Companies generally consider it a good idea for employees to be stakeholders in the business in which they work and believe share-based incentives offer the ability to reward, motivate and retain key staff.
There are various ways in which employees of private UK companies can receive share incentives (i.e., an equity stake in their employer): either through the grant of options or as a direct award of shares. Commercial, cultural and tax considerations often dictate which route is chosen.
Tax advantaged options
Enterprise Management Incentive (“EMI”)
Enterprise Management Incentive (“EMI”) options are ideal for small independent companies with a UK presence and gross assets below £30m wishing to incentivise employees with equity. EMI options are tax-efficient, easy to implement and companies have flexibility regarding the terms by which the options will become exercisable: time, performance or exit-dependent with the ability to include good/bad leaver provisions.
The maximum entitlement of an individual EMI option holder at the date of grant of the EMI option is £250,000 (based on the value of the shares). There should be no tax charge in respect of the exercise of the option for either the employee or the employer if the exercise price is set at market value (generally agreed in advance with HMRC).
On a subsequent sale of the shares there will be a charge to capital gains tax on the difference between the disposal proceeds less the exercise price of the option. The employee can use their annual allowance and, if an EMI option holder satisfies the two year holding requirement between grant of option and disposal of shares, business asset disposal relief can reduce the rate of capital gains tax payable to 10% (for gains up to a lifetime limit).
Most venture-backed startup companies structure their equity incentives as an EMI option scheme whenever it is available.
Company Share Option Plan (“CSOP”)
For companies that have outgrown EMI, the Company Share Option Plan (“CSOP”) is a discretionary tax-advantaged plan under which options can be granted to eligible employees. The exercise price of a CSOP option £30,000 must not be less than its market value at the time of grant and for unlisted companies the market value must be agreed in advance with HMRC.
As of 6 April 2023, the maximum entitlement of an individual CSOP option holder at the date of grant of the CSOP option is £60,000 (based on the value of the shares).
There is no income tax liability on exercise of a CSOP option if the date of exercise is at least three years from the date of grant or if the right to exercise arises because of the option holder ceasing employment due to disability, injury, redundancy or retirement and the option is exercised within six months of leaving, or on certain corporate events.
Non-tax advantaged options
Options granted outside of a tax-advantaged arrangement are subject to income tax (and potentially National Insurance Contributions) on the “spread” at exercise and capital gains tax on any further profit at sale.
Although offering no tax efficiencies, these arrangements are flexible and simple to understand and operate.
Awards of Shares
Awards of shares to employees can be subject to time vesting, performance conditions and good/bad leaver provisions just like options.
There will be an income tax charge on acquisition if the employee pays less than market value.
If the shares are subject to restrictions (such as vesting) the employee and employer would usually enter into a section 431 election within 14 days of acquisition to avoid adverse post-acquisition income tax charges as the restrictions lift. Any profit on sale should then be subject to capital gains tax.
Companies often create a new class of “hurdle” or “growth” shares which entitle the employee-shareholders to a percentage of the proceeds on an exit of the company above a pre-determined hurdle value (greater than current value). Given the hurdle, these shares should have a very low market value at acquisition and can therefore be acquired by the individual without much cost. Any profit on sale (at the exit) should then be subject to capital gains tax.
Learn more about equity incentives for US companies in Establishing the Ownership Culture: Stock vs Options.
Last reviewed: March 7, 2023