The Chancellor did not have much scope in this year's Budget for giving away substantial new tax reliefs on employee share schemes but he has announced a raft of tidying up changes which are expected to give a modest £5m tax relief in total each year.

Whilst some of the changes are pure anti-avoidance there are a number of interesting changes which will have a significant impact on the design and operation of schemes over the years to come.

All changes take effect immediately unless otherwise stated.

Reversal of Mansworth v Jelley

Mansworth v Jelley, which was decided in December 2002, is reversed where unapproved options (and EMI options) are exercised on or after 10 April 2003. This will alleviate the unfairness to UK resident trusts which, on satisfying unapproved share options, have been liable to pay capital gains tax calculated on the basis of the market value of the shares delivered rather than the exercise price paid by employees. On the other hand, unapproved (and EMI) option holders will no longer be able to take advantage of the artificially enhanced base cost in computing the gains on a subsequent disposal of the shares so as to reduce the amount of chargeable gains. Nevertheless, the exercise of unapproved options before 10 April 2003 may still result in corrective returns and a reduction of tax.

Approved Share Option Schemes

The rationale for some of the features of approved share options has disappeared over the years, particularly the three year rule excluding income tax relief where an option is exercised within three years of a previous tax exempt exercise. The Chancellor now proposes changes which will bring approved share options in line with the design of other all-employee approved schemes and will also make changes which prevent NIC abuse in the use of approved share option schemes. The restructuring of approved share options is as follows:

  • in the initial three years after grant, good leavers (ie, those who leave on account of injury, disability, redundancy or retirement) will in future be entitled to income tax and NICs relief on option gains (and will thus be brought into line with the position of good leavers under SAYE schemes and SIPs). Exercise in all other circumstances in the initial three years after grant - apparently including exercise on a takeover or scheme of arrangement - will in future be subject to PAYE and NICs. At present, income tax through self-assessment arises but this will in future be limited to private company shares where there is no market for the shares
  • from three years after grant, approved options may in future be exercised income tax and NICs free in whole or in part on as many occasions as the option holder may wish (regardless of whether a tax-exempt option has been exercised in the past three years)

There will also be new rules which will allow bridging finance arrangements to be included as part of an approved share option scheme without the difficulties which arise at present.

The tax changes on approved share option schemes will require changes to employee guides and tax notes with immediate effect. In addition, notices of exercise will in future need amendments to ensure that PAYE and NICs can be deducted where necessary.

Partnership shares under SIPs

In future, participants in a partnership share offer will be able to make a single annual purchase of shares. At present, there is a monthly limit of £125 a month (or 10% of salary, if less) and this has to date prevented companies using annual bonuses for the purchase of shares. For some companies, scrapping the obligation to offer partnership shares each month may considerably simplify the operation of partnership share offers and reduce costs.

There will also be greater flexibility from employers to exclude overtime payments and other variable pay in calculating the statutory 10% of salary limit in the operation of partnership share offers.

The above proposals may require amendments to the rules of SIPs operated by clients but as these proposals reflect changes to the legislation it should generally be possible to make the amendments without shareholder approval. These changes will take effect from Royal Assent to the Finance Act 2003.

SIPs generally

There have been problems where employees in a Group have been transferred to another Group company that also operates a SIP, since the rules have previously prevented an individual participating in more than one SIP in any tax year. The legislation will now be changed so that there will be greater flexibility where such internal reorganisation takes place.

Again, changes will be needed to scheme rules but this should not generally require shareholder approval. ThIs change will take effect from Royal Assent to the Finance Act 2003.

Dividend Shares under SIPs

The holding period for dividend shares (accumulated dividends) under SIPs will, in future, correspond to the holding period for the free, matching or partnership shares in respect of which the dividend shares arise. The Revenue consider this change will facilitate administration and reduce costs.

This change will take effect from Royal Assent to the Finance Act 2003.

SAYE Scheme

On a takeover or scheme of arrangement, there have in the past been problems where employees have been transferred to "associated companies". Such employees will now be able to exercise on leaving employment with an associated company in the same way as if he or she had left employment with the original employer.

This change will take effect from Royal Assent to the Finance Act 2003.

Approved Schemes generally

The Chancellor proposes a number of simplifications of the procedures for Revenue approval of approved share schemes:

  • It will no longer be necessary to obtain formal approval of any new scheme which is implemented in exactly the same form in which preliminary approval has been given by the Inland Revenue. Provided there are no changes to the scheme after preliminary approval has been given, the scheme will be approved by the Inland Revenue with effect from the date on which it is established by the company. This will facilitate the immediate grant of options following the establishment of a new scheme and also reduce the costs to companies.
  • Only amendments to key features of any existing scheme will require Inland Revenue approval in future, bringing the CSOP and SAYE legislation into line with that of the SIP. This will also reduce the costs to companies. "Key features" will not include purely administrative features. Changes will be needed to scheme rules but this should not generally require shareholder approval. These changes will take effect from Royal Assent to the Finance Act 2003.

The "material interest" rule will also be brought into alignment in all approved schemes. Under the material interest rule, employees cannot participate in a scheme if, together with their associates, they hold more than a certain percentage of the share capital of the company. This is thought likely to be brought into line in approved share option schemes at the 25% threshold applying to SAYE schemes and SIPs, but the percentage will be confirmed in the Finance Bill.

Unapproved Employee Share Schemes

Where PAYE and NICs apply in respect of an unapproved employee share scheme, the employer is liable to deduct the PAYE and any employee NICs through payroll. If there are insufficient earnings to make a deduction, or if the employee fails to authorise a deduction and make good the PAYE within 30 days following the exercise of the option or receipt of shares, the employee is treated as receiving a benefit equal to the amount of the unrecovered PAYE and NICs. Employees will in future have 90 days to refund PAYE to their employer without incurring a benefit in kind.

At present, there is a limit on the amount of employee NICs that may be recovered each month from an employee. That limit is being abolished and employers will, in future, be able to recover all employee NICs on share-based earnings at one time. In addition, recovery may be made over an extended period into the following tax year. This is intended to assist employers in view of the 1% NIC increase operative from 6th April 2003.

To improve reporting procedures in respect of unapproved employee share schemes, not only the employer but also any issuing company and any UK "host" company in respect of employees of foreign corporations will in future be obliged to provide information on unapproved employee share scheme gains.

Anti-Avoidance Provisions

The Revenue will have new powers to calculate share-based gains by making adjustments of artificial transactions which have reduced the amount of gains or otherwise involved a manipulation of share-related benefits. This change will take effect from 16 April 2003 (for tax) and an appointed day after Royal Assent to the Finance Act 2003 (for NICs).

In addition, gains acquired by employees where any value accrues as a result of the lifting of restrictions, or where shares are convertible into other more valuable shares, will in future be subject to tax based on the amount of the gains accruing as a result of the transaction rather than the total gains over the period of ownership.

This change will take effect on an appointed day following Royal Assent to the Finance Act 2003.

Other proposals to be included in the Finance Bill

There are other proposals to be included in the Finance Bill which have previously been announced and which will have an impact on the design of share schemes:

  1. restrictions on the deductibility of payments into employee share trusts (see our briefing on Corporation Tax Relief for the Cost of Employee Share Schemes).
  2. the new statutory corporation tax deduction (see our briefing on Corporation Tax Relief for the Cost of Employee Share Schemes).
  3. Treasury Shares - which we believe will lead to a diminution in the usefulness of employee share trusts (see our briefing on Treasury Shares).

Article by Colin Chamberlain

© Herbert Smith 2003

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

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