order to qualify. Issue of Shares to Existing Employee Shareholders It may also possible to offer growth shares to existing shareholders to allow future gains to be tax free. Suppose Company C has one class of ordinary shares in issue held as follows: Ordinary shares Voting + economics Eligible for Shares for Rights Tax Relief Founder 1 6,000 60% No (material interest) Founder 2 2,000 20% Yes Employee 1 500 5% Yes Employee 2 500 5% Yes Employee 3 500 5% Yes Employee 4 250 2.5% Yes Consultant 250 2.5% No (not an employee) Total 10,000 100% The articles of Company C could be amended to create a new class of growth shares which have no rights other than to participate in exit consideration (or distributions on a winding-up) in excess of a hurdle specified by the board on issue. Growth shares participate with ordinary shares above the hurdles pro-rata to the number of shares in issue. Eligible shareholders are given the opportunity to surrender their employment rights in exchange for (say) 100 growth shares for every 1 ordinary share they hold. Ordinary shareholders who do not participate receive a bonus issue of growth shares to keep them whole (their shares are first re-designated as A ordinary shares with the same economic rights as ordinary shares so the bonus issued goes to them alone).
The issued share capital of Company C after the issue of growth shares is as follows: Ordinary A Ordinary Growth Voting + economic Growth Share Hurdles UMV for tax purposes Founder 1-6,000 600,000 60% 100 Founder 2 2,000-200,000 20% 99.99 2,200 Employee 1 500-50,000 5% 99.96 2,200 Employee 2 500-50,000 5% 99.96 2,200 Employee 3 500-50,000 5% 99.96 2,200 Employee 4 250-25,000 2.5% 99.92 2,200 Consultant - 250 25,000 2.5% 100 Total 3,750 6,250 1,000,000 If ordinary shares are worth (say) 100 each the hurdles would be set as above to ensure the AMV of the growth shares for those participating in shares for rights is 2,000. They would each make elections to pay income tax on the UMV of their shares and would be deemed to have given consideration of 2,000 (and no other consideration) so the amount assessed to income tax would be 200 each (assuming HMRC agree the UMV exceeds AMV by 10%). For those employee shareholders who do not exchange their shares for rights, the reduction in the value of their A ordinary shares is treated as consideration for the issue of the growth shares by section 421D(3) ITEPA 2003. The reduction in value in this case should correspond to the value of the growth shares with the result that Founder 1 pays no income tax on the receipt of his growth shares. Company C qualifies for a corporation tax deduction equal to the value of the growth shares assessed to income tax ignoring the 2,000 of consideration which is treated as paid for the shares so in this example the deduction would be 11,000. If Company C pays corporation tax at 20% the corporation tax savings would be 2,200. The effect of these arrangements is that 99% of exit consideration achieved in excess of the hurdles is paid to the holders of growth shares. The disposal of growth shares will be tax free for participants who acquired them through shares for rights. Is this too good to be true? On the face of the legislation not obviously, however: (a) it is possible to apply a purposive construction to the legislation such that the "free shares" have not be given in consideration for the surrender of employment rights; and (b) the arrangement may fall foul of the general anti-avoidance rule. In practice anyone considering such a structure would need to consider the rules in detail and such planning should be undertaken for commercial purposes. However, we highlight this as a type of structure that could in the right circumstances be applied and which shows how wide the legislation potentially is.
Risk Warning The legislation is new and there are some issues which are unresolved or untested. This paper is based on the legislation and the guidance issued by HMRC at: http://www.hmrc.gov.uk/employeeshareholder/index.htm HMRC may take the view the legislation was not intended to be used as we have suggested so there is a risk either the legislation will be amended (possibly with retrospective effect) or that HMRC will deny tax relief by applying a different interpretation to the rules or by applying the GAAR. Former employees who have sacrificed their rights for shares may want to bring unfair dismissal claims in the future and may be tempted to argue they did not validly sacrifice their rights because (for example) the procedure was not followed correctly or the arrangements meant they gave consideration for the shares or that the shares were not fully paid. Next Steps Shares for rights should not be considered in isolation. It will usually be necessary to structure any arrangements so as to ensure participants qualify (or continue to qualify) for entrepreneurs' relief on shares which are not exempt from capital gains tax. Other tax advantaged plans (such as the enterprise management incentive plan) should be considered too. We have separate fact sheets on entrepreneurs' relief and EMI. Please contact any member of the Employee Incentives and Benefits team if you would like to discuss any issues in this paper. This paper is based on the law of the United Kingdom as at 30 September 2015. About Bird & Bird Bird & Bird is an international commercial law firm with more than 1,100 lawyers in 27 offices worldwide. Bird & Bird's UK employee incentives and benefits team is ranked in the UK editions of Chambers and the Legal 500. The team: "are adept at both transactional and share scheme mandates, particularly those with an international aspect" "were very easy to deal with and very practicable in the sense of relating to non-legal people in an understandable way" Chambers 2015
"is known for its capacity in handling complex international mandates, particularly on behalf of technology sector clients" "contains a number of quality individuals and is doing some impressive international work" "are pragmatic in their advice [and] recognise what we need to do in order to get to a favourable outcome" "are very knowledgeable about the different alternatives open to us and provide us with very appropriate advice" Other Fact Sheets Available: Chambers 2014 Company Share Option Plans Discretionary Share Option Plans Employee Share Markets Enterprise Management Incentive Plans Entrepreneurs' Relief and Growth Shares Long Term Incentive Plans and Deferred Bonus Plans Share Incentive Plans For more information or a free initial meeting please contact: Colin Kendon Partner and Head of UK Employee Incentives & Benefits D: +44 (0)20 7905 6312 T: +44 (0)20 7415 6000 colin.kendon@twobirds.com Dan Sharman Associate D: +44 (0)20 7905 6343 T: +44 (0)20 7415 6000 dan.sharman@twobirds.com Fleur Benns Legal Director D: +44 (0)20 7415 6114 T: +44 (0)20 7415 6000 fleur.benns@twobirds.com
For information on tax issues more generally please contact: Mathew Oliver Partner & Head of UK Tax Group D: +44 (0)20 7905 6258 T: +44 (0)20 7415 6000 mathew.oliver@twobirds.com For information on employment issues more generally please contact: Ian Hunter Partner D: +44 (0)20 7415 6140 T: +44 (0)20 7415 6000 ian.hunter@twobirds.com This document gives general information only as at the date of first publication and is not intended to give a comprehensive analysis. It should not be used as a substitute for legal or other professional advice, which should be obtained in specific circumstances.
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