The current UK government has made a virtue out of cutting red tape from business. As a part of that agenda, 1^st September 2013 saw the introduction of the Employer Shareholder Status (ESS), a new employment status that offers current or potential employees the opportunity to exchange certain statutory employee rights for tax advantaged shares worth between £2,000 and £50,000. Interestingly, while ESS applies to England, Scotland and Wales, it is not in force in Northern Ireland. This is because the rules require changes to both tax law and employment law. Northern Ireland employment law has been devolved to the local administration, and it has not legislated on the matter. At present the Department of Employment and Learning has indicated that it has no plans to consult on this issue.

Initially proposed at the Conservative Party Conference in October 2012, the ESS scheme is intended to support and nurture “fast growing small and medium companies that want to create a flexible workforce”. It has been trumpeted as clear evidence that “Britain is open for business”. The reality is that the scheme has experienced a slow pick up.

The arrangements are not without critics many of whom believe them to be an attack on what they see as essential employee rights. This article will focus on the arrangements as announced and leave those arguments for others to debate.

The defining attribute of ESS status is that any gain realised on the disposal of ESS shares is fully exempt from capital gains tax. The advantage is obvious in comparison to a 10% tax rate offered by its nearest associate, the EMI scheme in conjunction with Entrepreneur’s Relief, or the standard 28% rate that would be imposed on a higher rate tax payer without ESS or Entrepreneur’s Relief. Consider the 47% combined rate for additional rate payers on earnings and the contrast becomes even clearer.

However, in order to avail of this preferential tax treatment, stringent conditions must be complied with.

Conditions

The employee shareholder is a clear and separate status from that held by ordinary employees; not only are these individuals shareholders but they also possess very distinct rights from the rest of the workforce. In exchange for tax advantaged shares employee shareholders forsake the right to, among others:

• Sue for unfair dismissal
• Statutory redundancy pay
• Request flexible working and time off to train

All this must be clearly communicated to and considered by the employee and must be strictly adhered to in order to qualify for ESS and benefit from the associated tax advantages.

All particulars of the employee shareholder’s contract and new shares must be communicated to the individual via a written agreement; with all the relevant conditions clearly outlined. When considering this offer, the individual must be provided with independent legal advice financed by the employer. HMRC has confirmed that no BIK will arise from the provision of this advice. Following receipt of this agreement and such advice, a mandatory seven day cooling off period must be observed.

Shares

These stringent conditions extend to the shares which are provided to the individual upon acceptance. They must be ordinary, newly allotted and fully paid up but can however be redeemable and of a separate class to currently issued shares. The employer can also exercise discretion over dividend and voting rights.

A minimum of £2,000 worth of undiscounted shares must be provided to the employee when transitioning to employer shareholder status. It is essential that no consideration whatsoever is provided by the employee. The allotment is referred to as the employee’s “deemed payment” in exchange for the rights renounced. No charge to income tax or national insurance arises on the granting of shares of this amount, however any amount above this will be taxable as earnings subject to income tax.

These prerequisites when taken as a whole create a complex path to employee shareholder status. All must be met. Given the complex subject matter, it is likely that prospective employers may require externally provided advice in the fields of tax, share valuation and employment law. As a result of this additional burden and the fact that employees are under no obligation to accept following this process, it is unlikely that ESS will become mainstream. However, given the significant upside, for a niche segment of employers and employees this will be a highly attractive mode of share transfer.

Assessing the Suitability of the Schemem

It is evident that in order to fully harness the maximum potential of this structure, ESS should be executed in a way where the upfront charge to income tax is minimised with a view to maximising any future capital potential. As a result, the share valuation process is a critical concern and should be afforded careful deliberation when assessing the feasibility of implementation. The implications of such considerations are outlined below. Beneficially, HMRC has confirmed that it aims to agree valuation prior to the allocation of shares to employee shareholders. Such valuations should be available approximately 4 weeks following the submission of all necessary information to HMRC and will stand for 60 days.

The provision of £2,000 worth of shares to the employee shareholder as “deemed payment” is a non-negotiable requirement of the status and so presents an initial hurdle to many employers. On one hand, this figure may prove problematic for nascent companies or those that are currently loss making as these companies may struggle to reach this valuation particularly where relatively small allocations of shares are made. Further to this, as the shares must be allotted fully paid up this will likely be facilitated by the capitalisation of reserves which may not be an option for many start-ups. At the other end of the spectrum, mature large or public companies may find this income tax and national insurance free amount to be insufficient to provide their employees with an attractive incentive.

Considering these parameters of ESS, developing private companies that are experiencing their first signs of growth emerge as the prime candidates to employ this new status and reap the maximum benefits of the associated tax treatment. These companies are in a position to offer shares to their employees when they have minimal market value and maximum growth potential.

Opportunities and Pitfalls

• A corporate tax deduction is available in respect of the total of the employee’s taxable value on acquisition of shares and the £2,000 deemed payment. Further to this, under ESS the buy-back of shares is not considered to be a distribution from the company. Such distributions are usually taxed at up to 30.56%.
• To date HMRC has only released guidance on the income tax element of ESS with CGT guidance to follow. However it has become clear that No Gain No Loss transfers normally enjoyed between spouses will not be available under this arrangement.
• The £2,000 deemed payment and CGT exemption is unavailable to those with a material interest (>25%) and their connected parties.
• Careful consideration should be given to reorganisation or refinancing as the implementation of a new holdco may trigger a disposal for ESS purposes. Any subsequent disposals of shares in the new holdco are then likely to be subject to CGT.
• Existing company share plans can be replaced or supplemented by ESS where suitable. This may be particularly attractive for employers who are currently operating unapproved schemes.
• For companies wishing to take a cautious approach with respect to retrospective legislation, this can be implemented in conjunction with EMI as a “top up” or Entrepreneur’s Relief planning.
• Unlike other approved schemes, ESS is not an all employee scheme and does not require a defined holding period or claw back of tax relief in any case.

Conclusion

When assessing ESS as a whole, the only definite conclusion available is that this is not a one-size-fits-all arrangement. While the additional burden of the complex offer and acceptance process may be significant, as outlined above, in certain circumstances this may be a relatively small price to pay for “free” shares and tax free capital growth.

One aspect that will apply to all employers, and employees being offered the shares, is that this is not a decision to be taken lightly and should be afforded real and concerted consideration before any steps are taken.

Vincent Adams is a Senior Tax Manager with EY

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