Employee share incentives for unlisted companies

Structured correctly, a share incentive programme can play a significant part in encouraging retention and achievement of long-term performance objectives in a cost-efficient manner for a company. Additionally, share-related incentives are seen by investors as a useful tool to align the interests of managers and investors.

This guide, which is aimed at companies whose shares are not listed on a stock exchange, provides an introduction to the types of share incentive plans available to such companies.

Share option or upfront share acquisition?

Employee share incentive arrangements can be categorised into two forms:

• those under which an employee is given the right to acquire shares in the future, generally following a specified period of time and/or the occurrence of an event (e.g. an exit for investors in the company), and sometimes also subject to the achievement of specified performance targets relating to the company and/or the employee (option); and
• those under which the employee acquires shares upfront with the shares possibly being subject to forfeiture should the employee leave the company within a specified period or before the occurrence of a specified event (e.g. an exit) and/or if specified performance targets relating to the company and/or the employee are not met (up-front acquisition).

Options

An option entitles the employee to shares in a company in the future, at a price per share ('exercise price') fixed when the option is granted rather when the shares are acquired. The exercise price may be fixed at, above or below market value at grant including a nil-cost exercise price (in this case, generally if the shares are transferred to the employee from an employee benefit trust).

The employee will not bear any financial risk if the shares fall in value until they decide to exercise the option and acquire the shares. Equally, until options are exercised, the employee is not a shareholder and has no right to vote at shareholder meetings or to receive any dividends.

Options are normally granted by the company but may be granted by an existing shareholder (for example, a founder) or another third party, which could be a trust.

Enterprise management incentive (EMI) options

EMI options are intended to help smaller, high-risk companies with growth potential to recruit and retain high calibre employees. If a company is eligible to grant EMI options, this type of option will generally be the most appropriate and attractive due to its tax-favoured treatment and flexibility.

EMI options allow the company to determine the exercise price (at, above or below the market value of the shares at grant), any performance-related exercise conditions and the exercise provisions, including whether the optionholder can exercise the options and acquire the shares before, or only on, an exit. An EMI option plan can be used for the grant of only one option or on more than one occasion to such numbers of employees as the company chooses, with the options granted being on the same or different terms as the company determines.

There are a number of strict legal requirements which must be satisfied in order for options to qualify as EMIs, but options which do qualify carry generous tax advantages to participants. A particular attraction of EMI options is that the gain made by the optionholder on a sale of shares acquired on the exercise of an EMI option granted 24 months before they are sold will normally be eligible for Business Asset Disposal Relief, regardless of the percentage shareholding being acquired, which would reduce the rate of capital gains tax (CGT) for additional or higher rate taxpayers to 10% for gains in excess of the optionholder's CGT annual exempt amount.

For more information on EMIs, including legal requirements and tax treatment, see our Enterprise Management Incentives guide.

Non tax-advantaged options

If a company does not qualify to grant, or an employee to receive, EMI options, or the company wants to grant options above the £250,000 individual EMI limit, it may grant options that are not tax-advantaged.

There are no specific legal or participation requirements for non tax-advantaged options, which may be granted with an exercise price below, at or above the market value of the shares at the grant date.

As with EMI options, there is no charge to tax (or NICs) on the grant of a non tax-advantaged option, but income tax (and possibly NICs) will be due on exercise, on the difference between the exercise price and the value of the shares at exercise. CGT may be due on the sale of the shares if they increase in value following exercise, subject to the employee's CGT annual exempt amount.

Company share option plan (CSOP)

Another possibility is the grant of options under a tax-advantaged CSOP.

Generally, CSOP options may only be granted over shares in a company that is independent, or whose shares are listed on a recognised stock exchange. CSOP options can be granted either by the employer or a parent company, and the shares must satisfy various requirements.

For more information on CSOPs, including legal requirements and tax treatment, see our tax-advantaged company share option plan guide.

Upfront acquisition

As an alternative to options, a company or a third party (such as a trust) may invite selected employees to acquire shares upfront. As a shareholder, the employee will have the same rights as other holders of the same class of shares to receive any dividends and to vote at shareholders' meetings and will also bear the full financial risk that the shares may fall in value.

