The following article is produced in partnership with one of the UK’s leading share plans lawyer and tax barrister, David Pett of Temple Tax Chambers.
An employee share option is the right, granted by an employer, or associated person, to acquire a given number of shares in the employer company (or its ultimate holding company). Such an option is normally exerciseable at some time in the future and is typically conditional upon continued employment and possibly also upon the attainment of individual or corporate performance conditions. An employee does not own the option shares unless and until he or she acquires them by exercising the option.
Typically, the price payable to acquire the shares (the exercise price) is set at the market value of the option shares at the time of grant.
Some types of employee share option, which satisfy prescriptive requirements (such as an Enterprise Management Incentive (EMI) option, an option granted under a Company Share Option Plan (“CSOP”) or an ‘all-employee’ Save As You Earn (“SAYE”) share option plan) may qualify for favourable UK tax treatment. An employee share option which does not qualify for such favourable UK tax treatment is commonly referred to as an “unapproved” share option.
A Joint Share Ownership (or JSOP) award is an alternative to an ‘unapproved’ employee share option. It takes the form of an agreement (a “Joint Share Ownership agreement or “JOA”) between the employee and a ‘co-owner’ (typically an employee benefit trust (“EBT”), but possibly also another existing shareholder) under which the employee acquires a beneficial interest as joint owner of a given number of shares. What follows assumes that the co-owner is an EBT trustee. The shares are, from the outset, beneficially jointly owned (on unequal terms), by the trustee and the employee, subject to the terms of the JOA.
The jointly-owned shares may be registered in the names of the joint holders, or registered in the name of a nominee. In some cases, the shares may remain registered in the name of the trustee who holds them as bare trustee for the joint beneficial owners.
Under the JOA, when the shares are, in due course, sold (possibly at a time, or within a period, specified in the JOA) the proceeds are divided between the employee and the trustee such that the employee receives the growth in value accruing since the time of grant (less, typically, a small rate of simple interest accruing over a fixed 3-year period – the “carrying cost”), and the trustee receives the balance (i.e. the value at the time of grant plus the carrying cost).
In purely economic terms, if it is assumed that shares acquired by the exercise of a share option would be sold immediately after they are acquired upon exercise of the option, the alternative of using a JSOP award delivers broadly similar economic value (i.e. growth in market value accruing from the time of grant to the time of sale), but in a manner which is taxed instead as capital gain.
No tax is charged on the employee when an employee share option is granted but, when it is exercised, income tax is charged on the full amount of the gain on exercise (i.e. the difference between the price paid to acquire the shares and their market value at the time of acquisition) at the employee’s highest marginal rate. Tax is charged whether or not the shares are then sold, or indeed whether or not they are then capable of being sold.
If the shares acquired are “readily convertible assets (“RCAs”), the tax must be accounted for by the employer under Pay As You Earn (“PAYE”) and both employers’ (13.8%) and employee’s (2%) NICs are payable on the amount of the taxable gain. The option agreement will normally reserve to the grantor of the option the right to sell sufficient of the option shares to enable the employer to recover from the employee the income tax and employee’s NICs for which the employer has to account under PAYE. If the employee fails to “make good” to the employer, before 90 days after the end of the tax year in which the option is exercised, the full amount of income due, a further penal charge to income tax and NICs will then arise on the benefit of the employer having, in effect, paid the employee’s tax.
The employer may require the employee to bear the cost of the employers’ NICs charged and, if so, this will increase the rate of tax and NICs charged on the employee and reduce his or her net gain.
Subject to statutory requirements, the employer company may be entitled to relief from corporation tax for the amount of the option gain.
Unlike an unapproved share option, the ‘tax point’ of a JSOP award is at the time of acquisition by the employee of his interest in the jointly-owned shares i.e. at the time of award. The taxable value of that interest is typically relatively small as it reflects the fact that the employee will only benefit if, and to the extent, that there is future growth in value of the shares. If the appropriate tax election is made, any gain accruing to the employee when the jointly-owned shares are sold, or the employee sells his or her interest in the shares, will be charged to capital gains tax, with no NICs.
