A company may decide to gift shares to an employee(s) for different reasons. For example, you may wish to reward a particular employee’s recent performance or continued loyalty to your company, or you may do this with more corporate or commercial reasons in mind such as wanting to incentivise and motivate employees to invest their time and skills in helping to grow and build the company’s business.

Employees will be keen to accept shares in the company as a gift due to the tax benefits. Rather than any profits made on the sale of such shares being subject to income tax and national insurance contributions, the gifted shares attract Capital Gains Tax (“CGT”). This is because the gain on any sale or transfer of the shares by the employee is taxed as capital.

CGT rates are lower than Income Tax rates at 20% or even 10% if Entrepreneurs’ Relief (“ER”) applies. The liability to pay the tax will rest with the employee, not the employer.

How to gift shares to your employees

When a company is contemplating gifting shares to its employees, there are various ways it could go about doing this.

The company could decide to issue completely new shares or ask shareholders to transfer existing shares already owned by them to the employees. Unfortunately, the latter constitutes a disposal for CGT purposes, and ultimately the attractiveness of transferring existing shares over issuing new shares depends on the CGT bill resulting from the transfer.

In terms of price, the board of the company could determine a value for the shares or the employees could be given the shares completely free or at some discounted value.

If shareholders agree to transfer some of their existing shareholding as gifts to employees, they should be informed that the employees would then receive dividends at the same rate as the shareholder who gifted the shares.

Existing shareholders may prefer to gift some of their existing shareholding to the employees as using existing shares means that other shareholders do not suffer from any dilution (which would be the case if new shares were issued in the company and gifted to the employees).

On the other hand, issuing new shares has benefits in that no CGT will arise or be charged for the existing shareholder and the company could create a new class of shares for the employees receiving the gifted shares. This may help to keep existing shareholders happy as it would mean that the company could give the employee shares a lower dividend rate when compared to the existing shareholders’ dividend rate.

Enterprise Management Incentives (“EMI”)

Employee share incentive plans provide employers with a tax-efficient way to remunerate their employees and given that employees are more incentivised to stay with a company if they own shares in it, share incentives can often help reduce employment costs.

Share incentives can also help to align the interests of the company’s owners and its employees as both will be more united in wanting to build long-term shareholder value through growing the business in the expectation that everyone will eventually benefit from an exit event.

Qualifying companies can set up an EMI scheme whereby options are granted over shares, worth up to £250,000 per employee up to a cap of £3 million for the company, to eligible employees.

Particularly for start-ups, share options can be an important part of the package in attracting high calibre employees who can be persuaded to join a company for a lower cash salary when they see the potential for realising a significant capital gain in the future, i.e. on an exit event when their EMI options will commonly be exercised.

The company and the employee receiving the gift of shares will need to meet HMRC reporting obligations. As mentioned, employees are responsible for paying any tax arising in respect of shares gifted to them by their employer and must report the gift of shares to HMRC on their tax return (deadlines will apply). Employers have to report the award of shares to employees by 6 July each year following the award, and reporting is done via the PAYE reporting portal.

A number of statutory requirements must be met in order for a company to qualify to grant EMI options. In particular, a company must be an independent trading company with gross assets of no more than £30 million and fewer than 250 full-time employees. Certain trading activities will not qualify and there are detailed rules relating to the independence requirement, the trading requirement and the shares that can be used not detailed in this blog post.

The shares granted to employees under an EMI share option scheme must meet certain requirements, including that the shares must be fully paid up, ordinary shares.

To be eligible to be granted an EMI option, an employee must work for the company for at least 25 hours per week, or if less, 75% of their working time. Employees cannot be granted EMI options if they, or their “associates”, have a “material interest” in the company whose shares are used for the scheme, or in certain related companies.

A material interest is either:

A)    beneficial ownership of, or the ability to control directly or indirectly, more than 30% of the ordinary share capital of the company, or

B)    where the company is a close company, possession of or entitlement to acquire rights that would give 30% of the assets, if the company were to be wound up, and make them available for distribution among the participators.

EMI options can only be granted to employees and cannot be granted to non-executive directors or consultants, although you can choose to grant non-qualifying options to such employees.

