For businesses that trade through a company, circumstances might arise in which the ‘shareholders consider selling a minority stake in the company’ to a key employee or group of employees. This could be to ensure key talent is ‘locked in’ for the long term, a means of succession or to link effort to reward.
The pros and cons of transferring shares to key employees through an Employee Share Scheme (ESS) need to be carefully weighed because the devil is in the detail.
From a tax perspective, shares are typically held on capital account and therefore any gains in value are non-taxable. However, complex rules exist which try and delineate between an arrangement that resembles a generic shareholding interest, versus one that is received in connection with a person’s employment. The ESS arrangement tied to a person’s employment will directly effect the value of how the Share Sales Tax Date (SSTD) will be assessed, taxed or deferred according to a range of scenarios:
For example, if the rules of an employee share scheme state that an employee who leaves to work for a competitor must sell their shares for the lesser of cost or market value, this would carry a ‘material risk’ of occurring and therefore will defer the SSTD. Hence, the full value of the shares could be taxed on disposal. On the other hand, if a ‘bad leaver’, defined as someone dismissed for serious misconduct, this condition is less likely to occur and should not defer the SSTD. It is not uncommon to find income tax applies to shares within an ESS, when the participants have assumed it does not.
Another aspect that can complicate an ESS is the management of minority shareholder rights. When employees are granted shares, they become minority shareholders and are entitled to certain rights (such as voting rights) within the company. Managing these rights can be complex and cumbersome and can detract from the overall appeal of an ESS for some companies.
As companies consider their options, the fundamental gating question becomes what the shareholders are trying to achieve and whether there is a better option. An alternative is to implement a ‘phantom equity incentive’ where an employee is compensated (e.g. with bonuses) based on the value of a business and/or its performance. Phantom equity, can offer similar motivational benefits without the complexities of actual share ownership.