Share options: Aligning interests
04 May 2016
Share options are a way of linking employee and shareholder aims, and compensation to performance
Share option schemes are a widely used and an important means of retaining and incentivising employees. Aligning employees’ interests with those of shareholders and linking compensation more closely with performance are necessities, and share options provide a useful and flexible means of achieving both these aims. The various tax, regulatory and other requirements associated with operating a share option scheme can, however, be complex.
Tax treatment
The basic position is that there is no tax payable at the time an option is granted to an employee. Income tax will become due at the time the option is exercised, on the difference between the exercise price and the value of the shares.
Any holding period applied to the shares after the option is exercised should, therefore, bear in mind that the employee will normally have to pay tax on the value of the shares. This is regardless of whether they are actually able to sell the shares (and so receive cash out of which to pay the tax) at that time.
There are also statutory share option schemes such as Sharesave (SAYE), the Company Share Option Plan (CSOP) or, for companies with no more than £30 million gross assets, Enterprise Management Incentives (EMI). These may allow companies to grant their employees share options on a basis that the option gain is charged to capital gains tax on the sale of the shares, instead of income tax on the exercise of those options.
Operating PAYE
Any income tax payable on receipt of shares in a quoted company by employees will be due under PAYE. The PAYE amount will be calculated by reference to the market value of a share. Unless there is an extreme lack of liquidity in respect of a quoted company’s shares, recent closing prices should be a sufficient guide.
Recovering PAYE
The employer company, at the time of grant, is responsible for deducting PAYE on exercise, even if the option holder has since left employment.
This makes it important to have clear provision in the grant documentation for how the company can deduct PAYE – especially since there may be additional tax charges if the option holder does not properly reimburse the company. The company has a right in restitution to recover the amount from the option holder, but it is obviously better to have the right and how it is to be operated set out clearly in the option documents.
Normally, the company should be able to deduct PAYE from the salary or cash bonus paid to the option holder. If this is not possible, the company may, for example, wish to be able to retain and sell some of the option shares for this purpose, as the option holder’s agent.
National insurance
If PAYE is due, so will employer and employee national insurance contributions (NIC). Employee share options may include an ‘NICs election’. This results in one of the few circumstances in which liability for employer NICs is transferred to the employee. Payment of the employer NICs will be tax deductible for the employee – although this can still lead to a very high effective marginal rate of tax in the hands of the employee.
Employment law
Share options form part of an employee’s overall remuneration package. An employee who is unfairly dismissed may therefore be entitled to compensation for loss of the value of any share options they would otherwise have been able to exercise.
It is, however, possible to exclude liability for the loss of share options where the employee leaves by reason of the employer’s breach of contract, provided the exclusion is clearly expressed. Such clauses are often (unsurprisingly) disputed if an employee leaves on poor terms.
In order to be effective, the clause should be clearly drafted and fairly drawn to the attention of the employee – it is not enough to insert it as part of the small print. The same position applies to clawback of shares acquired after an option is exercised (although not to ‘malus’ as applied to unvested options – see below).
Similarly, if the employer has discretion as to whether the employee may exercise share options on leaving, this is not – whatever the wording of the clause – absolute. The employer must still exercise its discretion reasonably and in good faith.
Stock exchange rules
Quoted companies must comply with rules – whether in the AIM rules, the Model Code or other regulations governing a particular exchange – which are intended to ensure that employees in possession of price sensitive information do not exploit their advantage over external shareholders.
Directors and other senior employees who may have such information must not deal in company securities, including share options, in the period leading up to the publication of financial results − or at other times when in possession of unpublished price-sensitive information. It is important to have systems to track this and ensure that these rules are not breached.
Similarly, directors’ dealings in company securities must be disclosed to the market. Last year, fines of over £500,000 were levied on a company for failure to make timely disclosure of dealings by senior executives, so this requirement should not be treated as a mere formality.
Shareholder expectations
There has been increased pressure in recent years to ensure that employee compensation is sufficiently linked to company performance over the long term. The Principles of Remuneration published by the Investment Association (IA) are widely regarded as representing best practice in this area.
The principles continue to acknowledge that share-based incentives are one of the most effective ways to align the interests of employees and shareholders. However, to operate effectively, such incentives should be carefully structured. For example, incentives should be subject to malus (the forfeiture of all or part of an award before it has vested or been paid out) and clawback (the recovery by the company of sums already paid to employees).
Attention should also be paid to dilution limits. The principles recommend a limit of 10% of issued ordinary share capital to the use of newly-issued shares for all employee share schemes in a rolling 10-year period and of 5% to discretionary executive share schemes.
As it is not unlikely that a company’s share capital may undergo significant changes over the course of a decade, these limits should be carefully tracked and companies should ensure they leave sufficient headroom for future awards.
The most recent version of the principles only made one change against the previous version, to clarify that long-term incentives – potentially including share options – should have a minimum three-year performance period. The total performance and holding period should come to at least five years.
However, key relevant issues raised by investors for 2016 include:
- Investors will look closely at recruitment arrangements and will be concerned if recruitment awards are reissued or re-awarded after a fall in company value. Treatment of leavers should be fully justified.
- There is concern that some executives receive high levels of remuneration for performance that does no more than meet the threshold. High levels of remuneration should be linked to high performance.
- Pay structures are becoming too complex, leading to a lack of clear incentives.
Reporting
Transactions, such as the grant of awards, should be announced to the market. There are also specific requirements to disclose share incentive arrangements in the company’s financial report and accounts, and in the annual remuneration report.
UK listed companies (not including AIM) must produce a directors’ remuneration report each year, setting out specified information relating to directors’ pay. This can become a fairly legalistic document and concerns have been raised by investors on this point.
There are provisions to allow commercially sensitive information to be kept confidential, but where this is the case, investors will still expect a commitment to disclose key information in the future. In particular, IA members will expect retrospective disclosure of threshold, target and maximum target levels of bonus against what was actually achieved.
There is also a specific requirement for all companies to report to HMRC the grant, exercise and other events in relation to awards. As of last year, the company must file an online annual return, through the same system used for PAYE. The new online system introduced by HMRC last year suffered some technical problems and many companies had trouble correctly submitting their returns. Some also found the templates supplied by HMRC for online reporting difficult to complete.
With the 6 July deadline for submitting 2015−16 share scheme returns now approaching, companies should ensure that they complete online returns well in advance, in order to allow time for any problems to be recognised and corrected.
Accounting rules
The accounting rules for ‘share-based payments’ can be complex and at times counter-intuitive. Share options should be recorded at ‘fair value’ in the company’s accounts at the time of grant. This is a notional value which reflects the uncertainty as to whether, and at what share price, the option will eventually be exercised.
As accounting charges can be substantial and may not necessarily be reflective of the apparent economic value of share options to employees, it is worth incorporating the accounting treatment into the planning of share option schemes at an early stage.