Share schemes have historically been considered as the 'tax-efficient' way of rewarding employees for good performance. The reason for this is that (subject to certain exceptions) capital gains are taxed at 20% (or 10% if Business Asset Disposal Relief is available) when compared with the marginal rate of 47% (for income tax and National Insurance contributions) for additional rate taxpayers.
A tax approved share scheme can also avoid employer NICs (at 13.8%) and provide a corporation tax deduction for the employer on the gain in the value of the option shares.
When considering the overall tax cost for all parties, there could be a 65.8% saving when rewarding employees through share options versus cash bonuses.
A CGT rate increase could be bad news for share schemes, as it could remove one of the key benefits. Such a move would however not be surprising. Labour has already pledged to scrap CGT rates on performance related gains for private equity fund managers, bringing those in line with Income Tax (for more on this, see our article on Labour's tax plan for carried interest).
Although an increase in the CGT rate would reduce the tax benefit arising from a share scheme, the commercial reasons remain as strong as ever, and are worth revisiting:
- Aligns thinking between owners and employees
The classical issue that cash bonus incentives face is that they can encourage short-term thinking. A share scheme allows an owner of the business to offer equity to an employee, without having to dilute their shareholding immediately. It encourages the workforce to think more as a business owner and how to seek a longer term return on their share options/shares.
- Drives good behaviour of option holders to achieve exit or performance conditions
By giving employees and management an opportunity to become part owners, they take responsibility for increasing the value of the business. This could drive the business to achieve specific performance conditions or to reach the level desired by exiting shareholders.
A share scheme can also be linked to ongoing performance conditions such as sales bonuses. It can set the foundation for achieving the targets necessary for an exit.
- Exercise price funded by consideration from buyer (exit only scheme)
The other main advantage of share schemes is the cash flow benefit. A company might not have the budget to offer higher salaries to its key performers today. An exit only share scheme allows the employee's share reward to be paid from consideration on sale of the company. Theoretically, the existing owners should not lose any value in arranging such a scheme. If the performance conditions are met, this would lead to a larger company valuation on exit.
- Delays the timing of the tax liability (exit only scheme)
Share plans can also offer flexibility around timing of the tax charge. For example, the grant of an EMI share option will not create any immediate tax charge for the employee. The tax charge will instead be delayed until either the point of exercise or disposal of the option. This will be advantageous for employees and management who may already be paying additional rate income tax.
If the Labour government does equalise CGT and Income Tax, whilst the tax benefits might be lost, there are still considerable commercial benefits.
