Executive Share Schemes or share screams? Are your equity incentives delivering tricks or treats?

Carefully crafted and well-maintained equity incentives can provide excellent benefits, but there are some trip hazards that can derail outcomes. This article explains some key aspects that executives should keep in mind to ensure their equity rewards are optimised and not compromised.

Trick or treat tax treatment

The aim of equity incentive awards for executives is to provide an attractive reward component that aids the attraction and retention of key skilled talent. The participating executive will hope for meaningful financial reward based on business value creation and often the expectation is for favourable tax treatment.

Capital or income

It may be tempting to think that a share-based reward will always deliver value in capital form but where the award is employment-related that is not always the case. Tax treatment will ultimately depend on the form of award and the jurisdictional footprint of the participant.

For executives, resident and performing work duties in the UK, an equity award will be optimised if it delivers value as a capital gain on a third party liquidity event and may be less favourable in other circumstances.

For those executives who are internationally mobile or within the UK's 'non-dom' regime and are facing the prospect of UK tax charges on overseas income and gains under the proposed incoming changes to non-domicile taxation, there should be greater scrutiny of whether their foreign employment-related equity plan interests will deliver capital or income treatment. As we explained in our previous article here, foreign plans (including profits interest arrangements favoured by US private equity) will typically not deliver optimal outcomes for those in the UK. There therefore often needs to be significant UK tax advice intervention to craft an alternative form of award.

Points to note are:

Treat (tax optimised)	Trick (tax compromised)
Statutory tax-advantaged share plans: Enterprise Management Incentive (EMI); Company Share Option Plan (CSOP); Save-As-You-Earn (SAYE) or Share Incentive Plan (SIP). Awards under these plans are tax-favoured providing qualifying conditions are met.	Whilst tax-advantaged outcomes might be expected, disqualifying events can adversely impact the tax position, meaning higher liabilities arise. The most prevalent share plan, EMI, is the arrangement where we see the most horror stories, either because of defective implementation or disqualifying events that have arisen after the initial grant. This can mean an EMI option expected to be tax-free at exercise and with a share sale gain charged at 10% (i.e. executive keeps 90% of the value realised) instead is treated as a non-tax-advantaged option chargeable to income tax and National Insurance Contributions (NIC) (i.e. executive keeps less than 60%). For other tax-advantaged plans, the favourable tax treatment can be compromised if the award is not held for the full duration of the statutory maturity period (which can be either 3 or 5 years).
Restricted shares (including growth shares) subscribed for directly. The future upside value gain should be charged to capital gains tax (CGT). It is important that arrangements are implemented robustly and that applicable tax elections are signed.	There may be an initial income tax (and potentially NIC) charge if the shares are subscribed for at a discounted price. It's therefore important to understand in advance how this can be funded and to check that an appropriate and robust UK tax purpose valuation approach has been followed. If the initial subscription price has been paid only on a part-paid basis or if an employer loan has been advanced to the participant, then the executive may wish to consider how their debt obligations will be met or unwound if they become a leaver. If they become a 'Bad Leaver' they might forfeit their shares at nil value but still have a loan balance to repay. The devil will be in the detail of the articles of association, investment agreement and share subscription documents, so take legal and tax advice ahead of subscribing to avoid an unwelcome surprise when the executive leaves the business at a later date. The upside opportunity can look great, but the downside risk can have a sting in the tail. To ensure that future value gains are charged to CGT, and not income tax and NIC, it is imperative that certain conditions are met. For UK executives this will mean either paying an unrestricted market value subscription price or signing a s431 ITEPA election jointly with the employer. For US executives (anyone who is a US citizen or green card holder wherever they reside and work in the world) this will mean ensuring the shares can be regarded as 'property' for US tax purposes (i.e. in addition to capital rights the shares will also need to have voting or dividend distribution rights) and that a s83b IRC election is filed with the Inland Revenue Service.

Treat (tax optimised)

Trick (tax compromised)

Statutory tax-advantaged share plans:

Enterprise Management Incentive (EMI); Company Share Option Plan (CSOP); Save-As-You-Earn (SAYE) or Share Incentive Plan (SIP).

Awards under these plans are tax-favoured providing qualifying conditions are met.

Whilst tax-advantaged outcomes might be expected, disqualifying events can adversely impact the tax position, meaning higher liabilities arise.

