UK: Inland Revenue Company Share Option Plans

Last Updated: 20 February 2001
Article by Graeme Nuttall

In Brief

Company Share Option Plans (CSOPs) Are Unaltered By The Pre-Budget Report
What A CSOP Involves
What You Can Do With A CSOP
Are The Approval Conditions A Problem?
Are The Tax Advantages Worthwhile?
The EMI Alternative Gains Popularity
How FFW Can Help
Who Are We?

(CSOPs) Are Unaltered By The Pre-Budget Report

The Inland Revenue approved company share option plan (CSOP) is an established method of providing share options to executives. The CSOP remains unaltered by the pre-budget report of 8 November 2000:

  • The mechanics of how the scheme operates are familiar to many employees.
  • There is no limit to the number of employees who can participate.
  • A CSOP usually fits in with a company's incentive requirements although some compromises may be needed to satisfy Inland Revenue approval conditions.
  • Each participant may only hold options with a value (at grant) of up to £30,000. Therefore, the CSOP may have to operate in conjunction with either or both an enterprise management incentives ("EMI") arrangement and an unapproved share option scheme.
  • Some companies cannot establish CSOPs because of their ownership structure.
  • Companies of all sizes and whatever their business can establish CSOPs.
  • There are significant potential tax advantages for participants.
  • The CSOP solves the employer's National Insurance contributions (NICs) problem.

What A CSOP Involves

In outline, a CSOP works as follows (with reference to typical documentation):

  • A company establishes the scheme (scheme rules) and obtains Inland Revenue approval of it.
  • In the case of an unquoted company, the market value of the scheme shares is agreed with the Inland Revenue before an option is granted.
  • The board selects employees and invites them to participate (letter of invitation).
  • The selected employees agree to participate (application form).
  • The selected employees are granted options to acquire shares in the company within, usually, a ten year option period (option certificate).
  • The option holders either exercise their options in whole or in part and acquire shares or allow the options to lapse (notice of exercise of option).
  • Any shares received belong to the employee absolutely.

What You Can Do With A CSOP

A CSOP provides a participant with an opportunity to acquire shares. It involves a cost to the participants (the exercise price) but an option will not be exercised unless it is "in the money". The scheme can be operated on an all employee basis but is usually used on a selective basis. The scheme could attach certain objective conditions to the exercise of options and can provide for options to be exercised on achieving a target event or according to a vesting schedule. In listed companies, shareholders expect to see one or more performance conditions attached to every option granted to an employee.

The key question is does the incentive the company wants to provide fit within the CSOP framework?

Are The Approval Conditions A Problem?

Framework

The CSOP incentive framework is as follows:

  • Participation is only available to an employee or a full time (25 hours or more a week etc.) Director of the company (or participating companies).
  • The option exercise price must not be manifestly less than the market value at the time of the grant of the option.
  • The market value of shares under option at the time an option is granted must not exceed £30,000 (options granted under other approved company share option schemes and executive share option schemes of the company or its associated companies are taken into account when calculating the £30,000 limit).
  • The option rights must not be transferable (except on death).
  • If an option is exercised three years or more after its grant then the exercise is tax free for the participant.

Scheme Shares

The scheme shares have to meet certain qualifying conditions. They must be:

  • Ordinary shares,
  • In a company which is not controlled by another company (unless, for example, it is a subsidiary of a listed company),
  • Fully paid up, and non-redeemable, and
  • Not subject to any restrictions other than restrictions attaching to all shares of the same class or certain employee pre-emption restrictions.

Other Conditions

There is other approval conditions to meet. If there is more than one class of shares the scheme shares must satisfy additional conditions. If the company is a close company (as defined for tax purposes) then a 10% or more shareholders (including options) cannot participate.

There can be difficulties achieving what a private company wants in respect of early exercise provisions (i.e. What happens if an employee's employment ceases early through injury, disability or in other circumstances).

If the CSOP framework looks right, a company must then decide whether or not the tax advantages make a CSOP worthwhile.

Are The Tax Advantages Worthwhile?

The CSOP provides a method of avoiding an income tax charge at up to 40% on a participant on the exercise of an option.

A tax-free exercise can only take place on or after the third anniversary and no later than the tenth anniversary of the date of grant. The tax relief is not available when an option is exercised within three years from the date on which the employee last exercised such an option free of tax.

So, in a ten year period, an individual could acquire tax free shares with a total initial market value of £90,000 (i.e. £30,000 x 3 = £90,000). This assumes that sufficient shares are made available under the scheme to enable this to happen. It also assumes that each option is exercised on its third anniversary and replacement options over the maximum value of shares are granted immediately. In the tenth year, the individual could on this basis have a further £30,000 of shares under option. Therefore, in the ten year period, the total value of shares acquired and under option could be £120,000. The total amount the employee would have to pay on exercising these options would likewise be £120,000. The benefit of exercising the option would, of course, depend on how much the share price has increased.

A participant who acquires shares tax-free may have a capital gains tax (CGT) liability but this would only arise when the shares are sold.

Consideration given for the grant of the option (if any) and for the acquisition of the shares is taken into account in computing any capital gain or loss arising on a subsequent disposal of the shares.

The first £7,200 (2000/2001) of all chargeable gains in a tax year are exempt from CGT. Taper relief may apply to reduce the effective tax rate depending on the shareholder's circumstances and how many complete years the shares are held.

No employees' NICs are currently payable on either the grant or exercise of CSOP options.

As well as tax advantages to participants, there is a very important tax advantage for employers. In the case of an unapproved option, the employing company will usually face an employer's NICs charge when an option is exercised. This charge is currently 12.2% (without limit) of the difference between the exercise price and the market value of the shares acquired at the time of exercise. This liability is unquantifiable and is a major concern for many companies. In contrast, under a CSOP there is an exemption from NICs whenever the CSOP option is exercised.

As a consequence of the tax breaks for CSOP options there is also reduced pay as you earn administrative requirements with a CSOP.

The EMI Alternative Gains Popularity

The CSOP has a rival.

The new enterprise management incentives (EMI) arrangement promises more, for fewer, if a company has gross assets not exceeding £15 million and carries on a qualifying trade. Introduced in the Finance Act 2000, EMI options are gaining in popularity. Key differences between EMI and the CSOP are:

  • Up to 15 employees only can participate (although this limit is very likely to be removed by the Finance Act 2001).
  • Each employee can hold options worth up to £100,000 at the time of grant.
  • When shares are sold CGT taper relief will normally start from the date options are granted.
  • EMI can be introduced quicker than a CSOP.

There are, however, extra complications involved in achieving and maintaining the tax advantages available under EMI that do not arise with a CSOP. This factor, in particular, must be considered carefully when assessing the EMI alternative. A separate briefing paper is also available from FFW, which provides more information on EMI options.

How FFW Can Help

We can advise whether or not a CSOP is possible for your company. We can help you decide whether or not it is worthwhile establishing a CSOP or whether another form of equity incentive is better suited. We can prepare all the scheme documentation and deal with the approvals procedure. We can assist with other aspects of establishing the scheme and granting options under it.

Who Are We?

FFW's employee benefits and share schemes team has substantial experience in all aspects of employee benefits, including equity incentives. Graeme Nuttall, head of the team, is a member of the HM treasury advisory group, which helps the Inland Revenue introduce new share schemes including EMI. Through membership of the Global reward plan group we implement international share schemes.

This document is intended as a general guide on complex subjects. It is not intended as a comprehensive review. It should not be relied upon as a substitute for advice in a particular circumstance.

© Copyright Field Fisher Waterhouse 2001.

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