Evolving Legislation - ARTHUR SELLWOOD outlines the progress of legislation regarding employee share ownership plans

Evolving Legislation

Arthur Sellwood outlines the progress of legislation regarding employee share ownership plans.

Before 1978, apart from occasional, and often short lived, exceptions, there were few tax advantages to be gained by employees from the acquisition of shares or share options by way of remuneration. Even before benefits in kind were brought so much into the picture, the allotment to directors and employees of shares for less than their market value was regarded as an emolument, to the extent of the excess of that value over any payment made for the shares, under the old rules of Schedule E. This was demonstrated in Weight v Salmon 19 TC 174, Ede v Wilson 26 TC 381 and other cases.

Again the granting of an option to obtain shares in the employing company incurred a Schedule E charge on the excess of the market price of the shares at the time the option was granted over the value at which they were to be acquired. The Revenue sought to impose such a charge at the time the option was exercised when the market price had usually risen above that at the time of the grant. But the House of Lords ruled against this in Abbott v Philbin 39 TC 82. The advantage gained from this decision did not, however, last very long. Its effect was reversed in 1966 by the legislation which later became section 135, Taxes Act 1988.

Before 1965, of course, it was possible for a tax-free capital gain to be made on the increase in value of the shares at the time of disposal over their value at the time of the Schedule E change. Equally, however, there might be an unrelievable capital loss. In any case, this possible advantage disappeared with the introduction of capital gains tax by Finance Act 1965.

Further developments

The 1966 legislation tended to make share option schemes unattractive. Companies began to introduce other schemes, such as share incentive schemes, by which the employee or director became owner of partly-paid shares, or shares fully-paid with the assistance of an employers loan.

The attitude to share schemes underwent a considerable change by way of Finance Act 1972. This set up authorisation rules which enabled employers to introduce both share acquisition and share option arrangements which avoided an income tax charge on growth in capital value. Unauthorised schemes were, however, subjected to such a charge. Some further control over these unauthorised schemes came into force by way of Finance Act 1973.

The more lenient approach to authorised schemes quickly changed. Finance Act 1974 withdrew the authorisation procedures so that all share acquisition schemes became subject to the legislation which had been directed at unauthorised schemes, whilst the legislation introduced in 1966 was again applied to share option schemes.

A new climate

Public opinion was now slowly beginning to change the attitude of the Government towards the ownership of shares. The Wider Share Ownership Council had been established in 1958 to advocate the spreading of share ownership amongst a larger section of the public. The feeling was also spreading that those whose labour contributed towards the profits and prosperity of industry and commerce should be rewarded with a greater share of those profits. From the late 1970s onwards, this led to a series of much more generous provisions for the treatment of approved schemes relating to the allotment of shares and share options to employees.

These started with the so-called profit-sharing provisions of 1978 (with some considerable amendments in 1980) which are referred to in more detail below. There followed the savings related share option scheme in 1988 and a more general share option scheme in 1984. These three schemes, after further amendments – particularly in 1986 – were consolidated into sections 185 to 187 of, and Schedules 9 and 10 to, the Taxes Act 1988. In 1989, provision was made for the establishment of employee share ownership trusts the function of which was to acquire and distribute shares. Whilst the various schemes were being established, the position regarding unapproved share option schemes remained much the same as it had been before, although occasional minor changes were made.

The method of operation of the approved schemes varied according to the purpose of the scheme. The conditions for approval of, and participation in, the various schemes was somewhat similar, except that the definition of the material interest which excluded those having it from participation was more stringent in the case of the general option scheme.

The old scheme

The scheme was referred to from the start as a profit-sharing scheme and, now that it is being phased out, is still referred to in Finance Act 2000 as the 'approved profit-sharing scheme'. The term is, however, a misnomer as shares could be allocated to employees without reference to the company's profitability. Except for the tax provisions, it was not a new concept. Before it came into operation it had been the practice of some companies to allot shares to employees as additional remuneration. By all accounts, however, this did little to widen the shareholding base as employees quickly cashed in the shares they received.

The concept of employees sharing in the profits of the company for which they worked had also gained ground. Many of the unions were, however, hostile to this. They feared that, if employees shared in the profits, they might also be required to share losses when these arose. It was feared too that, where profits fluctuated, the yearly remuneration of those sharing in them would sometimes go down rather than continuing the relentless rise which was then in vogue. Possibly it was a fear of antagonising the unions which led to the form taken by this so-called profit-sharing scheme.