The most prevalent share plan, EMI, is the arrangement where we see the most horror stories, either because of defective implementation or disqualifying events that have arisen after the initial grant. This can mean an EMI option expected to be tax-free at exercise and with a share sale gain charged at 10% (i.e. executive keeps 90% of the value realised) instead is treated as a non-tax-advantaged option chargeable to income tax and National Insurance Contributions (NIC) (i.e. executive keeps less than 60%).

For other tax-advantaged plans, the favourable tax treatment can be compromised if the award is not held for the full duration of the statutory maturity period (which can be either 3 or 5 years).

Restricted shares (including growth shares) subscribed for directly.

The future upside value gain should be charged to capital gains tax (CGT).

It is important that arrangements are implemented robustly and that applicable tax elections are signed.

There may be an initial income tax (and potentially NIC) charge if the shares are subscribed for at a discounted price. It's therefore important to understand in advance how this can be funded and to check that an appropriate and robust UK tax purpose valuation approach has been followed.

If the initial subscription price has been paid only on a part-paid basis or if an employer loan has been advanced to the participant, then the executive may wish to consider how their debt obligations will be met or unwound if they become a leaver. If they become a 'Bad Leaver' they might forfeit their shares at nil value but still have a loan balance to repay. The devil will be in the detail of the articles of association, investment agreement and share subscription documents, so take legal and tax advice ahead of subscribing to avoid an unwelcome surprise when the executive leaves the business at a later date. The upside opportunity can look great, but the downside risk can have a sting in the tail.

To ensure that future value gains are charged to CGT, and not income tax and NIC, it is imperative that certain conditions are met. For UK executives this will mean either paying an unrestricted market value subscription price or signing a s431 ITEPA election jointly with the employer. For US executives (anyone who is a US citizen or green card holder wherever they reside and work in the world) this will mean ensuring the shares can be regarded as 'property' for US tax purposes (i.e. in addition to capital rights the shares will also need to have voting or dividend distribution rights) and that a s83b IRC election is filed with the Inland Revenue Service.

Trick or treat transferability

An executive should check whether the shares they are to receive are freely transferable, transferable in prescribed circumstances or non-transferable. Most private company shares will have transfer restrictions of varying degrees. A listed company's shares might typically be freely transferrable, but restrictions can apply to the shares held by executives in certain circumstances, for example where an award is subject to a mandatory post vest holding period or where a post IPO lock-up or close period blackout applies.

Points to note, in addition to the important tax considerations relevant to restricted shares set out in the table above, are:

Treat (tax optimised)	Trick (tax compromised)
Private company articles of association that allow the executive's shares to be transferred to a 'Permitted Transferee' (i.e. a spouse or civil partner or a family trust for the executive and the executive's family members) will facilitate optimal personal tax planing. This can be particularly important in times when there is concern about potential increases in tax rates and/or loss of reliefs or allowances. This is particularly topical currently in the UK given the recent election of the Labour Government.	If a restriction on transfer is lifted e.g. an ability to transfer shares to a Permitted Transferee is subsequently introduced after an executive has acquired their shares, then unless a s431 ITEPA tax election was entered into at the time of subscription the executive might suffer an income tax charge at the time the change to the articles is made. If no such transfer is permitted, then standard personal tax planning avenues are not available. This can diminish the wealth benefit ultimately realised by the executive under the incentive arrangement.
One benefit of an equity incentive delivered in the form of an option, is that it can, sometimes, provide flexibility in relation to the timing of the tax charge. For example, an executive might be able to delay exercise of an Option until such time as the underlying shares (or at least some of them) can be sold to cover the tax charge. This can be particularly important in the context of an IPO, when the executive may be subject to a lock-up period and where there might be significant volatility in the share price and/or limited buyer demand on the chosen stock exchange. Having optionality over the timing of when to commit to acquire the shares (and thus trigger the tax point) can be helpful.	If an equity incentive award is to be realised at a time when the shares are not transferable for value, then an undesirable 'dry' tax charge can result. An example of such a compromised outcome would be where a Restricted Stock Unit (RSU) award vests on an IPO but a lock-up period prevents the executive selling the shares. The vesting of the RSU is automatic and triggers the tax charge (income tax and NIC) but this is then a 'dry' tax charge that has to be funded without ability to sell the shares. Another example would be an award of free shares under a French share plan, to an executive in the UK, which automatically vest on an IPO (triggering an earnings tax charge at that time whether or not the shares are then sold). Even if the shares are transferrable and offered for sale, any lack of demand in the market might mean there is not sufficient liquidity to enable the UK executive to sell sufficient shares at a high enough price to cover the UK tax liabilities (a matter that the French parent company might have overlooked, as the French executives would benefit from tax-exemptions under their local regime).

