There are few better ways of incentivising staff in the long term than allowing them to participate in their company's share capital on affordable terms. Tax advantaged share option schemes, such as the Enterprise Management Incentive (EMI) scheme, were introduced to minimise the tax costs of employee equity participation, but may not always be available (e.g. because the company is under the control of an investment fund).
In our previous article "Employee Share Schemes: 5 Effective Ways to Incentivise Employees" we summarised five common tax advantaged and non-tax advantaged share schemes. In this article we look at two popular methods of helping UK taxpaying employees to fund a market-value equity subscription – providing a loan, or issuing nil/partly paid shares – and the tax traps to avoid when doing so.
1. Why not just discount the share price instead?
When considering why employees might need assistance to fund their share subscription, it is helpful to remind ourselves why issuing shares "on the cheap" is problematic.
Unsurprisingly, the principal answer is tax: any amount of the market value of the shares that an employee is not required to pay under any circumstances, so that the amount is effectively 'gifted', will be liable to income tax and National Insurance Contributions at each employee's applicable rate. Conversely, any difference between the amount paid up-front for the shares and their market value is not taxable as earnings at the time of issue so long as the employee remains liable to pay that amount to the company in the future. See, however, the notional loan charge below.
Unfortunately, any tax is due at the end of the tax year in which the shares are issued, whether or not those shares have been sold/yielded any dividends by that time. In other words, if the subscription price is too low, employees will have to pay hard cash to fund taxes on shares that may not pay out for some time. This is known as a 'dry' tax charge. When issuing at a discount, directors will also need to be mindful of their fiduciary duties – i.e. can the directors be satisfied that issuing shares for free/at a discount to market value is in the company's and the shareholders' best interests?
The nominal value may be obvious (stated in the company's articles of association), but how does a company determine the market value of its shares? An external valuer could be engaged, but many companies are put off by the cost and complexity of this process. More commonly, the company's directors will prepare what they (based on historic financial performance and future projections) consider to be a justifiable valuation of the business, and by deduction the company's shares, on the date of the proposed share issue. If the company has recently undertaken a round of equity financing, the previous round price will often be the starting point if not the valuation used. Given that staff will often represent a small minority of the equity share capital, it can be argued that some level of discount should be applied, but the conservative approach is to use the full market value to set the share price.
2. Loans and deemed loans: what tax is payable, and when?
Where employees are granted a loan to fund their equity investment (i.e., the employee buys the shares at market value with the loan), the tax payable depends on the amount of interest accruing on that loan. If the interest rate is equal to or above HMRC's official rate (currently 2.5%), no tax will be payable on the loan. Note however that charging interest on the loan could mean the company is unable to rely on certain exemptions from the UK Consumer Credit Act (a complex topic in itself, and not covered in this article).
A more common scenario is for the loan to be interest-free, in which case HMRC will tax the employee for the 'benefit' of not having to pay the HMRC official rate of interest. The same effectively applies where shares are issued unpaid or partly paid; HMRC treats the unpaid amount on the shares which is not taxed as income upfront as if it were an interest-free loan to the employees.
So in the case of either an interest-free loan or unpaid share capital, the relevant employee will be liable for income tax and employee national insurance contributions (in the case of unpaid share capital, only if they are "readily convertible assets") at their applicable rate on (at the date of this article) 2.5% of the outstanding loan or unpaid capital amount each year. For example, if the outstanding amount is £100,000 and the relevant employee is a higher rate (40%) taxpayer, that employee will pay £1,000 in income tax which is 40% of £2,500. However, if an individual employee is sufficiently senior with management responsibility across the whole business (e.g. CEO or CFO) then relief on the income tax may be available for the relevant employee(s). More junior employees will however remain liable. Employer's national insurance would also be payable on 2.5% of the outstanding amount.
There are, however, certain exemptions from the notional loan charge (not covered in this article).
3. What if employees are existing shareholders?
Where a company is effectively controlled by five or fewer individuals it is considered a "close company" for tax purposes. Most owner-managed businesses are likely to be close companies.
Close companies should be aware that there are different rules applying to employees who already hold shares and those who don't. An employee that already holds shares may be considered a "participator" for tax purposes.
Subject to certain exceptions, where an employee who is already a shareholder receives an actual loan from the company (as opposed to being issued nil paid or partly paid shares), HMRC applies a temporary 32.5% corporation tax charge against the company on the amount of the loan. This charge is in addition to the income tax and national insurance charges outlined in section 2 above and is payable in the tax year in which the loan is made. The corporation tax charge should become repayable when the interest-free loan is repaid. If the loan is never repaid, the corporation tax charge becomes permanent.
4. What happens on exit?
As outlined so far, if structured correctly, interest-free loans and issuing nil paid or partly paid shares to employees are effective ways of giving shares to staff without much outlay up front. Much like staff enjoy the upside on an exit, HMRC also benefits. At exit, any gain made on the shares over and above the subscription price will be liable to capital gains tax. Each employee will be able to use their own capital gains reliefs to offset some or all of this tax to the extent that any reliefs are available. At time of writing, each UK taxpayer is entitled to £12,000 of tax-free capital gains each year. Above this threshold, the applicable rate of capital gains tax will apply.
5. What happens to the loan/unpaid capital amount on exit?
Any amount unpaid on a loan or shares will generally stand as a debt owed to the company. Therefore the employee will technically always owe the unpaid amount on the loan or shares. In an ideal scenario, the outstanding amount owed to the company will be deducted from the employee's proceeds on a successful exit.
In the event that the Company waives the requirement for the loan to be repaid, or the unpaid amount on the shares to be paid up (for example because the company has decreased in value), then income tax and national insurance charges become payable at the time of such waiver on the amount waived by the company.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.