COVID-19 UK: Employee Share Incentives – Helping companies through the downturn – Insight

April.01.2020

Most companies, particularly startups, are well aware that their equity is a powerful recruitment and retention tool. In a downturn, when companies may be facing decreasing profits and cashflow difficulties, share-based incentives move from an important part of a company's reward programme to centre stage. 

We have set out below an overview of:

  • certain pitfalls to avoid if making employees redundant, furloughed or reducing their hours, and
  • some of the ways in which companies can increase the tax efficiency of their option arrangements to incentivise their employees in the immediate future and provide them and their employer with greater tax savings over the longer term.

If you are a small business or startup, Orrick has outlined some of the measures the Government is providing to assist and support you with cashflow, debt and staffing problems as a result of the COVID–19 outbreak. 

Pitfalls

  • Redundancy is a "good leaver" reason under the rules of most share schemes. Some schemes provide that the option lapses 90 days after the option holder has left. If good leavers under an EMI scheme have a longer period than 90 days in which to exercise their EMI options, the company should make sure that it keeps a record of the market value as at the date the employee becomes redundant.

    • This is because any gain which arises after the employee ceases employment (which is a "disqualifying event" for EMI purposes) will, unless the option is exercised within 90 days of cessation, be subject to income tax and potentially employee and employer national insurance contributions.

    • Failure to keep a record of the market value at the time the employee is made redundant will mean there is no certainty as to which part of the gain should be taxed when the option is exercised.

  • A similar "disqualifying event" occurs where an employee with an EMI option is put on furlough leave under the Government's Coronavirus Job Retention Scheme. This is because, while the option holder has not ceased employment, they will no longer meet the working time requirement in the EMI legislation.

    • Some schemes may provide that the option lapses 90 days after a disqualifying event. For those schemes which do not, any gain which arises after the employee is put on furlough leave will (unless the option is exercised within 90 days of cessation) be subject to income tax and potentially employee and employer national insurance contributions.

    • We understand that this has been raised with HMRC. It is hoped that they will publish a concession (similar to the one that already exists for EMI option holders who are called up to serve as armed forces reservists).

  • Where an employee is not put on furlough leave, but their hours are reduced, an EMI disqualifying event will also occur if, at the end of the relevant tax year (6th April to 5th April the next year), the option holder has not, in fact, spent at least 25 hours a week or 75% of the option holder’s working time with the group. This will not be a problem if they have no other employment, but careful analysis will be needed if an option holder whose hours have been reduced takes on other employment to bridge the gap in their income, as we have seen some employers recommend to their employees.

  • Where a company hasn’t transferred the employer NICs to the option holder, the company will have a liability in the above situations where – having granted EMI options with an exercise price equal to the market value of the shares on the date of grant – it may not have expected any liability for the company. In this situation, companies should check whether their plan rules permit them to:

    • transfer the employer NIC liability to the option holders;

    • let the option holders exercise within the 90 day period post-disqualifying event in which the option will still be treated as a qualifying EMI option; and/or

    • prevent option holders exercising their options after the end of this 90-day period.

Opportunities to optimise tax efficiency

  • The share valuation which can be agreed with HMRC in respect of the grant of EMI and CSOP options is important for two reasons:

    • Where EMI options are granted with an exercise price per share equal to the actual market value of a share, no tax should arise on exercise (assuming certain other conditions are met). The same is the case for CSOP options granted with an exercise price per share equal to the unrestricted market value of a share.

    • There is an individual limit on the value of shares under an EMI option of £250,000 (£30,000 for CSOP options) and a limit on the value of a company's shares which can be put under option of £3m (all by reference to the unrestricted market value at the date of grant).

  • Therefore, the lower the market value which can be agreed, the greater:

    • the potential tax-free gain when the options are exercised; and

    • the number of shares over which EMI or CSOP options can be granted.

  • The current economic situation and the company's short to mid-term business projections may enable the company to agree a low share value with HMRC for the purposes of granting EMI or CSOP options.

    • HMRC's agreement to valuations is generally valid for 90 days. Companies about to grant options on the basis of a valuation agreed with HMRC in January 2020 may wish to consider whether they should go back to HMRC and ask them to agree a lower valuation.

    • For existing EMI and CSOP options, companies should consider seeking a lower valuation from HMRC and offering existing option holders the opportunity to surrender any options that have an exercise price which is higher than the current valuation, in exchange for new options with an exercise price reflecting the current market value.

  • To qualify to grant EMI options, a company must have gross assets of £30m or less. While no-one welcomes a downturn, some companies that may not have previously qualified to grant EMI options may become able to do so. As the economy picks up, having established an EMI scheme during their window of opportunity could turn out to be more tax efficient both for employees and the company.

  • To preserve cash, companies may wish to consider the extent to which they can pay out bonuses in shares or grant share options over shares with a value based on the bonus waived. In the long run, this may be a win-win. Research has consistently shown that companies with higher levels of employee share ownership have greater employee engagement and resilience during a downturn.