Pett Franklin's Share Schemes Update
06 December 2018
Read our updates on the following key issues:
Recent and proposed changes to the law on Entrepreneur’s relief could effectively reduce the scope of the relief for many shareholders. The key changes are as follows:
- Disposals made on or after 6 April 2019 will be subject to a two year qualifying period instead of the current requirement for the relevant shares to have been held for at least one year;
- In addition to the requirement for shareholders to hold 5% in nominal value of the total share capital of the company as well as being entitled to at least 5% of the voting rights, the new rules require that, for disposals after 29 October 2018, the shareholder claiming relief must also have a right to receive at least 5% of distributable profits and at least 5% of the net assets of the company; and
- Effective 6 April 2019, shareholders who satisfy the 5% holding requirement in a personal company will be able to elect to crystallise their relief immediately before dilution whilst electing to defer the payment of any tax due on the subsequent date of the actual disposal.
A full analysis of the impact of the changes to the law on Entrepreneur’s Relief and what it means for shareholders and companies can be read in Stephen Woodhouse’ article recently published in the Tax Adviser—Breaking Barriers, Tax Adviser.
Accounting for Leases and its Significance for EMI and Valuations
The start of 2019 sees a new era begin for accounting for leases, with IFRS16 becoming effective for accounting periods beginning on or after that date.
The central objective of the new international accounting standard is to bring many more leased assets onto the balance sheet. In fact most leases that last more than one year, including property leases, will need to be brought onto the balance sheet under this standard.
As a result, the fair value of a leased asset will need to be calculated and recognised as an asset on the balance sheet and the matching liability will also need to be recognised. Therefore the immediate impact on the overall net assets of the company may be small.
However, this has been a controversial change and the focus of attention so far has been on its impact on the Income Statement. Instead of there being a rental expense for the use of the assets, in future this will be replaced by a depreciation or amortisation expense and a finance charge. Overall the effect on profit before tax may be quite small if the rental expense is similar to the total of the finance charge and the depreciation or amortisation. However, the impact on EBITDA – Earnings Before Interest, Tax, Depreciation and Amortisation could be substantial if there are substantial leased assets. As modern valuations are often calculated by reference to Enterprise Value, which is a multiple of EBITDA, this could have a material impact on market values and the theoretical valuations which share schemes over unquoted shares often require.
Furthermore, the increase in the gross assets of a company from recognising more leased assets on the balance sheet could mean that some companies in future will fail to qualify for EMI options because the £30 million gross assets test at grant will be breached. EIS schemes also have gross asset tests that could be effected.
Fortunately, most companies that award EMI options choose not to prepare their financial accounts under International Standards but prefer to use UK Accounting Standards, now consolidated into FRS102 or for micro-entities into FRS105. UK accounting standards are not yet taking the same approach. Instead, operating leases continue to be disclosed rather than included on the balance sheet. However, in general, UK accounting standards tend to follow changes in International Standards, so in November 2018 the Esop Centre contacted the Financial Reporting Council (FRC), which is responsible for UK accounting standards, to try to establish their intentions regarding leased asset accounting. The FRC said there was no imminent intention to apply IFRS16 principles for leased assets in UK accounting standards, but that they have not ruled out following IFRS 16 at some point in the future and will be monitoring the implementation of IFRS16. Companies that have significant leased assets which want to grant EMI options will need to monitor developments in this area.
A Very Short Guide to Joint Share Ownership Plans (JSOP)
The Joint Share Ownership Plan (JSOP) was developed in 2002 by William Franklin and David Pett (the founding Partners of Pett Franklin) and has been widely and successfully used ever since.
JSOPs are intended for companies who want to incentivise employees by allowing them to benefit from growth in value of the ordinary shares of the company in much the same way as other shareholders, for whom growth is taxed as a capital gain rather than employment income. JSOPs only deliver value if real growth is achieved, so there is an inherent alignment with shareholder interests.
Unlike some other equity incentives JSOPs do not require complex alterations to company share rights and articles.
How does a JSOP work?
The concept is as follows:
- An employee, together with a third party, the “co-owner” (usually a trust) jointly acquires shares in the company.
- However, the co-owner and the employee each sign a “joint ownership agreement” setting out how the proceeds of sale will be split between then when the shares are eventually sold.
- This will give the employee a right to only participate in value above a hurdle, while the co-owner is entitled to no more than the value at acquisition plus the hurdle if there has been growth in the value of the shares.
JSOP interests can be performance-linked and are normally subject to forfeiture conditions if an employee leaves. The agreement between the co-owners can be designed to restrict voting rights and the rights to receive dividends.
Although the legal structure and taxation is different, economically JSOPs have similarities with growth shares or premium priced options. JSOPs can also be used in conjunction with other share schemes such as CSOPs or unapproved options.
What does it mean for the employees?
The employees will be charged to income tax on the value of their JSOP interest at the time they receive it, if they do not pay market value for their interests in jointly owned shares at the start of the JSOP. This can be quite modest as the employee’s JSOP interest only acquires significant value as the company grows in value and its share price rises. The growth in value will then be charged to capital gains tax in the hands of the employee on realisation.
Valuation is key to ensure a JSOP functions as expected. The valuation methodology for JSOPs was discussed with HMRC by William Franklin from its inception and been applied consistently over many years.
