Employee shareholder status: a new management incentive tool?

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

From 1 September 2013, companies and their employees will be able to enter into "employee shareholder agreements". In exchange for giving up certain statutory employment rights, employees will be able to acquire shares in a tax-efficient manner. Although, in terms of their application to the wider employment market, the proposals have received a lukewarm reception, the new law may instead offer a highly efficient vehicle to deliver equity interests to senior executives.

What is an "employee shareholder"?

An employee shareholder is an individual who has agreed, through an employee shareholder agreement, to give up certain statutory employment rights (including unfair dismissal rights and the right to statutory redundancy pay). In exchange, the employee must receive free shares in their employer company (or a parent company) with a minimum value of £2,000 as at the date of acquisition. Before an employee shareholder agreement can be entered into, the employer company must provide the employee with a statement summarising the rights being given up and giving details of the shares to be received in exchange. The employee must also take independent advice on the arrangement (the cost of which must be met by the employer company).

What are the potential tax advantages?

The most significant tax relief is that shares acquired in consideration of an employee shareholder agreement are exempt from capital gains tax. This represents a potential tax saving of up to 28% of the growth in the value of the shares from acquisition until disposal.

The relief only applies if the market value of the shares at the time of acquisition does not exceed £50,000 (and for valuation purposes, any restrictions applying to the shares pursuant to the articles of association or any other agreement are disregarded). However, provided that the shares are not valued at more than £50,000 at time of acquisition, the capital gains tax relief applies to all subsequent growth in the value of the shares without limit.

It is worth noting that income tax (and, potentially, national insurance contributions) may arise on the acquisition of the shares by the employee shareholder, but only to the extent that the market value of the shares on acquisition exceeds £2,000. Significantly, HM Revenue & Customs has indicated that it will agree the market value of shares acquired in connection with an employee shareholder agreement before the date of acquisition.

What is the rationale for this new arrangement?

The Government is hoping to help small and medium-sized companies to create a more flexible workforce: employees are encouraged to give up statutory protections in exchange for new rights that align their interests with those of the business owners.

In practice, however, there remain a number of barriers that are likely to prevent companies and employees from rushing into employee shareholder agreements. From a company's perspective, employee shareholder agreements are likely to be costly and time-consuming to administer. From the point of view of an average employee, giving up potentially valuable employment protections for a minority holding of shares may not necessarily be a good idea, particularly if the shares are subject to forfeiture provisions on cessation of employment.

Who might use the new arrangement?

Whilst employee shareholder agreements may not have the wide appeal that the Government originally intended, the potential tax savings are likely to be of great interest to senior executives, particularly those in companies with good growth potential. Senior executives are less likely to be concerned about forgoing statutory employment protections (as they tend to have stronger contractual protections) and are more likely to receive a material equity interest in return.

Examples of where employee shareholder agreements may be used for senior executives include:

• acquisition of 'sweet' equity on an MBO: Individuals acquiring new shares on a management buy-out are likely to be keen on any arrangement that takes them outside the capital gains tax regime. This will be particularly true for those individuals who may not qualify for entrepreneurs' relief (for example, because they are acquiring less than a 5% equity stake) which would otherwise reduce the effective rate of capital gains tax to 10%. One point to note in the context of MBOs, however, is that no additional consideration can be given by the employee for the shares acquired in exchange for an employee shareholder agreement. If other shareholders want the managers to have 'skin in the game', alternative structures for this will need to be explored.
• an alternative incentive arrangement to EMI: Although shares acquired through an EMI option are subject to the capital gains tax regime, it is unlikely that employee shareholder agreements will displace the use of EMI. Following the Finance Act 2013, shares acquired through an EMI option are likely to qualify automatically for entrepreneurs' relief, reducing the effective rate of capital gains tax to 10% and in addition, there is no upfront tax exposure on the grant of EMI options. Under EMI options, the company also benefits from a potentially significant statutory corporation tax deduction when the options are exercised. However, where the company or the individual do not meet the qualifying criteria for EMI, acquiring shares via an employee shareholder agreement may be a compelling alternative. It is also worth noting that 'value' shares (being shares that only participate in the future growth in the value of the company) could also potentially be used.

As with any new legislative regime, care will need to be taken when implementing an employee shareholder agreement. Aside from ensuring compliance with the employment framework, it will be critical to ensure that the shares are worth no less than £2,000, but no more than £50,000 so as to qualify for the special tax treatment. In this regard, the fact that HM Revenue & Customs has indicated that it will agree a share valuation with a company before an employee shareholder agreement is entered into, is extremely encouraging.

Any information contained in this article is intended as a general review of the subjects featured and detailed specialist advice should always be taken before taking or refraining from taking any action. If you would like to discuss any of the issues raised in this article, please get in touch with your usual Olswang contact. This article was included in our Olswang Corporate Quarterly Summer 2013 publication.