The original scheme had some very detailed provisions occupying nine fairly long sections of Finance Act 1978. The basic plan was for the setting up of a trusteeship to which the employer was to transfer funds to enable the trustees to acquire shares which were to be appropriated to individual employees. There was to be a retention period of five years during which control of the shares remained with the trustees and a further period of five years before the release date when the employee could dispose of his shares without incurring any income tax liability. There were rules setting out who could participate in the scheme and detailing conditions as to the shares to which the scheme applied. Many of the original requirements have been relaxed, some of them quite soon after the legislation was introduced. The retention period and the further period before the release date were considerably reduced. Originally the scheme was intended for full-time employees but, subsequently, part-time employees were allowed to participate. The basic pattern has, however, been retained.

The popularity of the scheme had, however, waned somewhat over the years, this no doubt being due in part to the increasing attractions of share option schemes. More recently, however, it was considered that there had been a trend away from option schemes in favour of what became known as long-term incentive plans. There had been no specific tax provisions relating to these, but it had been considered that no liability arose at the time of award but that there should be a tax charge at the time when the performance conditions attached to the shares were met and the employee was able to enjoy the full benefit of the shares. The Revenue, however, came round to the view that tax liability could only arise on the award of the shares. This caused difficulties for the recipients of such awards and also added to the scope for avoidance. Hence legislation was introduction by sections 50 et seq, Finance Act 1998. This made statutory the old view of when the tax charge should arise and also introduced some anti-avoidance measures. Some of the measures, however, proved impractical and further legislation was introduced by sections 42 and 43, Finance Act 1999.

Another piece inserted into this complicated jigsaw of legislation of the last thirty years is that relating to the Employee Share Ownership Trusts which have subsequently become known as QUESTS. Sections 67 et seq of, and Schedule 5 to, the Finance Act 1989 enabled companies which observed certain requirements to obtain a corporation tax deduction in respect of qualifying employees' share ownership trusts. The legislation provided for a charge to tax to claw back the relief if a 'chargeable event' occurred. Such a chargeable event would occur by way of non-qualifying transfers of securities by the trustees, by retention of shares for more than seven years and in other ways. The 1989 legislation was later amended by Finance Act 1994 and Finance Act 1996 with some minor changes in other years.

A new scheme

After publication of draft legislation and a further period of consultation, details of a new plan relating to employee share ownership were announced on Budget day, 21 March 2000. A press release (REV 3) of that date stated that the new plan was more attractive to companies and easier to operate. The SAYE share-save and the share option plan would remain in place but the old approved profit sharing scheme would cease in 2002 after which employers would have to move their old schemes into new ones. The new plan was described by the Financial Secretary as the cornerstone of a drive to tackle the productivity gap and to promote high investment.

The introduction of the new plan and other matters relating to employee share ownership legislation required ten sections (47 to 56) of Finance Act 2000 together with 130 paragraphs, some of them long and complicated, of Schedule 8 of that Act. It would be impossible in one article to cover all these details and it has been decided to devote the rest of it to one particular aspect of the new plan, viz the eligibility of individuals to participate.

A brief summary of the main other details of the plan is as follows. Two types of share are involved. 'Free shares' up to a value of £3,000 can be given to employees free of tax and National Insurance contributions in each year. Some of these can be allotted to the employees for reaching performance targets. Employees may buy the other type of shares, known as 'partnership shares', out of their pre-tax salary up to a maximum of £125 per month. Employers may give 'matching shares' (up to two free shares for each partnership share bought). The last date for application for approval of a scheme of the old type is 5 April 2001 and no deduction may be made for sums paid to the trustees of such a scheme on or after 6 April 2002. No appropriations of shares can be made under the old schemes after 31 December 2002.

Dividends on plan shares up to a total of £1,500 in any tax year may be reinvested in shares. The plan may provide that, where the company so directs, all cash dividends in respect of plan shares held on behalf of participants must be applied in acquiring further shares on their behalf, or that all cash dividends in respect of plan shares held on behalf of participants who elect to reinvest their dividends must be applied in acquiring further shares on their behalf.

Eligibility – special requirements

There is an overriding condition for approval of the new plans that every employee who:

(a) meets the eligibility requirements in relation to the award of shares under the plan, and

(b) is chargeable to tax under Case I of Schedule E in respect of the employment by reference to which he satisfies the employment requirement mentioned below,

is eligible to participate in the awards made and is invited to do so. Where an employee meets the necessary requirements under (a) above but is not chargeable to tax as under (b), he may be invited to participate. The plan must not contain any feature which has, or would have, the effect of discouraging any description of employee who is eligible from participating in awards.

