EMPLOYEE SHAREHOLDER STATUS - PLANET STUPID?

The new employee shareholder regime, by which employees can trade off the surrender of employment protections against the chance to get an equity stake in their employer on a tax efficient basis, was recently denounced by one writer in Taxation magazine as "a stupid idea from Planet Stupid". However, it is now on the statute books and arousing a great deal of interest.

NEW REGIME

Most of the complexity of the new regime relates to company law issues or to procedural requirements of the new legislation.

MAIN FEATURES

1. The minimum initial value of the shares acquired by an employee shareholder is £2,000, but the employee must not hold more than 25% of the share capital of the company. The company must therefore have an initial value of more than £8,000 (given that the employee shareholding will be valued at a discount because it is a minority) in order for the scheme to apply. This will knock out a lot of start-ups or highly leveraged companies, and
2. There is the problem of determining if the shares will be fully paid up as required by the legislation if the employee can give no consideration other than agreeing to give up employment rights. The guidance assumes that the shares will be paid up out of reserves. This again means that start-ups will have a challenge to meet requirements.

TAX RISKS AND BREAKS

There remain tax risks for the employee (and in some circumstances, the company) arising out of employee shareholder status, and these have tended to be forgotten in the excitement about what, are on the face of them, very generous tax breaks.

The headline tax breaks are that shares can be acquired – in certain circumstances – free of any upfront income tax charge, and that the shares, with an initial value of between £2,000 and £50,000, can be disposed of at the end of the day free of Capital Gains Tax. It is the CGT exemption in particular that is going to attract interest.


SO WHAT ARE THE TAX RISKS?

1. The obvious one is that if the financial limits in the tax legislation are not respected it is possible to have an employee shareholder who has given up their employment protections but does not get the tax relief for which they hope.
2. A greater risk comes with the risk of an upfront Income Tax charge on acquisition. Employee shareholder shares are not tax-exempt - there is a deemed purchase price of £2,000 that is credited against the market value of the shares acquired. If you get more than £2,000 worth of shares - looking at their restricted value, i.e. the actual value taking account of any restrictions to which the shares are subject - you still get a tax charge at the outset to the extent that market value exceeds £2,000.
3. Most private company shares are restricted securities for tax purposes. The values for the purposes of employee shareholder rules are the restricted values of the shares - taking account of their actual restrictions - but most employers will insist on a section 431 election under which the shares will be valued for tax purposes at their unrestricted value. If no such election is made, then a proportion of any eventual gain will be charged to Income Tax, which may also give the employer a National Insurance Contributions exposure. Making the election, however, creates the risk of an Income Tax charge on acquisition for the employee. Given that these shares must have real value - remember their restricted value must be at least £2,000 - an election to pay tax according to unrestricted value could well create a tax charge on acquisition. This is going to have to come out of the employee’s own pocket in most cases.
4. The CGT exemption, by contrast, should apply in most cases. One gap in the legislation, however, is that the rules specifically do not allow for rollover into replacement securities. If the company is sold on a share for share exchange, the employee (unlike most shareholders) will have a disposal of their shares for tax purposes. Any gain should be free of tax, but the replacement shares will not be within the employee shareholder regime. Any gain on a future disposal of the replacement shares will be subject to tax to the extent that the proceeds exceed the market value of the shares when they were acquired on the share for share exchange, and the clock for Entrepreneurs’ Relief purposes will have restarted at the time of that exchange - a share for share exchange followed within 12 months by a sale of the replacement shares will not be eligible for Entrepreneurs’ Relief even if the employee would otherwise be eligible for that relief until he has held the shares for a further 12 months. This would apply even if they would have got Entrepreneurs’ Relief on the disposal of shares acquired on a share for share exchange for normal shares outside the employee shareholder regime because the holding period for the shares would be deemed to include the time for which the original shares had been held.

CONCLUSION

In practice, employee shareholder status will be attractive to the kind of employee for whom the eventual tax break is more attractive than the value of his employment rights, and most of the work involved in setting up an employee shareholder arrangement will be concerned with the required procedural steps, with share values, and with company law issues, rather than tax.

That said, real health warnings need to be given in relation to the anticipated tax treatment, and in particular, employees are going to have to be able to deal with an initial Income Tax charge in a significant number of cases.

This article contains general advice and comments only and therefore specific legal advice should be taken before reliance is placed upon it in any particular circumstances.