UK: Corporation Tax Relief for the Cost of Employee Share Schemes

For many years, companies have relied on a mixture of case law and complicated tax-planning arrangements to obtain corporation tax relief for the cost of operating their employee share schemes.

Important legislative changes concerning the availability of corporation tax relief in connection with the operation of employee share schemes have now been unveiled and are already in operation. There are three separate changes as follows:

1. relief for the provision of shares to employees ("the new statutory corporation tax deduction");
2. restrictions on the relief for payments to employee benefit trusts; and
3. relief for the early funding of share incentive plan ("SIP") trusts under the Employee Share Schemes Act 2002.

Taken together, the changes operate to give automatic tax relief at the point shares are provided to employees (vesting or exercise) but restrict corporation tax relief where companies acquire the shares in advance through trusts (except SIP trusts in limited circumstances). A particular advantage of the new statutory corporation tax deduction is that it removes the need in most circumstances for complex and expensive arrangements using employee benefit trusts in order to obtain a corporation tax deduction for the cost of providing shares for employee share schemes. Relief for QUESTs will also be scrapped.

The availability of a statutory corporation tax deduction is based on completely separate principles to those of the proposed new accounting charges for employee share schemes (see our December 2002 employee incentives briefing "Accounting for share based payments – the effect on employee share schemes). The proposed P&L accounts charge will be calculated based on the "fair value" of awards at the date of grant whereas the corporation tax charge will now only be available at the date the shares are provided to employees (vesting or exercise). The prospect also arises of a corporation tax deduction which may in many cases exceed the charge to the P&L account.

Automatic corporation tax relief will be available to a company on the date that shares are provided to employees (vesting of an award or exercise of an option). The legislation is designed to match the corporation tax relief for the company with the taxation of the employee.

In order to qualify for this relief shares must be fully paid up, not redeemable and either in a listed company, a subsidiary of a listed company or a company not under the control of another company.

The deduction is equal to the difference between the market value of the shares when they are acquired and any amount paid by the employee to acquire them. Broadly speaking, this is the amount taxable on the employee and therefore matches the deduction for the company with the taxation of the employee.

The relief is due for the accounting period of the employing company in which the employee acquires the shares (and is taxed on that acquisition) and is available for shares acquired by employees in accounting periods beginning on or after 1 January 2003.

The significance of the new statutory corporation tax deduction (which will apply to all types of approved and unapproved share scheme) is that:

• companies will no longer need to operate complex arrangements (usually known as "tax-symmetry" or "opportunity cost" arrangements) using employee benefit trusts to obtain a corporation tax deduction equal to the "opportunity cost" of issuing shares under employee share schemes (i.e. the difference between the market value of shares on the date of acquisition by employees and the price paid for them). Employee benefit trusts will, however, continue to have other useful roles in employee incentive arrangements, e.g. to act as an internal market for unquoted companies, to acquire shares in the market in order to avoid problems for listed companies caused by ABI dilution limits etc.;
• employee benefit trusts that acquire shares through the market for share schemes are likely to be operated more tightly without building up significant surplus asset value. We envisage trusts will be funded only by loans until the point shares are actually provided to employees when the corporation tax relief is available – the loans can then be written off or repaid (out of contributions);
• there will be a timing mismatch between (i) the proposed new accounting charge for the fair value of awards (which under FRED 31 will be spread over the years from the date of grant/award to the date of exercise/vesting) and (ii) the tax deduction (which will only be given at the date of exercise/vesting);
• the financial impact of the proposed new accounting charges may be more acceptable to companies because of the availability of the statutory corporation tax deduction;
• cash cancellation payments on takeovers may become less common as acquirers will wish the target company to obtain the more certain statutory corporation tax relief available (rather than rely on case law principles for a cash payment).

Statutory corporation tax relief for payments into a QUEST has been available for a number of years. The majority of companies that have taken advantage of QUEST corporation tax relief have made payments into the QUEST to acquire shares for their SAYE schemes and claimed the corporation tax deduction by making contributions equal to the accrued gains on the shares at the time of exercise (although some companies also pre-funded their QUESTs to obtain early corporation tax relief).

QUEST corporation tax relief will no longer be available for new contributions made to a QUEST in accounting periods beginning on or after 1 January 2003. For those companies in an accounting period that began in 2002, QUEST corporation tax relief will still be available until the end of the accounting period which began in 2002.

All other rules in the QUEST legislation remain unchanged, so existing QUESTs can continue to hold and distribute shares in the same way as they could before the changes. Other than meeting existing obligations, and any further grants where there are sufficient shares held within the QUEST to satisfy such grants, there will, however, be little use for QUESTs for most companies that currently operate such arrangements and any use of a QUEST may involve stamp duty.

If a company continues to operate a QUEST to satisfy SAYE options, it will obtain tax relief under the new statutory corporation tax deduction at the point the shares are provided (i.e. exercise) in place of the QUEST tax relief at the point of contribution to the QUEST.

Rules were introduced into section 69 Finance Act 1989, when the Share Incentive Plan (SIP) was announced, that allow shares held by the QUEST to be transferred to a SIP trust without triggering a claw back of corporation tax relief already claimed. These rules have been extended so that they apply to shares or funds held at 26 November 2002. This will help companies that wish to wind-up their QUESTs to move the shares into a SIP trust without losing relief previously claimed (although companies will need to consider the capital gains tax position on the transfer).

Previously, a corporation tax deduction was available to a company at the date that it made a contribution to an employee benefit trust based on the amount of that contribution.

Under the new legislation, this will no longer be the case. Where benefits are provided out of the employee benefit trust in the form of shares to employees (including on the exercise of options) then tax relief will only be available under the statutory corporation tax deduction outlined above. In other words, there is no relief for any contribution to an employee benefit trust to provide the shares.

Where the employee benefit trust pays out cash or other benefits the deduction for any contribution into the employee benefit trust is simply delayed until the accounting period in which the cash or assets are transferred to employees and those employees are, generally, charged to income tax and NICs, or when the assets are used to meet a qualifying expense. With non-share benefits the amount of relief is restricted to the cost of providing the benefit (i.e. the contribution) or, if less, the market value of the benefit when it is received by the employee.

The legislation has been introduced in response to a number of specific tax-planning arrangements (principally involving the payment to employees of dividends on shares in special purpose companies in lieu of cash bonuses or the provision of loans).

Newly enacted legislation contained in the Employee Share Scheme Act 2002, and effective from 6 April 2003, allows companies early corporation tax relief for money paid to SIP trusts that is used to buy blocks of their own shares for transfer to employees within ten years.

The corporation tax deduction is dependent on the company’s payment being used by the SIP trustees to purchase not less than 10% of the total ordinary share capital of the company in the year immediately following the initial purchase of shares made with this money. Shares already awarded to employees under a SIP, as long as they continue to be subject to the SIP, count towards calculation of the 10% holding of the SIP trust.

The full amount of the corporation tax deduction will be withdrawn if at least 30% of the shares acquired with the payment have not been distributed to employees within five years, or if all the shares acquired with the payment are not distributed within ten years. Where the deduction is withdrawn and the relevant shares are subsequently transferred to employees the company can claim a deduction for the period of account in which all the shares are finally transferred.

© Herbert Smith 2003

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