The EMI options must be capable of being exercised within ten years of the date of grant.

It is best practice for EMI option agreements to specify exactly when options will lapse, particularly at the end of a window period for exercise.

Points to be aware of when gifting shares to employees

Gifting shares to employees involves an element of risk and therefore it is always advisable to seek professional advice when wishing to do this and to make sure that the company’s articles of association and any shareholders’ agreement include provisions to protect the company’s shareholders.

One of the risks for the company gifting shares is that the employee they gift the shares to may ultimately cease working for the company (note that this will usually result in the options lapsing). If the employee was a valued member of staff, the directors may not want that employee to have to relinquish their shareholding in the company just because they are no longer an employee. On the other hand, the directors may want certain employees to relinquish their shares in the company and not continue to benefit from the prosperity of the company because of the circumstances surrounding the termination of their employment.

It is possible, and common in practice, to address these risks attaching to the gifting of shares to employees through good leaver and bad leaver provisions in a shareholders’ agreement or within the legal documentation governing the EMI share option scheme. An employee will usually be classed as a good leaver if they leave employment on the grounds of death or disability.

Alternatively, the existing management / directors may view an employee as a good leaver because they have worked for the company for a significant amount of time and therefore want that employee to continue to benefit despite no longer being an employee of the company.

A bad leaver is usually defined as any employee that does not come within the good leaver definition. An employee will also often be determined to be a bad leaver if they leave in circumstances justifying dismissal e.g. gross misconduct.

Another risk when gifting shares to employees is that the situation may arise whereby some shareholders wish to sell their shares on an exit event, but others do not. This risk can be addressed by inserting drag along rights into the company’s articles of association. A drag along right means that if a majority of the shareholders wish to transfer all (not some) of their shares to a bona fide purchaser on arm’s length terms, this majority can require all other minority shareholders to sell and transfer all of their shares to the proposed buyer as well.

Tax issues

Once an employee exercises their shares and they subsequently sell or transfer the shares on to a third party at a profit, the employee will then be liable to pay CGT as they will be in receipt of a capital gain.

If the employee finds that they are liable to pay CGT in relation to the gifted shares, they should consider whether they qualify for ER, which would bring the CGT rate down to 10% (from the usual 20% rate).

The employee will qualify for ER if the shares are held for at least 12 months from the date they were granted the shares to the date they sell them.

The employer could issue the relevant employee a bonus which the employee could then use to meet any income tax and national insurance liability in relation to the gifted shares. Although the bonus payments made by the company will attract income tax liability for the employee and national insurance contributions for both the employee and employer, this may be offset by the fact that the bonus payments will help to decrease the company’s corporation tax liabilities as the bonus payment is an allowable deduction against trading profits.

For the employee, the tax treatment of an EMI qualifying option is as follows:

At the point of grant, there is no income tax liability.

At the point of exercise, there is no income tax liability if the exercise price was at least equal to the market value of the shares at grant. If the exercise price was less than the market value of the shares at grant, then income tax is due on the difference between the exercise price and the market value at grant.

On a disposal of the option shares, CGT may be payable on any gain over the market value at grant, that is, the difference between the sale proceeds and the market value of the shares at grant.

Valuation of Shares

The exercise price of an EMI option can be set at any value and can be nil if option shares are not newly issued.

Setting an exercise price that is less than market value at grant has consequences for the tax treatment of the EMI option on exercise, as mentioned above. The exercise price is usually agreed with HMRC at the outset before the options are granted.

The Shares and Assets Valuations (“SAV”) team is the specialist department within HMRC that will value, amongst other things, unquoted shares for tax purposes.

The SAV must be sure to carry out valuations for tax purposes on the basis of ‘market value’ as defined in the relevant statute.

The definition of market value for CGT can be found in section 272(1) of the Taxation of Chargeable Gains Act (“TCGA”) 1992, which provides as follows: “In this Act “market value” in relation to any assets means the price which those assets might reasonably be expected to fetch on a sale in the open market”.

As part of the valuation process, you will most likely be required to prepare and submit a valuation of assets to HMRC’s SAV team.

Get in touch here if you would like to find out more.