Treat (tax optimised)

Trick (tax compromised)

Private company articles of association that allow the executive's shares to be transferred to a 'Permitted Transferee' (i.e. a spouse or civil partner or a family trust for the executive and the executive's family members) will facilitate optimal personal tax planing.

This can be particularly important in times when there is concern about potential increases in tax rates and/or loss of reliefs or allowances. This is particularly topical currently in the UK given the recent election of the Labour Government.

If a restriction on transfer is lifted e.g. an ability to transfer shares to a Permitted Transferee is subsequently introduced after an executive has acquired their shares, then unless a s431 ITEPA tax election was entered into at the time of subscription the executive might suffer an income tax charge at the time the change to the articles is made.

If no such transfer is permitted, then standard personal tax planning avenues are not available. This can diminish the wealth benefit ultimately realised by the executive under the incentive arrangement.

One benefit of an equity incentive delivered in the form of an option, is that it can, sometimes, provide flexibility in relation to the timing of the tax charge. For example, an executive might be able to delay exercise of an Option until such time as the underlying shares (or at least some of them) can be sold to cover the tax charge.

This can be particularly important in the context of an IPO, when the executive may be subject to a lock-up period and where there might be significant volatility in the share price and/or limited buyer demand on the chosen stock exchange.

Having optionality over the timing of when to commit to acquire the shares (and thus trigger the tax point) can be helpful.

If an equity incentive award is to be realised at a time when the shares are not transferable for value, then an undesirable 'dry' tax charge can result. An example of such a compromised outcome would be where a Restricted Stock Unit (RSU) award vests on an IPO but a lock-up period prevents the executive selling the shares. The vesting of the RSU is automatic and triggers the tax charge (income tax and NIC) but this is then a 'dry' tax charge that has to be funded without ability to sell the shares.

Another example would be an award of free shares under a French share plan, to an executive in the UK, which automatically vest on an IPO (triggering an earnings tax charge at that time whether or not the shares are then sold). Even if the shares are transferrable and offered for sale, any lack of demand in the market might mean there is not sufficient liquidity to enable the UK executive to sell sufficient shares at a high enough price to cover the UK tax liabilities (a matter that the French parent company might have overlooked, as the French executives would benefit from tax-exemptions under their local regime).

Naughty or nice NICs?

In certain circumstances, a liability to employer's and employee's NIC will arise regarding an executive's equity incentive award. Whether or not an NIC charge is levied will depend on whether the shares are 'Readily Convertible Assets' (RCAs) or deemed to be such at the time of the taxable event. Shares in a controlled subsidiary will be deemed to be RCAs and this is a point that can surprise some participants who, wrongly, assume only a sale event or quoted company status triggers such a charge.

The UK is perhaps the only jurisdiction that allows the employer to transfer responsibility for the employer's social security liability (i.e. the employer's NIC) to the employee. This can only be done as part of a share option award (not regular salary or cash bonus) and there must be a specific bilateral agreement to the transfer within the equity award documents. The executive then receives tax relief for this (i.e. the amount of gain subject to income tax is reduced to reflect the employer NIC cost borne).

At the time of writing, employer NIC is 13.8%, with speculation this might rise. The incidence of an underprovided and unfunded employer NIC liability is a key red flag concern on transaction due diligence and, prior to the ability to transfer the liability, could result in business sale transactions and IPOs aborting. Whilst it might be tempting for executives to challenge the imposition of employer NIC, it should be kept in mind that a lower net of tax gain may be preferable to no corporate event and no gain at all.

For further information contact Liz Hunter, Partner, Incentives.

Note: The tax treatment and tax rates outlined in this article are stated as at 29 October 2024 and do not reflect any changes subsequently announced in the 30 October 2024 UK budget or otherwise.