Keywords: UK approved share plans, preferential tax treatment, share plans
Grants of equity awards are an important component of employee compensation in the United Kingdom - just as they are in the United States. The United Kingdom provides preferential tax treatment (for both employers and employees) for equity incentive plans that meet certain requirements ("approved share plans"). These plans can be very useful to enable US companies to deliver awards in a tax efficient way for UK participants (and the employing companies).
Recently, a bill was introduced in Parliament which, among other things, is intended to simplify the rules on these plans. This update summarizes the proposed changes, and considers the impact they will have on the operation of approved share plans.1 Generally, the changes should make the operation of approved share plans easier, and extend the circumstances in which preferential tax treatment is available. In addition, companies that wish to implement a global share plan in the UK using the approved plan provisions may be able to mirror the terms of the global plan more closely in certain areas.
We recommend that companies review their approved share plans in the light of these changes. As discussed below, particularly in the case of equity compensation plans governed by US law, plan amendments may be required to preserve the status of a plan as an approved share plan.
The changes primarily concern approved Company Share Option Plans (CSOPs), Save As You Earn Share Option Schemes (SAYE plans) and Share Incentive Plans (SIPs).
CSOPs allow the grant of tax-advantaged options to UK employees over shares to the value of £30,000 at the date of grant (with the exercise price being no less than the market value at date of grant). If exercised more than three years from grant, or in certain "good leaver" circumstances, the gain on exercise is free of income tax and both employee's and employer's social security contributions in the UK. Any gain realized on sale of the shares may be subject to capital gains tax (CGT), although the first £10,900 of gain (for the current tax year - this is the "annual allowance") is tax free, and CGT rates are lower than income tax rates.
SAYE plans involve participants entering into a savings arrangement for three or five years, funded by fixed deductions from their salary, to a maximum of £3,000 per year. At the same time, they are granted a share option, exercisable at the end of the savings period, using the money in the savings account (if they wish to exercise). The exercise price must be at least 80% of the market value of the shares at the date of grant. As for the CSOP, exercise is tax free, with CGT potentially on sale of shares (although often this will also be tax free as it will be below the annual allowance).
For both CSOP and SAYE options, in contrast to US incentive stock options, a tax deduction is available for the employer for the gain realized by the employee, whether or not this is taxable in the hands of the employee.
SIPs are arrangements that allow free shares to be awarded to employees (to a value of £3,000 per year), and/or allow employees to purchase shares using pre-tax income (to a maximum of £1,500 per year) with free matching shares (up to a ratio of two free shares for each purchased share). Shares awarded generally need to be held for the participant in a trust for five years for the full tax benefits to be obtained - if they are, then both the award of the shares and the sale of those shares by the employee are tax-free - no income tax, social security contributions or CGT. In addition, the employing company is entitled to a tax deduction for the value of any shares awarded.
SAYE plans and SIPs can both be used (in different ways) by US companies to implement Internal Revenue Code Section 423-style employee stock purchase plans in a tax-efficient manner in the UK - and in the case of SIPs, the tax advantages can be better than those that apply in the US, as the deductions from salary with which shares are purchased are taken from pre-tax salary. They are both "all-employee" plans - participation must be offered to all UK employees who have completed a minimum service period.
All of these plans must be approved by the UK tax authority, HM Revenue & Customs (HMRC), prior to use, hence the name. This is a relatively straightforward process, although it can take several weeks. In the case of CSOPs, these are often implemented by way of an "approved schedule" to an omnibus share plan, which sets out the changes to the general rules which apply to approved options, so that they meet the requirements of the legislation. Options under the plan, as amended by the schedule, will then, following HMRC approval, qualify for the UK tax advantages. SAYE plans and SIPs, are more usually implemented by way of a stand-alone plan.
In March 2012, the Office of Tax Simplification made various recommendations to the UK government regarding the simplification of approved share plans. HMRC conducted a consultation process on its response to these recommendations over the summer of 2012, and has also consulted on draft legislation on the implementation of some of the recommendations. The Finance Bill 2013, published on 28 March, contains draft legislation, in what is likely to be close to final form, for the changes to be implemented by legislation this year. The changes will come into effect when the bill comes into force, expected to be towards the end of July.
