Open consultation

In May, the Department of Finance announced a six-week consultation on the taxation treatment of share based remuneration. This announcement stems from the Programme for a Partnership Government, and comprises a formal consultation to review ways to more effectively incentivise entrepreneurship. The intention is that the consultation will consider and identify possible changes to the current system for taxing gains on shares received by employees from their employers. Submissions are due by 1 July 2016.

The consultation process has two objectives:

1. To review the current Revenue approved share schemes and the taxation treatment applying to them. This will help determine if they are fit for purpose in the current economic environment or whether they are misaligned with the business environment and need to be changed.
2. Submissions received will be reviewed to determine if it is feasible, within the parameters of policy, for new share based remuneration incentives to be introduced.

The significance of the second objective should not be overlooked. In a tax environment which is dominated by BEPS and the EU Commission, any potential incentive to be introduced needs to be considered carefully in the context of State Aid provisions. Additionally, from an economic perspective, due consideration needs to be given to the impact any changes will have on the Exchequer, employment creation and economic growth.

Potentially a good thing?

While we are only at the starting point and it is too early to tell what will happen, if the underlying intention of the consultation is to potentially introduce a more effective mechanism to remunerate employees, this has the potential to be positive. At a fundamental level, the typical rationale for offering shares to employees in a company is to attract and retain key talent. Aligning the goals and fortunes of the company with that of key employees should, in theory, result in lower rates of attrition, improved employee buy-in and increased motivation.

From an economic perspective, some of the earlier proponents of employee share schemes believed that capitalism’s viability depended upon continued growth. To achieve this, economies could grow by distributing the benefits of that growth to the workforce.

Unfortunately, the tax code as currently drafted is not SME friendly. The tax treatment applied to share incentive plans imposes considerable restrictions on SMEs attracting and retaining highly skilled employees. This is on the basis that income tax, USC and PRSI are typically triggered on the exercise of a share option. While the employee may now have an interest in the company, they are faced with coming up with the funds to discharge the tax liability that arises. Employees in multinational companies have the potential to sell some of the shares acquired to discharge the tax. However, for SMEs there may not be a market for the shares or they may be precluded under a Shareholder Agreement from selling the shares until the occurrence of a crystallising event (e.g. sale of the business).

So how could we potentially address this issue? Our nearest neighbor, the UK, has a number of schemes where employees can receive shares free/opt to buy shares with favourable income tax consequences at the outset if certain conditions are met. These shares schemes, in some cases, also have favourable capital gains tax provisions on a subsequent sale of the shares. Furthermore, the rates of CGT in the UK will fall to 10% or 20% from 6 April 2016 when the Finance Bill 2016 receives Royal Assent.

The introduction of similar arrangements in the Irish tax system would assist SMEs in attracting key hires and competing with larger multinational employers who have a presence in Ireland. In terms of capping the potential capital gains tax arising on a future sale of the shares, it would be interesting to see if this could be interlinked with the 20% CGT rate introduced this year for entrepreneurs.

Overview of current treatment

The taxation treatment to be adopted depends on the nature of the scheme and whether it is Revenue approved or not. A high level overview of the most common schemes is set out below.

Unapproved Share Option Scheme

Income tax and USC are charged on the difference between the option price and the market price when the option is exercised (assuming we are dealing with a short option). Where the option was granted on or after 1 January 2011, there is also employee PRSI (4%) charged on exercise. Employer PRSI is not charged.

Income tax and USC due on gains realised on the exercise of options must be paid within 30 days after the date of the exercise along with the submission of a Form RTSO 1. The tax due within this 30 day period is calculated at the top rate of income tax unless the employee can prove to Revenue that he will not be a top rate taxpayer for that year. The 3% USC surcharge is not imposed. The tax is payable on a self-assessment basis and failure to comply will lead to interest being imposed.

If the shares appreciate in value between the date of exercise and disposal, the gain realised may be subject to CGT. The gain will be taxable at the rate of 33%.