It is further required that every employee who is invited to participate in an award and actually does so must be invited to do so, and must actually do so on the same terms. But the award of free shares by reference to an employee's remuneration, length of service or hours worked does not infringe this requirement. If the award is by reference to more than one of these factors, each factor must give rise to a separate entitlement related to that particular factor and the total entitlement must be the sum of those separate entitlements. Where the award of shares provides for performance allowances, there are special rules.

No feature of the plan is to have, or be likely to have, the effect of conferring benefits wholly or mainly on directors or higher-paid employees. It must not be possible to manipulate group schemes in favour of directors or higher-paid employees.

The arrangements for the plan must not many any provision, or be associated with any provision, for loans to some or all of the employees of the company or, in the case of group plans, of any participating company. There is a similar provision in the case of the existing approved profit-sharing schemes.

Eligibility of individuals

Eligibility requirements have to be met at a specified time. In the case of free shares, the employee must be eligible to participate in the award at the time it is made. The position with regard to partnership shares is more complicated. There may be an accumulation period. If there is not, the individual must be eligible to participate in the award at the time the share money relating to the award is deducted from his remuneration. Where the plan provides for an accumulation period, this must not exceed twelve months and its length and the dates on which it begins and ends must be specified in the partnership share agreement. Such an accumulation period allows for amounts deducted to be accumulated and applied as a lump sum in purchasing shares. Where there is such a period, the individual must be eligible to participate in the award at the time of the first deduction of partnership share money relating to the award. For 'matching shares' the eligibility date is that for the underlying partnership shares to which the matching shares are related. The eligibility requirements fall under three headings as shown below.

The employment requirement

Reference to this requirement has been made in an earlier paragraph. The plan must provide that an individual is not eligible to participate in an award unless he is an employee of the company or, in the case of a group plan, of a participating company. If the plan provides for a qualifying period, the individual must, at all times during that period, have been an employee of the company (or of a participating company in a group plan). It is possible for a plan to require that a person should have been an employee for a specified period before qualifying for participation. For free shares, this period must not exceed eighteen months. In the case of partnership or matching shares, when the plan does not provide for an accumulation period, the qualifying period must again not exceed eighteen months ending with the deduction of the partnership share money relating to the award. If an accumulation period is provided, the qualifying period must not exceed six months ending at the beginning of the accumulation period relating to the award.

Different qualifying periods may be specified for different awards of shares as long as each such qualifying period is within the permitted maximum specified above. But, for any award, the same qualifying period must apply to all employees of the company (or of participating companies in the case of a group plan).

No material interest

The previous approved profit-sharing scheme and the continuing option schemes contained provisions excluding individuals who have or, within the previous twelve months, have had a material interest in a close company.

The new employee share ownership plans must likewise provide that an individual is not eligible to participate if he has, or has within the preceding twelve months, had a material interest in a close company whose shares may be awarded under the plan or in a company which has control of such a company or is a member of a consortium which owns such a company. An individual has a material interest if he alone or he and his associate(s), with or without other associates, has such an interest. A material interest means the beneficial ownership of, or the ability to control directly or indirectly, more than 25 per cent of the ordinary share capital of the company. In the case of a close company, a material interest can also mean the entitlement to receive more than 25 per cent of the assets in a winding up. The term close company includes a company which would be close if it were resident in the United Kingdom and a company which would be close if the quoted company exemption under section 415, Taxes Act 1988 was not available.

Where a person has been granted options over shares which are to be satisfied by the issue of new shares, these new shares are to be taken into account in calculating that person's percentage of the ordinary share capital. But interests in shares held by the trustees of an approved profit-sharing scheme or an approved employee share ownership plan, as far as the shares have not been appropriated to an individual, are left out of account in such a calculation.

No other participation

There are provisions intended to prevent employees obtaining the benefit of free shares under more than one scheme. An employee cannot receive an award of free shares under an employee share ownership plan if he has had shares appropriated to him in the same year under another such plan established by the company or a company connected with it. The same applies if he has participated in the same year in an approved profit-sharing scheme established by the company or one connected with it.

A similar prohibition in respect of partnership or matching shares applies only to participation in another approved employee share ownership plan and not also to participation in an approved profit-sharing scheme.

Where a participant in a scheme is eligible for free shares which are subject to performance conditions, he is deemed to have participated in the scheme even if he fails the conditions.

The meaning of the term 'connected company' for the purpose of these requirements is set out in paragraph 16(3) of Schedule 8 to the Finance Act 2000.

Arthur Sellwood is a former Inspector of Taxes.

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