Cormac Brown | Brown Lombard

23

Apr 2013

Finance Act 2013: Tax Treatment of Share Incentives and How to Make Private Company Share Schemes Work

Posted by Cormac Brown / in Articles / Link

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Introduction

In Ireland, SMEs1 comprise a substantial proportion of the enterprise economy, with over 99% of businesses falling within this sector and almost 70% of people employed by them.2 Thus, SMEs play a key role in future employment generation. The provision of employee equity incentives by SMEs can increase the success and profitability of such companies by attracting and retaining key staff. While foreign direct investment provides headlines in terms of employment, it must also be recognised that the SME sector has the potential to be a real driver in terms of employment growth. Large firms, particularly in the manufacturing sector, can pay 25–30% more than SMEs, and the provision of employee equity incentives is a key reward mechanism that can bridge this gap.

While the concept of employee share ownership has been around for a long time, the use of employee equity incentives is more prevalent among larger Irish public companies and multinationals that have imported their overseas share plans. In comparison, employee share ownership could be described as a well‑known but under‑used tool for potential growth among SMEs. Such arrangements have the potential to become a significant and often valuable element of compensation for employees. Employee equity incentives provide a facility whereby employees are recognised and rewarded as shareholders in the business. The reward is directly related to the performance or value of their business and encourages employees to contribute to growth and profitability. Furthermore, share incentives are now one of the few non‑cash benefits to remain not liable to employer PRSI. This can constitute a significant saving to employers when compared with the equivalent value of a cash bonus.

This article examines the current tax treatment of share incentives in Ireland, the changes in Finance Act 2013 and the current perceived barriers to the establishment of employee share ownership incentives in SMEs. We also examine the impact of the findings of the Nuttall Review in the UK, which highlight the positive impact that employee share ownership has on business performance.

Outline of Current Taxation of Employee Share Ownership

The general provision in Ireland is that shares granted to an employee arising from his or her employment (excluding share options) are taxed on the value of the shares at the date of acquisition as a perquisite under the general Schedule E charging provision contained in s112 TCA 1997. The taxable amount is the value of the shares, less any amount paid by the employee. It should be noted that this is the general provision and that the position may change where the shares are awarded under an approved profit‑sharing scheme, a Save‑As‑You‑Earn (SAYE) scheme or a restricted share plan that meets certain legislative conditions. Additionally, there is detailed anti‑avoidance legislation in the area, with different rules regarding what is liable to tax in certain conditions.

Under the changes introduced in Finance Act 2011, and related social welfare changes (together, “the 2011 Changes”), income tax arising on shares is deducted under the PAYE system on allotment of shares. USC and employee PRSI also arise on the taxable value of the shares. Before this, an employee receiving shares from his or her employer was required to pay income tax through the self‑assessment system. This was a significant change in the operation of employee share schemes, as the responsibility for the payment of the tax transferred from the employee to the employer. There was considerable change in the PRSI area from when the proposals were initially announced in the 2011 Budget to the current rules. Daryl Hanberry’s articles in issues 1 and 2 of the 2011 Irish Tax Review provide a detailed commentary on the 2011 Changes and the practical impact on the operation of employee share schemes.

In relation to non‑monetary emoluments such as shares, the general provision is that the employer is required to pay the tax arising through the PAYE system on the non‑cash emolument regardless of whether or not this has been deducted from the employee. In recognition of the fact that an employer could be facing a significant cash‑flow cost where the tax on the share award was paid but not recouped, Finance Act 2012 inserted s985A(4B) TCA 1997. This provision enables an employer to withhold from the employee and sell a sufficient number of shares to pay the income tax liability arising on the grant of the shares where the employee has not reimbursed the employer for the tax. This provision assumes that there is a market in the shares and does not provide much relief for SMEs.

Shares acquired under the exercise of options continue to be taxed under s128 TCA 1997, and PAYE was not extended under the 2011 Changes. The amount that is liable to tax is the value of the share at option exercise date, less any amount that the employee pays to exercise the option. The 2011 Changes applied employee PRSI and USC to the taxable profit arising on the exercise of share options. Income tax, USC and employee PRSI are paid under the Relevant Tax on Share Option (RTSO) system, whereby the option holder pays tax directly to the Collector‑General within 30 days of the exercise of the option. For options exercised before 1 July 2012, employee PRSI was deducted by the employer in respect of current employees. However, for options exercised after 30 June 2012, no employer withholdings are required.