Currently, the CSOP, SAYE and SIP legislation allows early leavers to withdraw their SIP shares, or exercise their CSOP or SAYE options, when the participant leaves by reason of retirement, without losing the tax benefits. However, the legislation defines "retirement" by reference to retiring upon reaching an age specified in the plan rules, and the requirements are slightly different for each type of plan.
The proposed amendments will remove the requirement for plan rules to contain a specified age to benefit from the preferential treatment, and provide simply that no tax will be due if SIP shares are withdrawn from a SIP following the participant ceasing to be an employee by reason of retirement, nor if CSOP or SAYE options are exercised within six months of ceasing employment by reason of retirement.
The revised legislation does not contain any definition of retirement. In the summary of responses to the consultation, dated December 2012, HMRC stated that the government proposes to allow businesses to apply their own definition of retirement. They go on to say "HMRC guidance will set out the circumstances in which a presumption can be made that an individual is retiring. This guidance will make clear the general principle that, for the purposes of the tax advantaged employee share schemes, retirement must take its normal and natural meaning. Moreover, it should not be possible for an employee to have retired for the purposes of a scheme, but not for any other purpose." We have not yet seen the guidance but it will be published in draft before the changes are implemented.
Since 2011, employers in the United Kingdom have no longer been able to specify a default retirement age, at which they can compel employees to retire without the risk of an age discrimination claim. In light of this, removing the specified age requirement from the share plan legislation makes good sense. However, it does mean that businesses will be faced with the problem of defining (or possibly just identifying) retirement without reference to age (in order to avoid potential age discrimination considerations). This is an issue that many will have already faced in relation to unapproved plans when the default retirement age provisions were first removed. How to deal with this in relation to approved plans should become clearer when HMRC publishes its guidance. Our current expectation, based on the draft legislation, is that companies will not be required to include their own definition of retirement in plan rules.
Other "Good Leavers"
The proposed changes provide that any CSOP or SAYE options exercised within six months of the participant ceasing to be in relevant employment by reason of a change of control of the employing company, or the transfer of the participant's employment under the UK Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE),2 will be tax-free, even if within three years of the date of grant. This will primarily affect the sale of the participant's employer out of the group of companies which contains the company establishing the plan. In most cases, cessation due to TUPE transfer would be tax-free in any event as this would also count as redundancy (basically, involuntary termination of employment in connection with a reduction in force), which is already included as a "good leaver" provision. However, having the express provision in relation to TUPE should reduce confusion around this point.
The changes align the tax treatment for CSOP and SAYE options with the tax treatment applicable to SIPs, as SIP shares can already be removed from the SIP tax-free on these events. For SAYE plans, the changes will also require that options must be exercisable during the six months following those events (but not so as to extend the latest exercise date).
Some welcome improvements have been made to the provisions relating to takeovers. In particular, CSOP and SAYE options may be exercised tax-free, and SIP shares may be withdrawn from the SIP tax-free on the occasion of a cash takeover (subject to detailed conditions to prevent tax avoidance) regardless of the time from the date of grant or award. For these purposes, a cash takeover is where the participant is only offered cash for his shares, and (for options) no roll-over option over shares of the acquirer is offered. Previously such exercises or withdrawals could have been taxable.
Restrictions on Shares
One of the issues that has previously caused problems with the implementation of approved plans is the requirement that, subject to certain exceptions, the shares used cannot be subject to any restrictions which do not apply to all the shares (or all the shares of the class used in the plan). This provision is now being removed and replaced with a requirement that participants be notified of the restrictions on the shares at the time the award is made.
Increasingly, listed companies, in particular in the financial sector, are looking to impose clawback provisions, so that in certain circumstances shares acquired on exercise of options, or the proceeds of the sale of those shares, may be returned to the company. This has not until now been possible for approved plans. Under the new rules, we would expect that companies would look to imposing these provisions on their approved CSOP options, as well as unapproved share awards.
