Incentives for Senior Executives of Quoted Companies
Most UK quoted companies have made annual incentive awards to selected senior executives in the form of either, or both, share options and so-called LTIPs (Long term incentive plans).
LTIPs have taken the form of either:
(a) contingent share awards - that is, a deferred and conditional award of a given number of shares which may vest (i.e. to which the executive becomes unconditionally entitled) after, typically, 3 years to the extent that performance targets, relating to the corporate performance of the company, are met; or
(b) nil-cost option awards - that is, the grant of an option to acquire a given maximum number of shares at no, or only nominal, cost payable on exercise, the option becoming exercisable (to the extent that performance targets are met) after 3 years and remaining exercisable at the decision of the optionholder for a period of up to ten years from grant. By contrast with a contingent share award, the decision as to when to exercise the option once it has vested will typically be that of the option holder.
In some cases, executives may be awarded shares at the outset of the performance period, but on terms that such shares will be forfeited to the extent that performance targets are not met. In the UK these are sometimes referred to as restricted share awards. An executive to whom such shares are awarded may, typically, choose to elect to be charged to income tax and NICs on the initial value of the shares - with future growth charged to CGT - or wait until they vest and then be charged to income tax/NICs on what could be a substantially greater amount.
Share options are, often, granted as HMRC-approved Company share option plans (CSOP) options up to the first £30,000 of value (of the option shares as at the date(s) of grant), and otherwise as unapproved share options. In either case, such options are invariably granted with an exercise price equal to the market value of the option shares at the time of grant so that the executive only benefits from future growth in value (by contrast with an LTIP award under which he derives the full value of the vested shares). If a CSOP option is exercised more than 3 years after grant, or within 6 months of leaving by reason of injury, disability, redundancy, retirement or take-over, there is no charge to income tax or NICs on the option gain. Instead, any growth in value over the exercise price is charged to CGT when the option shares are sold.
In all other cases, income tax and NICs are charged under PAYE on the option gain at the time of exercise of the option, whether or not the option shares are then sold. In some cases, the grantor reserves the right to satisfy its obligation to issue or transfer shares on payment of the exercise price, by simply procuring payment of a cash sum equal to the gain, or by procuring the transfer from an employees' share trust of shares equal in value to the amount of the option gain - thereby reducing the dilutive effect of issuing new shares at an undervalue which are likely to be immediately sold into the market.
Deferred share bonus plans
These take a variety of forms but, in essence, involve an executive opting, or being obliged, to take some or all of his annual bonus in the form of shares ("bonus shares") which, if retained for a given period (typically up to 3 years), and if further performance targets are met, will then be matched by an award of additional shares. The shares first acquired are normally purchased or subscribed at market value using net of tax bonus, but the additional shares are normally matched against the number of shares which could have been acquired had the gross amount of bonus been invested. Income tax and NICs is payable on the value of the additional shares at the time they are transferred.
There may be a tension between the desire to avoid increased rates of future income tax and NICs by acquiring the shares out of net bonus, and the commercial need (driven by changes in good corporate governance) to provide for forfeiture of the bonus shares if the actions for which the bonus was first awarded prove not to have been in the best interests of shareholders. This can be addressed either by awarding the bonus shares subject to a risk of forfeiture (thereby deferring the tax point) or by providing that if the employee leaves or shares are to be forfeited, the executive will then receive back a sum sufficient to reimburse any tax they first suffered on the bonus used to acquire the forfeited shares.
A degree of tax-efficiency can be achieved by splitting the conditional entitlement to additional shares into two awards: a CSOP option or a joint share ownership award (see below) and a deferred award of a fixed amount equal to the initial value of the additional shares. In this way, the growth in value of the award shares will be charged to CGT, not income tax.
A simpler way of structuring such deferred bonuses is to invite an executive to apply his net annual bonus in the "purchase" of a joint share ownership award at a price which reflects the initial unrestricted market value of his interest as joint owner of the shares (typically in the region of 3-12% of the initial market value of the jointly owned shares). If performance targets relating to a further period of, say, 3 years are met, he or she could then also be awarded, by the plan trustee, the initial value of the jointly owned shares (which will then have accrued to the co-owner trustee).