In the United Kingdom, in principle, anything an employee receives from her employer may be regarded as taxable income.
The problem often comes up in practice where companies give their employees shares/options over shares for nothing or at a discount. In these circumstances, an income tax charge will be crystallised, as discussed below. This issue is particularly relevant for start-up companies where share-based compensation is prevalent and for venture capital investors seeking to make or exit an investment in such companies.
The Key Consequences
On receipt of the shares:
Income tax liability for the employee
In addition, if the shares are “readily convertible assets” when the income tax charge crystallises:
Class 1 “employee national insurance contributions” for the employee
Class 1 “employer’s national insurance contributions” for the employer
Employer must operate PAYE (payroll) in many cases in order to collect the tax due from the employee.
But what does that mean, and why is it a problem? It is a potential problem because:
An employee’s income tax liability can be up to 45%, with the employee’s national insurance contributions forming a further 2% cost.
Employees must pay the tax in cash, notwithstanding that they may be receiving non-cash assets (i.e., shares). This can clearly create cash flow issues for the employee (i.e., on a share issue, the tax charge is crystallised at the time of the receipt of the shares, not on their disposal when there is an obvious source of funds to pay the tax, and hence this is referred to as a “dry” tax charge).
An employer’s national insurance contributions are 13.8% and are levied on top of the gross salary (although they are tax-deductible for corporation tax purposes). They are the employer’s responsibility (though in limited circumstances can be passed on to the employee).
It can often be difficult to accurately value the shares (especially in private companies), so it is sometimes hard to know if payroll operated correctly.
The UK tax code has a penalty regime for payroll failures—this can be punitive in the worst cases (penalties of up to 100% of the tax and national insurance due).
HMRC will pursue the employer for payroll failures (i.e., so it is not an employee problem in the first instance).
Can anything be done? Yes. Employees can be required to pay full market value on the acquisition of shares. This should generally mean that future growth will be a capital gain.
However, this is often not practical as a result of the inherent value in shares at the time of the proposed issue (as a consequence, the employee would not be able to afford to pay the tax charge). Accordingly, it is common to see the introduction of a class of share that arguably has little or no value on the date of issue.
Examples of this include:
Growth shares: a special class of shares carrying the right to participate only from future growth in the value of the company (e.g., if a company is worth £10 million, the growth shares would participate in future growth above £10 million on an exit)
Hurdle shares: a special class of shares carrying the right to participate only from future growth in the value of the company above a hurdle (e.g., if a company is worth £10 million, a hurdle share might give a participation on an exit above £12 million).
Typically, these classes of share will carry no income or voting rights and will be subject to leaver provisions.
Alternatively, it is useful to consider using a government tax approved share scheme. The most relevant for start-ups and venture capital investors is likely to be enterprise management incentives (EMI options):
EMI options are targeted at small trading companies (that have a trading business in the United Kingdom).
If the relevant criteria are met (which include gross assets of less than £30 million), there is no income tax or national insurance contributions on the exercise of an EMI option. The growth in value of the shares is a capital gain.
The key requirement is that the option strike price must be equal to the market value of the shares when it is granted. Failure to meet this requirement will result in income tax treatment for some of the gain.
EMI options may also be combined with business asset disposal relief (formerly known as entrepreneurs’ relief), which is a low capital gains tax rate of 10% (rather than the usual rate of 20% for higher earners).
Is there anything else available? There are unapproved plans, but they are generally not tax efficient. This is because the difference between the strike/exercise price and value at the time of exercise will be subject to income tax. As options are often exercised and then immediately sold on exit, this means that all of the relevant gain will typically fall to be charged to income tax.
Key MIP Considerations for Venture Transactions
As a venture capital investor or start-up company, it is useful to carefully consider and implement a management incentive plan (MIP) in order to mitigate the consequences highlighted above. The main object to MIP planning is generally to ensure that any gains realised by management from their equity are charged to capital gains tax (at a top rate of 20%) rather than income tax and national insurance (which could result in a top effective tax rate in excess of 50%). The following additional considerations are useful to take into account:
Where possible, the most beneficial approach is to grant EMI options, as the employee will potentially be eligible to claim business asset disposal relief (formerly entrepreneurs’ relief) and obtain a 10% tax rate on the first £1 million of gains.
If the company is not EMI-eligible, capital gains tax treatment can potentially still be obtained by issuing management equity in line with the HMRC/BVCA MoU on management equity investment, or through a “growth share” scheme.
MIP planning is most effective if the scheme is established at the earliest opportunity, whilst the company shares are low in value. The longer the delay, the harder it is to secure capital gains treatment.
The tax rules relating to employee equity incentives are complex. It is relatively common to find that the employee incentives have been issued in an inefficient manner, either because the employer has not taken appropriate advice or because the arrangement has not been implemented correctly
Where an MIP has been implemented incorrectly, it may be possible to mitigate the additional tax cost for employees by triggering an immediate income tax charge, thus ensuring that subsequent gains are within the capital gains regime, and putting in place appropriate arrangements to fund the resulting liability.
The United Kingdom’s income tax regime will apply to any circumstances in which an employee receives equity for anything less than market value at the relevant time. There are limited ways of structuring around this (to try to ensure relevant gains receive capital treatment). These include growth or hurdle shares (if the proposal is to award equity on day one) or if options are preferred, EMI options. As a venture capital investor or start-up company, it is useful to carefully consider and implement an MIP in light of the above.