Another consequence of the change is that it should make it easier for companies to align recovery provisions for any tax and social security withholding obligations which may arise on the exercise of CSOP options with those for unapproved options. HMRC currently takes the view that a straightforward provision giving the company the right to sell some of the shares acquired on exercise on behalf of the participant to meet the tax liabilities (in the form often used for unapproved options) is not allowed because of this provision.
For private companies, it should be easier to impose "leaver" provisions on the shares acquired (for example, if an employee shareholder ceases to be an employee, he is obliged to offer his shares to the other shareholders). However, HMRC has declined to simplify the rules relating to approved plans where the relevant company has different classes of shares, with the consequence that care will generally need to be taken to ensure that the imposition of the restrictions does not create a separate class of share.
The approved plans requirements currently prohibit the grant of awards to employees who have a "material interest" in the company. These provisions are now being removed as unnecessary for the all-employee plans (SIP and SAYE), and for CSOPs they are being changed (so, broadly, the material interest definition will be changed from a 25% shareholding to a 30% shareholding).
Other Provisions Relating to SIPs
Two further changes apply just to SIPs: the annual limit on the value of dividend shares that can be acquired by a participant (currently £1,500) is being removed, and where a company is offering "partnership shares" (shares purchased by the participants out of pre-tax earnings), the participant is to be given more choice on the method of determining the number of shares where the company operates an accumulation period for contributions from the participants.
Adoption of New Plans
HMRC will now review and comment on draft plans based on the draft legislation, although such plans will not be approved until after the legislation is in force.
Some proposed changes are to be subject to further consultation, with a view to being introduced in 2014; in particular, a move from the current system, where HMRC approves plans before they can be used, to a self certification process by the establishing company.
Automatic Amendment of Share Plans?
The draft legislation provides that any existing approved plan "has effect with any modifications needed to reflect" many (but not all) of the changes in the legislation - no amendments to a plan are necessary for those changes to become effective.
Plans Governed By UK Law. For plans governed by UK law, this automatic amendment provision should be effective. However, we still recommend that companies amend the text of their plan rules to reflect these automatic changes, to avoid confusion arising from a discrepancy between the text of their plan rules and the legislation. We believe it is unlikely that any shareholder or participant consents for the amendments will be required under the plan rules.
Plans Governed by US Law. For plans and awards governed by US law (often the case where a CSOP is implemented by way of an approved schedule to an existing global plan), it is less clear whether the legislation (when enacted into law) will be effective to automatically amend a plan or UK schedule.
This will likely require an analysis of a plan's or UK schedule's text. Accordingly, amendment of a plan or UK schedule governed by US law may be required to take advantage of some of the legislation's provisions. More importantly, certain changes in the approved plan rules included in the legislation must be adopted in order to preserve a plan's or schedule's approved status. If these amendments are not made (because changes do not automatically amend the plan and the company does not itself amend the plan), there may be a question about the continuing availability of tax reliefs. This applies mostly to SIPs and SAYE plans however, where it is more likely that there is a stand-alone plan governed by UK law.
Whilst we still consider it to be unlikely that any shareholder or participant consents would need to be obtained if the company must amend its plan rules, shareholder approval and participant consent should be considered in light of the changes to be made, the actual text of the plan, applicable law, and any applicable stock exchange rules regarding shareholder approval of material amendments.
Furthermore, there will be some additional flexibility to make discretionary changes to plan rules to reflect some of the amendments (such as the proposal to allow restrictions on plan shares). This is another good reason for companies to give serious consideration to amending their approved plans when the legislation comes into force.
Certain amendments to plan rules require HMRC approval. HMRC has confirmed that its approval will not be required for any amendments to approved plans solely to reflect the new legislation.
Originally published June 12, 2013
1. This update only concerns the treatment of approved share plans under the United Kingdom's tax laws. US citizens working in the United Kingdom and other employees subject to the US income tax laws may still be required to include amounts realized from approved share plans in reporting gross income for US tax law purposes. In addition, the laws of other countries may apply.
2. TUPE provides employees certain employment protections when the business in which they are employed is transferred from the existing employer to a new employer.
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