Capital gains tax (CGT) may arise on the sale of the shares. The calculation of the base cost for CGT is the taxable value of the shares for income tax purposes, plus the amount that the employee paid, if any, to acquire the shares.

Employee Share Schemes in SMEs

The issue of funding the tax liability that arises when SME employees are allotted shares is a significant deterrent to the use of employee share incentives. Irish tax law does not draw a distinction between tax on share awards in private and listed companies, but the issue of illiquid shares does not normally present a problem for listed companies.

Employees in listed companies typically have the option built into their share scheme of selling a proportion of the shares in order to discharge the tax liability. Alternatively, employees can self‑fund the tax liability by paying the PAYE, USC and PRSI to their employer, or the employer can deduct the required amount from their net salary. Unlike in the UK, there is no method in Ireland of deferring when tax is due to be paid on the allotment of shares to employees in private companies. Private company shares are, by definition, illiquid, and the employee may incur a significant tax liability in acquiring an illiquid asset. Currently in Ireland, income tax, USC and PRSI result in a marginal tax rate of 52% immediately on the acquisition of the shares, thereby creating a cash‑flow issue for the individual that may not be capable of being financed.

For both private and public companies, there is a very attractive method of reducing the taxable value of shares whereby the shares allotted to employees are subject to what is commonly referred to as “the clog”. Where there is an agreement between the employer and the employee that requires shares to be held for a specified period, the taxable value of the shares can be reduced by between 10% and 60%. The precise requirements of the scheme are contained in s128D(2) TCA 1997 and do not require Revenue approval. The reductions are as follows:

There are other requirements for a share to be a “restricted share”, including:

A written agreement is in place under which the shares cannot be assigned, charged, transferred or disposed of for the required holding period.
The shares are held in a trust established by the employer for the benefit of employees and directors.
The written agreement is in place for bona fide commercial purposes and does not form part of a scheme or arrangement of which the main purpose, of one of the main purposes, is the avoidance of tax.

Finance Act 2013: Provisions Impacting on Employee Share Awards

A new s811B TCA 1997, as inserted by s12 Finance Act 2013, imposes a charge to income tax under Schedule D, Case IV, on loans and benefits from employee benefit trusts or similar arrangement. While this new section is aimed at employee benefit trusts located offshore, it is just as possible that the section could apply to employee benefit trusts set up for the purpose of holding restricted shares as defined by s128D TCA 1997.

This provision could potentially tax the value of the discount allowed by s128D, which obviously would defeat its purpose. Section 811B(8) contains a specific exclusion for Revenue‑approved schemes such as employee share ownership trusts, approved profit‑sharing plans and SAYE schemes. Additionally, s811B(2)(c) contains a specific exclusion stating that s811B will not apply where the benefit is already being taxed under ss118, 118A, 121, 121A or 122 TCA 1997, but this does not extend to s128D. It is understood that Revenue has confirmed that this new section should not apply to s128D arrangements and is aimed at arrangements that involve aggressive tax avoidance. It would be preferable to see an exclusion from s811B on a statutory basis, as there is for approved share plans.

UK Experience

In the UK, the Government has identified employee business ownership as a vehicle for creating more sustainable growth and encouraging a more responsible way of running businesses. Graeme Nuttall, a leading expert in the field, was appointed as the UK Government’s independent adviser on employee ownership. The Nuttall Review3 was commissioned against the background of the financial crisis and was part of a wider assessment of how long‑term economic growth can be sustained and more evenly balanced in the future. It was established in February 2012 to “identify the barriers to employee ownership and help find solutions to knock them down”.

The Nuttall Review was published in July 2012; it shows clearly the benefits of employee share ownership and proposes methods to promote wider employee ownership in the UK. It contains 28 recommendations that set out a framework for removing the obstacles to the promotion of employee ownership.

Why Use Employee Ownership?

