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US equity for UK employees – tax considerations

Posted on March 20, 2024 by Alicia Sprott

Type of equity offered

The equity offered to UK subsidiary employees will typically replicate what is offered to US employees. This may include any of the following:

Options, including US tax-advantaged Incentive Stock Options (ISOs)
Restricted Stock Units (RSUs)
Profit units (in the case of a US LLC parent)

Are such awards taxable in the UK?

Where the employee is working in the UK, such awards will be subject to UK tax. This can be problematic in practice if awards are made by the US parent, without informing the finance or HR team of the UK subsidiary. The UK subsidiary will be responsible for operating any Pay As You Earn (PAYE)/National Insurance Contributions (NICs) due and paying any penalties for non-compliance.

Key UK tax considerations

Where equity is offered to UK employees, it is important to review the documentation from a UK tax perspective. The key considerations will include:

Will Income Tax be due on award?
Will Income Tax be due on a later vesting of the award or later sale of the equity?
If Income Tax is due, will PAYE and NIC withholding be required?
Does the documentation contain adequate PAYE/NIC withholding clauses and indemnities to protect the employer?
Does the documentation specifically authorise the employer to pass the cost of any employer NIC to the employee?
Should protective ‘section 431’ tax elections be considered?
How should the awards be reported to HMRC on the UK subsidiary’s Employment Related Securities Annual Returns?

Can we improve what is offered?

Where awards have been designed from a US tax/legal perspective, they may be inefficient from a UK tax perspective.

Whilst it is generally not agreeable from a US perspective to make material changes to scheme rules or to create new share classes to suit the interests of the UK employees, in some cases it is possible to modify awards to improve the UK tax position.

For example, an option scheme would normally have significant PAYE/NIC charges on exercise, but by making small changes to the individual option certificates or by adopting a UK sub-plan to operate alongside the US main plan, it may be possible to restructure as UK tax-advantaged Enterprise Management Incentive (EMI) or Company Share Option Plan (CSOP) schemes. This can create significant tax savings for the UK subsidiary and its employees, whilst having little to no effect on the operation of the scheme, from a US perspective.

For further advice on US equity options for UK based employees, please contact David Bareham, Share Schemes Director.

Vermilion Holdings Ltd v HMRC – When are options employment related?

Posted on November 9, 2023November 9, 2023 by Alicia Sprott

In summary, an option over 2.5% of the company was originally granted for consultancy work performed, where no employment/directorship existed. Had no further changes occurred, this presumably would have been outside the scope of Pay As You Earn (PAYE)/National Insurance Contributions (NICs).

However, a refinancing round resulted in the original option being replaced, with the new option now being over 1.5% of the equity issued. Additionally (and crucially), the consultant in question was also appointed as executive chairman.

On eventual exercise of the option, Vermilion sought non-statutory clearance from HMRC that the exercise was outside of the scope of PAYE/NIC. This was on the basis that the original option was granted pre-employment and that the directorship taken up on grant of the new option was not relevant. Whilst this was not an unreasonable argument (and Vermilion won their case on this up to the Court of Session, the highest court in Scotland), the Supreme Court ruled that the ‘deeming provision’ below applies and the option exercise is subject to PAYE/NIC. This appears to apply a more literal interpretation of the deeming provision, even in the case where the new option replaces a non-employment related option as part of a refinancing round.

The law and interpretation of the deeming provision

In addition to factually assessing whether an option is granted by reason of employment (or holding an office such as a directorship), provisions also exist to deem the option to be employment related. Specifically, the law states ‘a right or opportunity to acquire a securities option made available by a person’s employer, is to be regarded as available by reason of an employment of that person unless:

The person by whom the right or opportunity is made available is an individual; and
The right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person’.

In summary, where an employment or directorship exists at the time of grant, the deeming provision makes it very difficult to argue that an option exercise is outside the scope of employment taxes.

Why is this case important?

It is sometimes unclear if an option has been granted by reason of an individual’s employment. Where an option is granted by reason of employment, the exercise of the option will result in Income Tax, and in many cases NICs. It is therefore tempting to argue that options may have been granted for non-employment reasons, such as pursuant to a consultancy contract or acquired in an individual’s capacity as an investor. The recent ruling in Vermilion v HMRC confirms just how difficult it is to make this argument.

Wider ramifications

The deeming provision for employment related options has an equivalent for employment related securities, which deems shares, loan notes and other securities as within the scope of employment taxes. Advice should be sought where shares, options, convertible loans or other instruments are issued as part of a financing round, especially where the recipient holds employment/directorship as it appears they will be within the scope of PAYE/NIC, even if they finance on the same terms as pure investors.

This case also demonstrates the importance of having robust tax indemnities drafted into the legal documents. Where PAYE/NICs are due, it is primarily the responsibility of the employer to withhold these amounts and pay them to HMRC. Having appropriate indemnities should ensure that the company can recover such amounts from the employee.

To discuss your existing options schemes and how this case may affect you, contact David Bareham, Share Schemes Director, or Mark Allwood, Partner.