JSOPs are more complex to implement than for example unapproved share options. They require a co-owner, and its acquisition of the shares has to be funded. There are also corporate tax and law issues that need to be addressed.
By its nature, a JSOP is designed to incentivise employees to work towards increasing value in a company. The underlying aim is commercial for both the employer and the employee. JSOPs, as used by our clients, are not designed to facilitate tax avoidance and in particular are not designed to be used for individuals who are not employees. This includes the case of individuals providing services via a personal service company where remuneration is guaranteed for services provided. Pett Franklin is recognised as a leader in share schemes and does not encourage and/or advise individuals or companies in the design and/or implementation of tax avoidance schemes. We are committed to promoting genuine sustained growth for our clients.
The future of Employee Ownership and Management Buyouts
Is a quiet revolution gathering pace? The Employee Ownership Association (EOA) at its recent annual 2018 conference in Birmingham estimated that there were currently about 200,000 employees in the UK working for companies with a John Lewis style ownership structure. That is a structure where the majority of the shares are owned by a trust – an Employee Ownership Trust (EOT) which holds those shares for the long-term benefit of employees as a whole. The EOA believes that could grow to 3 million by 2030.
That would be a quiet revolution in Britain’s business ownership structure and business culture and it has been significantly facilitated by farsighted legislative changes in Finance Act 2014, which abolished the dry tax charge on entrepreneurs who sell their business to an EOT.
We are finding that a sale to an EOT appeals to many retiring entrepreneurs who are concerned with preserving the independence and values of the business they created and are willing to be patient in securing value for their retirement from the business they created.
The removal of the dry tax charge on the sale of the EOT, which is actually tax free (apart from stamp duty), also means that a sale to an EOT can make good financial sense and offers a new way of achieving employee and management buyouts. We would expect many more entrepreneurs and partnerships to follow this business model and convert into EOTs in the years ahead as its advantages become better understood.
As specialist employee ownership and share schemes advisers, with a uniquely integrated legal, accounting, tax and valuation practice we offer a practical, experienced and integrated approach to help companies convert to EOT ownership. Read about some of the EOT transactions we have advised on here.
Labour Proposals for Executive Remuneration
In November 2018, while the attention of the business world was focused on the latest stages of the UK government’s attempt to exit the EU, and the worldwide threat of rising protectionism and Trump inspired Trade Wars, a policy proposal from Labour for Executive Remuneration received little attention. This is a different and separate policy proposal from the 10% in 10 years of company shares to be owned by Inclusive Ownership Trusts which the Shadow Chancellor revealed at the 2018 Labour Party Conference.
The proposals for Executive Remuneration are set out in a report commissioned by the Shadow Chancellor John McDonnell and the Shadow Business Secretary Rebecca Long-Bailey and were prepared by a group of academic accountants and lawyers. They are not official Labour Party policy, but the proposals were warmly welcomed by Mr McDonnell and Mrs Long-Bailey. The report is available for download here.
They propose very radical changes to the setting of Executive Remuneration to curb what the report describes as “undeserved remuneration” and deal with a “Policy failure to check executive pay and secure an equitable distribution of income”.
The proposals include many specific changes which, through legislation and changes in codes, would radically alter the way Executive Remuneration was set for the UK’s 7000 largest companies and groups - essentially businesses that employ more than 250 people. The scope of these changes would extend to partnerships and charities.
Company Law would be changed to require employee and customer stakeholders to be involved in the process of setting Executive Remuneration, not just the directors and shareholders. Through legislation, these stakeholders could have the power to set an upper limit cap on Total Executive Remuneration.
Company Law would be changed to provide for legislation to clawback Executive Remuneration. “Golden handshakes, hellos, handcuffs, parachutes, goodbyes and severance” would be prohibited.
The use of company shares to remunerate executives is seen as contributing to “undeserved remuneration” and a lack of transparency and understand-ability in Executive Remuneration which prevents control of Executive Remuneration. Therefore, in order for the Total Executive Remuneration cap to operate, it is proposed that all Executive Remuneration should normally only be paid in cash, and that company equity should only exceptionally be available for Executive Remuneration if the share schemes are also offered on the same terms to all employees.
If an individual’s annual Total Remuneration exceeds £1 million per annum then remuneration in excess of this would not be eligible for corporation tax relief.
Remuneration to any employee in excess of £150,000 per annum would need to be disclosed in the annual accounts in bands of £10,000 with each individual named. Persistent failure to comply with Minimum or Living Wage legislation would lead to criminal charges on the directors and personal minimum fines equal to the Executive’s Remuneration.
These proposals would be enforced by a combination of legislative changes and new Codes of Conduct which would be monitored by a new Companies Commission. This would replace voluntary organisations such as the Financial Reporting Council (FRC) which are considered to have “failed”. A separate report on the future Companies Commission and how it would oversee and enforce UK Company Law and corporate governance is also being prepared.
Given the present state of the government and British politics, as government and political parties seek to respond to the 2016 Referendum result, it may be unwise to assume that proposals along at least some of these lines will never be implemented.
Pett, Franklin & Co. LLP are experts in employee share schemes, executive incentives and share valuation. To find out more about we how we can help you or your client, please contact William Franklin on firstname.lastname@example.org or call 0121 348 7878.