Individuals care more about the things that they own, and the same principle applies to companies. The aim of employee ownership is to make the employee think and act like an owner. Where an employee has ownership in a company, his or her interests are closely aligned with those of the company. The bottom line is that “employee ownership drives economic benefits for companies that adopt it”.4 There is a substantial amount of academic literature on the subject of employee ownership. The Nuttall Review summarises the benefits of employee ownership as being:

improved economic performance,
increased economic resilience,
greater employee engagement and commitment,
driving innovation,
enhanced employee well‑being and
reduced absenteeism.

The key point, as established by the Nuttall Review, is that better performance is driven “by a combination of share ownership and employee engagement”.5 A survey of UK companies, carried out on behalf of Cass Business School, found that employee‑owned companies, with fewer than 75 employees, performed better in terms of profitability than non‑employee‑owned companies. The Nuttall Review refers to a study by J. Lampel6 that found that employment grew faster in employee‑owned companies. The following table demonstrates employment growth rates.

The Employee Ownership Index compiled by Field Fisher Waterhouse, where Nuttall is a partner, tracks the share performance of listed companies that are at least 10% employee‑owned. This index has outperformed the FTSE All‑Share Index by an average of 10% annually since 1992.7

Barriers to Employee Ownership

The Nuttall Review took evidence from a wide range of sources and identified three categories of barriers to employee ownership. These barriers are not unique to the UK and could equally be said to apply in an Irish context; however, to date, no similar studies have been carried out on employee ownership in Ireland.

The first barrier identified was a lack of awareness of the concept of employee ownership. Employee ownership is often misunderstood as being for social enterprise, not‑for‑profit organisations and enterprises, and worker co‑operatives. The implications are “that opportunities to adopt employee ownership are lost when employers, employees and advisers are unaware of its relevance and benefits”.8 A common theme that emerged is that advisers, including taxation specialists and business intermediaries, did not provide the advice that businesses needed to adopt employee ownership. In common with the Report of the Innovation Taskforce, discussed below, the Nuttall Review identified particular times during the business life‑cycle of a company when employee ownership is a very useful measure.

The second barrier identified was a lack of resources available to support employee ownership. Tax, legal and accounting advice on the matter was difficult to find. Additionally, finance for employee ownership has proved to be a considerable challenge. A comparison was drawn between the information that is available for conventional business models – a limited company, for example – and the information that is available for employee ownership.

The third barrier identified was the perceived complexity of tax, legal and regulatory environments. The establishment of an employee‑owned company raises tax, corporate structure and governance issues that must be assessed by those interested in employee ownership. In fact, it is the perception of the complexities that had the biggest effect on businesses.

What Should Be Done?

The Nuttall Review makes 28 recommendations on providing “a framework for promoting employee ownership and moving it into the mainstream of the economy”.9 The UK Government’s response10 to the Nuttall Review, published in October 2012, accepted 22 of the recommendations, partially accepted three and supported three. This response clearly indicates that action is required on the part of many stakeholders, including Government Departments and HMRC. The recommendations range from general to specific and include:

Key organisations from the employee ownership sector and co‑operatives should develop an independent institute.
A time‑limited taskforce should be established, comprising legal, tax and accountancy bodies and representatives of employee‑owned companies, to consider how employee ownership can be a more central part of the advice given by professional advisers and intermediaries.
Simple employee ownership toolkits should be developed that would include an “off‑the‑shelf” template to cover tax, accounting, legal and other regulatory matters. The Department for Business, Innovation and Skills, together with HMRC and the Treasury, is working on this issue.
The Government should produce a report 12 months after its formal response, indicating the progress made on the recommendations. It is envisaged that Mr Nuttall would carry out such a review.

Company Law Reforms Identified in the Nuttall Review and Their Relevance to Ireland

The Nuttall Review concluded that the current UK provisions concerning share buy‑backs in private companies definitely discourage employee ownership structures by making them too burdensome. Private companies that offer employee share schemes often have a policy that employees who own shares in the company are required to sell such shares on leaving their employment. It is possible for private companies to buy back the shares and cancel them, provided that they comply with specific requirements under the UK Companies Acts. Similar provisions exist under Irish company law, and they are sometimes perceived as a deterrent to SMEs implementing an employee share ownership scheme.

