Budget 2003: Changes To Employee Share Schemes And The Capital Gains Tax Treatment Of Share Option Gains

The 2003 budget introduces a range of measures affecting employee share schemes. Some of these changes require immediate consideration and action by employers operating such schemes, and these are summarised below.

These schemes include Company Share Option Plans (CSOPs), under which up to £30,000 worth of tax favoured share options can be granted to employees on a selective basis, and savings related share option schemes (SAYE schemes), under which options must be made available to the majority of employees. The most important changes are as follows.

• CSOP options exercised profitably within three years of grant incur an income tax charge. From 10 April 2003, it must be accounted for by the employer under PAYE (not employee's self assessment), and national insurance contributions (NICs) will also be levied. No tax will, however, be charged on the early exercise of options by "good leavers" (i.e. those made redundant or who leave for health reasons or retire). Existing CSOP rules do not include mechanisms for employers to recover PAYE and NIC. Because of the changes described above, such mechanisms are now needed. All CSOP rules should be updated to include mechanisms for recovery of employees' tax as quickly as possible.

• A more welcome change is that the amendment of CSOP and SAYE scheme rules will become easier. At present, all changes need prior Inland Revenue approval, but in future (after the Finance Bill becomes law, expected in mid July 2003) only changes to "key features" will need such approval. CSOP and SAYE scheme rules should be updated to ensure the changes only to "key features" need prior Inland Revenue approval. Further less urgent updating can then be done more easily.

Currently, employers do not enjoy guaranteed corporation tax deductions for the cost of providing new or market purchased shares to employees (unless they award shares under a Share Incentive Plan). For accounting periods beginning after 31 December 2002, a statutory corporation tax deduction will be available, but only when the employee is subject to UK income tax on the share award (or would be except for the fact that the shares were obtained under an Inland Revenue approved share option scheme or an Enterprise Management Incentive Plan or the employee is not resident in the UK).

Many employers have made extensive use of employee benefit trusts (EBTs) to provide tax efficient remuneration. Some of the tax benefits of using EBTs will be restricted by changes brought in by the budget. Corporation tax relief for contributions to EBTs on or after 27 November 2002 will only be available if and when a cash payment or a transfer of assets is made out of the trust and is either subject to income tax and NIC (or it would be if the employee concerned worked in the UK, or it is made in connection with termination of employment). This will not apply, however, to company contributions to pension plans (whether occupational or personal) or accident benefit schemes or the new corporation tax deductions for providing share related benefits (see above).

These Inland Revenue approved plans allow employees to purchase "partnership" shares with deductions from gross salary, receive awards of "matching" shares on making such purchases and/or receive awards of "free" shares unconnected to any partnership share purchases. The key changes to SIPs from the date the Finance Bill 2003 becomes law will be as follows.

• At present, employees can only make the maximum annual purchase of partnership shares by paying twelve monthly deductions from salary. In future, employees will be able to choose to purchase partnership shares up to their annual limit at any time during the year.

• Employees will be able to participate in two SIPs run by connected companies in the same year (but not simultaneously), enabling continuity in SIP participation where an employee moves between companies within a group.

• Employers will be able to decide whether all or part of an employee's salary will be used when calculating the maximum amount an employee can spend on partnership shares. This approach is far simpler than the current requirement to use the total salary, which creates difficulties due to monthly variations in, for example, overtime payments and bonuses.

As a result of these changes, some amendments to SIP rules will be required when the Finance Bill becomes law.

The Inland Revenue lost this case in the Court of Appeal in December 2002. The effect was to increase the capital gains tax (CGT) deductions available against gains made on the sale of certain shares (i.e. those acquired by the exercise of unapproved share options and/or approved options where income tax was charged on exercise) by enhancing the CGT base cost of such shares. This means that in addition to the price paid for the option and the amount charged to income tax on exercise, the market value of the shares at exercise is also deductible. This could obviously be very favourable for the taxpayer. Where options were satisfied with shares provided by a UK based trust, however, the trust (funded by the employer) could suffer because the deemed disposal value for the trust is the enhanced CGT base cost.

The budget has reversed this judgment, so for shares acquired through options exercised on or after 10 April 2003, CGT will be calculated as before (i.e. ignoring the market value enhancement on exercise described above).

CGT already charged on share option gains for years affected by this case can only be amended if the tax return is still open to amendment, i.e. for tax year 2001/2002 until 31 January 2004, for tax year 2002/2003 until 31 January 2005, or for earlier years, only if the tax return is under enquiry by the tax inspector. However, in certain cases, the effect of the judgment will be to change a capital gain to a capital loss or to increase a capital loss, and in those cases, it might be possible for the loss to be either set against the capital gain on the share option, and secure a repayment of CGT, or be carried forward and set against capital gains in later years, even if the CGT charge for the tax year is not open to amendment.

If your company uses a UK based trust to provide shares to satisfy share options, the effects of Mansworth v Jelley, and its reversal, will require consideration. Any employees who may be affected by this case ought also to consult their own tax advisers.

This commentary is a publication of Jones Day Gouldens. The contents are intended for general informational purposes only and are to raise your awareness of certain issues (as at July 2003) under the laws of England and Wales. This commentary is not comprehensive or a substitute for proper advice, which should always be taken for particular queries. It may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and receipt of it does not constitute, a solicitor-client relationship.

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