Save as you Earn (“SAYE”) Option Scheme

Under a Revenue approved SAYE all employees and full-time directors of the company establishing the scheme who have been employees/directors for a specified period not exceeding three years, must be eligible to participate in the scheme on similar terms. This may not be appropriate from a practical perspective as the company may wish to incentivise a specific pool of employees as opposed to all employees.

Gains arising on the exercise of a relevant share option are brought within the definition of “relevant emoluments” for USC purposes. While such gains continue to be exempt from income tax, the employer is liable to deduct and pay USC via the payroll system when the options are exercised. Companies operating the SAYE scheme will not be obliged to make such payroll deductions where the employee exercising the option is no longer an employee. In such instances, the USC will be payable by the former employee on a self-assessment basis.

PRSI due on gains realised as a consequence of the exercise of a right must also be deducted by the employer and remitted to the Collector General. If a gain is realised by a former employee, PRSI is to be paid by the individual directly to the Department of Social Protection through the special collection system.

A charge to CGT will arise on gains realised on the disposal of the shares. The base cost for CGT purposes will be the amount paid i.e. the option price on acquisition. The current rate of CGT is 33%.

Approved Profit Sharing Scheme

Under an approved profit sharing scheme, employees can benefit by receiving a potentially income tax free stake in the company’s success through increasing share value. The employer has an opportunity to offer a tax effective incentive linked to profitability and align the work forces interests with those of the company. All employees and full-time directors of the company establishing the scheme, who have been employed for a specified period of no more than three years, must be allowed to participate on similar terms.

Under an approved profit sharing scheme, USC and PRSI are levied on the Initial Market Value (IMV) of the shares that are appropriated in lieu of salary foregone. However, Revenue permit employers (at their discretion) to deduct USC and PRSI when the salary is foregone.

In the first instance, the responsibility for the deduction and payment of the USC and PRSI rests with the employer. From the employer’s perspective, the deduction should ideally be done when funds are being given to the trustees to purchase shares. The chargeable value is the IMV of the shares that are to be appropriated to the scheme participants.

Continuing changes

One could potentially say that 2008 was the year in which SMEs, and by default employees with share schemes, began to experience a higher tax cost. The CGT rate increased from 20% to 22% in October 2008. This was the beginning of the gradual increase in the rate of CGT to today’s rate of 33%. However the 2008 increase, while important, did not have had an immediate effect on people. After all, who was making capital gains in 2008? The introduction of the 20% CGT rate in January 2016 for entrepreneurs is a welcomed development. However, this reduced rate is unlikely to be available for many employees due to the minimum 5% shareholding requirement. A 33% rate is arguably too high.

In 2010, the curtailment of tax relief on interest incurred on money borrowed to fund the purchase of shares was introduced. Tax relief on interest as a charge helped to reduce the cost for employees of acquiring a shareholding in their employer company. Significant anti-avoidance provisions and the High Income Earners Restriction had previously been brought in to prevent the abuse of reliefs such as this. The abolition of the tax relief on interest as a charge not only resulted in making shares more expensive for employees, it also resulted in companies having one less alternative source of finance (i.e. share issues).

The manner in which PRSI is applied is somewhat of an anomaly. Employee PRSI applies to all share based remuneration. However, the same remuneration is exempt from employer PRSI. While this is a beneficial saving for employers (10.75%), it is another layer of cost for the employee. This helps to push the marginal rate of employee taxation to 52%.

Conclusion

Share based remuneration has always been a useful mechanism to attract, retain and align key employees with employers. However, for the most part it has been used by multinationals. While some SMEs are interested in offering shares to employees, the current employee tax treatment of share options or shares awarded undermines the benefit granted. The resulting tax costs can be perceived by employees as burdensome – how to I pay for this?

Given the importance of SMEs in the Irish economy, it is important that our legislation is fit for purpose. Helping SMEs will only result in ideation, creativity, productivity and growth. While a positive step was taken with the introduction of the 20% CGT rate for qualifying entrepreneurs, it is hoped that further advancements will be made in October’s Budget to assist this important Irish sector.

Cormac Kelleher is a Tax Director with Mazars.

Email: ckelleher@mazars.ie