Employee options in M&A transactions

Posted on August 24, 2023 by Alicia Sprott

Employee options often play a key role in M&A transactions and need to be considered by all parties. We consider some key issues to be aware of:

Which options will be exercised as part of the deal?
How will the exercise price be funded?
Tax pitfalls and opportunities

Which options will be exercised?

When a company merges with or is acquired by another company, employees with share options usually get to exercise all their options, otherwise known as ‘full vesting’. However, there are some exceptions to this. For example, if employees have not worked for the required time or if certain performance targets have not been met by the time of the deal, they might not be able to exercise their options in full.

Before the deal, it’s essential to review if any unexercised options will become fully vested. Some options contain ‘accelerated vesting’ clauses, whereby any outstanding performance or time-based vesting targets are automatically waived if an exit occurs.

If the decision to waive these targets depends on the directors’ discretion, care must be taken. This can have adverse implications for tax-advantaged options, such as Enterprise Management Incentives (EMI) and Company Share Option Plans (CSOP), where applying director discretion to accelerate vesting can cause a loss of tax-advantaged status, resulting in PAYE and National Insurance contribution (NIC) charges.

How will the exercise price be funded?

Where the exercise price represents a material cost to the option holders, thought needs to be given to its funding. If the payment is pure cash, the exercise price, along with any PAYE/NIC, can typically be withheld from sale proceeds.

However, if the payment includes non-cash elements, such as shares, loan notes or earn-out rights, it can become complicated when withholding such amounts from the gross sales proceeds. In some cases, the cash consideration is not sufficient to cover the exercise price and PAYE/NIC liabilities. Therefore, it is often necessary to adjust the split of cash to non-cash consideration, for option holders to receive more cash. Where a deal includes substantial non-cash consideration, an early analysis of the net cash impact on option holders is recommended – especially for those holding unapproved options – to identify those cases where there is a cash ‘gap’.

Tax pitfalls

The immediate tax issue to consider is whether the exercise of an option creates PAYE/NIC charges. Whilst tax-advantaged options, such as EMI and CSOP, can potentially remove these liabilities, they can still be subject to PAYE/NIC in certain scenarios, such as:

EMI options granted at undervalue
EMI options subject to a disqualifying event (such as for a leaver who retains their options)
CSOP options exercised within three years of grant

A penal tax regime applies where PAYE is not correctly accounted for or recovered from the employee within the required time limits.

A review of employee options will typically be the focus of legal and tax due diligence, with appropriate warranties and indemnities then provided by the sellers.

Tax opportunities

Where conditions for Income Tax relief are met, EMI and CSOP options can provide employees with exit proceeds at Capital Gains Tax rates at 20%, or even 10%, in the case of EMI options held for two years or more.

Additionally, the exercise of employee options typically results in a Corporation Tax deduction for the employer company. This deduction is based on the market value of the shares when the options are exercised, less the exercise price paid, and is due even where the employees’ gains are not subject to Income Tax.

Where sizeable Corporation Tax deductions are due, the sellers may seek to negotiate with the buyer so that any resulting tax saving leads to additional sale proceeds being paid to them. In other words, the sellers may seek to benefit from the tax advantages by increasing the amount they receive from the sale. This negotiation would be a way for the sellers to capture some of the financial benefits that arise from the favourable tax treatment of the transaction.

How haysmacintyre can help

Our Share Schemes team has extensive experience advising from a buyer or seller’s perspective and can help with:

Sale readiness and vendor due diligence
Buyer financial and tax due diligence
Financial modelling
Tax planning for individual and corporate sellers
Post-deal tax compliance for employers and sellers

Get in touch with David Bareham, Share Schemes Director, for further advice.

Employee equity in difficult economic times

Posted on July 20, 2023September 21, 2023 by Alicia Sprott

In contrast to previous recessions however, the job market is still buoyant, with businesses finding it increasingly difficult to attract and retain talent. Against this tough economic backdrop, and to aid with talent retention, employers are looking to offer meaningful rewards and incentives to employees whilst minimising cash spend.

Use of equity incentives
Equity incentives are commonly used as an alternative to cash-based bonus schemes. The main reasons equity plans are often favoured are:

The lack up up-front cash layout for the business is appealing, where cash is generally squeezed.
The interests of the employees are better aligned with those of the owners.
Employees have a higher potential upside compared to cash-based incentives.
Equity incentives can be more tax efficient compared to cash-based incentives.

Common incentives mechanisms
Equity incentives are specific to the business in question. However, the most common mechanisms that we see are as follows:

Enterprise Management Incentives
Company Share Option Plan
Growth shares

How haysmacintyre can help
When considering equity incentives, it is vital to design and implement them with the appropriate level of care. haysmacintyre has extensive experience designing and implementing all of the aforementioned schemes and
more.

If you would like to discuss how haysmacintyre can help your business, please contact David Bareham, Share Schemes Director, or your regular haysmacintyre contact.