On 15 February 2013 the UK Government published its response to a consultation that it carried out on the implementation of the Nuttall Review recommendations on share buy‑backs. The Government intends to implement these recommendations by amending the UK Companies Acts by secondary legislation. These amendments will introduce the following changes:

Private companies will be able to finance buy‑backs out of capital (for the purposes of, or pursuant to, an employee share scheme) by way of a special resolution and the signing of a solvency statement.
It will also be possible to authorise off‑market share buy‑backs by way of an ordinary resolution.
The ability to authorise in advance multiple share buy‑back contracts connected with an employee share scheme will be introduced.
Where a buy‑back is being made for the purposes of, or pursuant to, an employee share scheme, private companies will be allowed to pay for their shares in instalments, with no maximum time limits for such payment, and the articles of association of a private company may provide that small amounts of cash, which do not have to be identified as distributable reserves, may be used to buy back the shares. It is hoped that these proposals would help private companies make more use of employee share schemes and any other employee equity arrangements.

The proposed reforms in the UK could be mirrored in the Irish context as part of measures to encourage employee ownership in private companies and to increase its use as a tool for recovery and growth.

Office of Tax Simplification Review

In tandem with the Nuttall Review, the UK Office of Tax Simplification (OTS) reviewed various types of unapproved employee share schemes and published its final report on 16 January 2013. The report recommends changes to the taxation of Employment‑Related Securities (ERS) and ERS options. Some of the recommendations are radical and, if adopted, would have a significant impact on how ERS are operated. The recommendations include:

Substantial reform of the main ERS and ERS option income tax provisions so that income tax arises only when the shares become “marketable”, unless the employee elects for an earlier tax charge. “Marketable” means that the employee can actually realise the securities in money or money’s worth. PAYE and social insurance contributions would arise for tax charges only on marketable ERS.
A substantial reduction of income tax and Class 1 social insurance in respect of amounts of PAYE due on ERS or option taxable events and not reimbursed by employees within 90 days.
The creation of an employee shareholding vehicle, which would enable companies to manage employee shares better.
A simpler share valuation method, by increasing the availability of pre‑transaction valuations, and a greater provision of valuation information.

Findings of the Innovation Taskforce Report

The Report11 of the Innovation Taskforce (“the Report”) published in March 2010 includes a number of tax recommendations to incentivise innovation. The purpose of the Report was to identify action areas to position Ireland as an international innovation hub. To encourage start‑ups, the Report recommended the implementation of a “founder share” option that qualifies for CGT treatment and a reduced rate of CGT for shareholders in innovation companies.

The “founder share” option recognises the fact that a successful innovation company may go through many rounds of funding before it is sold. The founders’ holdings often get diluted during the various funding rounds, as, more often than not, they do not have the necessary funds to subscribe for shares that would maintain their percentage shareholding. In lieu, founders are given share options, which attract a very high marginal tax rate on exercise. The Report recommends that CGT rates apply on the exercise of options by the founder as an incentive.

The Report proposes that, for shareholders in innovation companies, a reduced rate of CGT of 12.5% should be applied where the proceeds from any sale of the shares are reinvested in another innovation company within a reasonable timeframe. Where the proceeds are not reinvested in time, the normal CGT rate would apply on the gain arising on the sale of the innovation company. To date (March 2013) neither of these proposals has been implemented.

Does Nuttall Have Relevance to Ireland?

In a word, yes. The Nuttall Review shows that there is persuasive evidence that diversity among a company’s decision makers gives that company greater flexibility and resilience in difficult economic times, and therefore company structures that include employee ownership arrangements are to be encouraged, particularly as a method of strengthening the general economy. With Ireland having a broadly similar tax and legal system to the UK, many of Nuttall’s recommendations would have equal, if not more, relevance here. The UK has a history of employee ownership, and with the implementation of the Nuttall Review recommendations, it will be in a strong position to maximise its economic benefits. A critical analysis of the Nuttall Review recommendations from an Irish perspective would assist in assessing what changes can be implemented, so that the undoubted benefits of employee ownership can be encouraged in Ireland.

The authors would like to thank Niall Kavanagh, Office of the Company Secretary, Elan Corporation plc, for his contribution to this article.