By contrast with an employee share option, there is no relief from corporation tax for the employer in respect of the gain accruing to the employee.
Nevertheless, the disparity in rates of income tax/NICs and capital gains tax (“CGT”) mean that, all other things being equal, the overall tax payable by the employee and employer is likely to be significantly less (and therefore the employee’s net gain will be significantly greater) by using a JSOP award rather than an ‘unapproved’ share option (although there will be no employer’s relief from corporation tax for the gain realised by the employee).
Unlike an employee share option, the initial value is derived from splitting the market value of the jointly-owned shares between the employee and the trustee. To the extent that ‘hope value’ is ascribed to the employee’s interest, this must correspondingly reduce the value of the interest of the trustee. This means that there is a limit to the extent to which value can be so ascribed to the employee’s interest, and this is an important factor in restricting the initial taxable value to a (typically) commercially acceptable ‘up-front’ cost.
In the case of a JSOP award, the employee acquires from the outset a taxable interest in shares entitling him or her to benefit from future growth in value of the shares in a manner which falls to be taxed as capital gain.
If granted a share option, the employee has, from the outset, no interest in the shares (only a contractual right to acquire them in future) and will suffer a charge to income tax, and possibly also NICs, on the full amount of that gain at the time the option is exercised.
Typically, a share option must be exercised within a given period (typically, 3-10 years), whereas a vested interest under a JSOP award can, if the JOA so provides, remain in place on an open-ended basis allowing the employee to defer triggering any tax on growth in value until he or she chooses to call upon the trustee to join in selling the jointly-owned shares.
A JSOP award triggers a (relatively) small upfront charge to income tax (and, if the shares are RCAs, NICs), the exact amount of which may not be settled for some time (as HMRC will not now agree the taxable value of the interest at the outset). In some cases in which the tax is due under PAYE, the employer pays a grossed-up cash bonus to cover the amount of estimated tax for which the employer must account (and which must be made good by the employee) when the JSOP award is made. In any event, if a penal tax charge is to be avoided, any amount of tax due under PAYE must be recovered from the employee before the end of 90 days following the end of the tax year in which the JSOP award is made.
The employee is required to report the grant of a JSOP award on his or her self-assessment tax return for the tax year in which the award is made (and also any chargeable gain on disposal of the interest in the jointly-owned shares). To this end the employer must inform the employee of the estimated initial taxable value of the employee’s interest acquired under the JOA so that the employee can report that amount on his or her return.
In the case of a share option, the employee’s obligation is to report in the self-assessment return the taxable gain on exercise of the option.
The employer is obliged to report the grant of both a share option and a JSOP award, as well as the exercise of an option or disposal of an interest under a JOA, on the annual electronic year-end return of reportable matters relating to employment-related securities.
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For over 20 years, David Pett, a specialist tax barrister practising at Temple Tax Chambers in London, has been ranked as a ‘leading expert’ (or equivalent) in the Chambers and Legal 500 directories of law firms and was, in 2016, referred to as “the god-father” in the field of employee share plan.
David is best known for devising and advising upon all forms of employee share plans including ‘growth share’ plans; ‘joint share ownership plans’; tax-advantaged CSOP, EMI share option, SAYE-share option and Share Incentive Plans, as well as ‘partly-paid’ share plans, arrangements for internationally-mobile employees, and all other forms of management and employee financial participation. He has extensive experience of both direct and indirect taxes and of the related company, securities and trust laws.
Fiduchi is a provider of trust and company services, and therefore its experts are well placed to help clients implement JSOPs. We liaise closely with other advisers such as David to ensure that all relevant legal, tax, accounting and valuation aspects are seamlessly covered in designing and implementing employee share plans.