In the last Tax Tuesday piece, we looked at incentivising key staff members through the popular, cost-effective and tax-efficient Enterprise Management Incentive (EMI) scheme.
While normally the first port of call when a typical owner managed business wishes to create an equity incentive scheme, in some cases the EMI will not be possible due to the strict conditions which must be met.
For instance, certain business activities do not qualify for the EMI. These include legal or accountancy services, certain financial services and property development to name a few.
In addition, the company in which an EMI is granted must be independent, meaning it cannot be controlled by another company (i.e. it cannot be a subsidiary in a trading group). Often it will be an employee in a particular trading division held within a subsidiary company who the business owners wish to incentivise. In this scenario they are not normally keen to award share options under EMI in the group’s holding company which owns a number of subsidiaries, some of which the relevant employee has no involvement with.
A popular alternative to EMI is the growth share scheme. Rather than granting options to an employee to acquire shares in the future, the employee receives a share award now.
These schemes come in a wide range of shapes and sizes, but they all follow the same basic premise; the value of shares awarded to an employee is tied to future growth in the company rather than the company’s present value, so, at the time the shares are awarded to the employee they have very low value.
The advantage of the shares having very low value at the time they are awarded is that the employee’s tax liability on being ‘gifted’ the shares is also very low.
On an eventual sale of the shares at some future point, they will have grown in value (assuming the company has grown) and the gain on the shares, assuming various conditions have been met and certain tax ‘elections’ (as set out in the tax legislation) have been made by the employee and employer, is subject to capital gains tax (CGT) rather than income tax (IT).
CGT rates are generally lower than IT rates; the likely rate of CGT which will apply on the gain (assuming the annual CGT exemption of £12,300 has been used elsewhere against other gains) will normally be 10% or 20%, rather than income tax rates of up to 45%.
A typical growth share scheme may set a ‘hurdle’ which is the point at which value starts to accrue on the shares. To take a simple example, take a trading company worth £1m. 95 of the 100 shares in issue are ordinary £1 shares. The remaining five are growth shares with a hurdle of £1.5m.
If in several years’ time the company is sold for £2m, the growth shareholder will get 5% x (£2m-£1.5m) = £25,000
The fact the value of these shares is tied so closely to growth in the value of the company acts as an incentive to the employee receiving them to work hard and help make the company a success.
Next time, we will continue this series on employee incentives by considering some of the opportunities which exist to provide various tax efficient benefits-in-kind.
For further information on growth shares or any other aspect of business or personal tax planning, please contact your relationship principal or email firstname.lastname@example.org.
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