TT5: Reward valued employees paying only 10% tax

July 27, 2001

The 2000 Finance Act introduced an exciting new share option scheme aimed at smaller trading companies that need to help recruit or retain key employees. Following changes to the rules made by the 2001 Finance Act, the scheme was broadened to include all employees.

What makes this scheme so special is that it can be targeted at selected employees and the gains they make in respect of the options are not subject to income tax and national insurance charges when the options are exercised. Tax is only payable when the shares are sold and even then it comes under the favourable capital gains tax (CGT) regime.

Even better is that the options are treated as business assets for CGT taper relief purposes, so that if the shares are sold at least four years after the options are granted, the tax is only 10%.

Furthermore, it has recently been announced that the qualifying period for taper relief will be reduced from four years to two years for disposals taking place after 5 April 2002 .

What are the qualifications?

It is necessary to have a suitable option agreement over ordinary shares between a qualifying company and an eligible employee. Appropriate notification must be given to the Inland Revenue in the specified form and share values must be agreed with the Inland Revenues Shares Valuation Division.

To qualify a company has to satisfy various conditions: its gross assets must not exceed £15m when the options are granted; it must be a trading company; the trade must not be on the list of proscribed activities (these range from farming and property development to legal or accountancy services); the company must not be under the control of another company (if there is a holding company, the options will have to be issued by the holding company).

To be eligible, an employee must: be employed by the qualifying company or a subsidiary and must work for at least the lesser of 25 hours per week or 75% of his working time; not be connected with the company (neither he/s he, nor his/her associates taken together, can own or be entitled to acquire more that 30% of the companys capital); not have more than £100,000 worth of option shares, value being fixed by reference to the share value when the options are granted and the company cannot have more than £3m worth of unexercised options at any given time.

While this flexible and attractive scheme is aimed at smaller companies, the limits are generous bearing in mind that minority shareholdings in unquoted trading companies are valued using sizeable discounts, thus the £100,000 limit should rarely be a problem. The real attraction is the 10% rate of tax on potentially substantial gains that could be made if the company is sold .

Barnes Roffe Topical Tips

  • This is a tax efficient, low-cost way of incentivising a company’s workforce.
  • It can be targeted at selected employees or can be used to motivate large groups of workers.
  • Different conditions and performance criteria can be applied to different individuals.
  • The trigger for the exercise of the options can be linked to a sale or flotation of the company, so employees who leave before get no benefit.
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