For businesses that trade through a company, circumstances might arise in which the shareholders consider selling a minority stake in the company to a key employee or group of employees. This could be to ensure that key talent is ‘locked in’ for the long term, as a means of succession if the existing shareholders are looking to wind-down or simply as a means to link effort to reward. The pros and cons of transferring shares to key employees through an Employee Share Scheme (ESS) need to be carefully weighed because the devil is in the detail.
From a tax perspective, shares are typically held on capital account and therefore any gains in value are non-taxable. However, complex rules exist which try and delineate between an arrangement that resembles a generic shareholding interest, versus one that is received in connection with a person’s employment.
If the arrangement is tied to a person’s employment, the ‘share scheme taxing date’ (SSTD), being the date when the value of an employee’s shares are taxed, is deferred until:
- there is no significant risk that the ownership of the shares could change for other than market value,
- the employee is not protected from a fall in value of the shares, and
- there is no material risk that the terms of the shares will change in a way that affects their value.
For example, if the rules of an employee share scheme state that an employee who leaves to work for a competitor must sell their shares for the lesser of cost or market value, this would carry a ‘material risk’ of occurring and therefore will defer the SSTD.
of transferring shares to key employees through an Employee Share Scheme (ESS) need to be carefully weighed because the devil is in the detail.
From a tax perspective, shares are typically held on capital account and therefore any gains in value are non-taxable. However, complex rules exist which try and delineate between an arrangement that resembles a generic shareholding interest, versus one that is received in connection with a person’s employment.
If the arrangement is tied to a person’s employment, the ‘share scheme taxing date’ (SSTD), being the date when the value of an employee’s shares are taxed, is deferred until:
- there is no significant risk that the ownership of the shares could change for other than market value,
- the employee is not protected from a fall in value of the shares, and
- there is no material risk that the terms of the shares will change in a way that affects their value.
For example, if the rules of an employee share scheme state that an employee who leaves to work for a competitor must sell their shares for the lesser of cost or market value, this would carry a ‘material risk’ of occurring and therefore will defer the SSTD. Hence, the full value of the shares could be taxed on disposal, being the time at which this condition ceases to operate. On the other hand, if a bad leaver is defined as someone dismissed for serious misconduct (such as fraud or theft), this condition is less likely to occur (immaterial risk) and should not defer the SSTD. It is not uncommon to find income tax applies to shares within an ESS, when the participants have assumed it does not.
Another aspect that can complicate an ESS is the management of minority shareholder rights. When employees are granted shares, they become minority shareholders and are entitled to certain rights (such as voting rights) within the company. Managing these rights can be complex and cumbersome and can detract from the overall appeal of an ESS for some companies. Additionally, setting up such schemes can be costly and time-consuming.