Unless the employee acquires the shares at market value, it is likely that income tax (and, if appropriate, NICs) will be payable on purchase and, possibly, on the subsequent disposal of the shares. That said, shares awarded to employees can be subject to restrictions (for example, preventing employees from selling the shares for a fixed period of time or requiring them to sell back or forfeit any shares should they leave the company). Restrictions like these will reduce the value of the shares and, in some circumstances, mean that income tax (and NICs) is not chargeable until the restrictions are lifted (or the shares are sold, if earlier). Equally, it may be considered appropriate for the employee to be taxed upfront on the full market value of the shares by making what is known as a "section 431 election", with any growth in value will be subject to CGT to the extent that the growth in value is in excess of the employee's CGT annual exempt amount.

Growth shares

Employees may subscribe for shares of a special (new) class, so that they benefit only from any growth in value of the company following acquisition of the shares, typically on a sale/IPO of the company, and usually where growth is above a predetermined hurdle.

On the basis that the new class of shares has no current rights or value, and there is a possibility that the company will not achieve the growth required for the employees to benefit from the shares, growth shares can have a relatively low market value when acquired by employees. Income tax (and, possibly, NICs) will be charged in the normal way to the extent the employee acquires the shares at a discount, but any growth in value will be subject to CGT to the extent that the growth in value is in excess of the employee's CGT annual exempt amount.

Growth shares can be complex, and valuation of the shares on acquisition is critical. It will usually be necessary to amend a company's articles of association in order to create a separate class of shares. However, they are a useful way of incentivising employees where shares would otherwise have a high market value, and the employee would be unwilling or unable to pay the full market value on acquisition.

ExSOP™

The Executive Joint Share Ownership Plan (ExSOP™) is a share incentive structure devised by Pinsent Masons. ExSOP™ awards grant the same financial benefit to participants as share options, delivering any growth in value of the shares - however, the ExSOP™ does this without transferring full legal ownership of the shares to the participant. This means that, after an initial upfront income tax (and possibly NICs) charge on the participant, only CGT will be payable on any growth in value to the extent that that growth is in excess of the employee's CGT annual exempt amount.

As the participant in an ExSOP™ would normally hold an interest in the award shares, rather than the full legal ownership (title), the day-to-day administration of the ExSOP™ would be simpler than for direct share purchase. The full legal title to the shares is usually held by an employee benefit trust.

ExSOP™ can be used as a "top up" to EMI limits, or as an alternative to non tax-advantaged share options for companies or individuals who do not qualify for EMIs. It also has advantages where the shares have a high market value, and the employee would be unwilling or unable to pay the full market value for the shares.

Employees benefit trusts

Unlisted companies often use trusts as part of their share incentive arrangements. These can be funded by the company either to initially obtain (subscribe for) shares or, more frequently, to purchase or acquire shares from departing shareholders. These shares can then be used to satisfy more share options; be sold to an incoming shareholder or employee; or to provide shares for a share purchase plan or an ExSOP™.

Trusts are usually situated offshore (for example, the Channel Islands) so that any increase in the value of shares held in the trust will be outside the scope of UK CGT.

UK corporation tax relief

Share incentives may entitle companies to a statutory UK corporation tax deduction. This tax relief is available if the shares acquired by a participant are in an independent company, or a company which is, or is controlled by, a listed company (other than a company which is "close" for UK tax purposes.

For share option plans, the tax relief is given in the accounting period during which the options are exercised, for the amount of the option gain.

Where shares, or interests in shares, are acquired upfront under a direct share purchase plan such as a growth share plan or ExSOP™ award, statutory corporation tax relief will only be available in relation to any amounts subject to income tax on acquisition of the shares (i.e. where the employee does not pay the full market value for their growth shares or for their interest in the ExSOP™ shares). It will not be available for any increase in share value on disposal. However, relief in relation to any expenses incurred in the issue of the award may be available in certain cases.

Tax registration and reporting requirements

All employee share incentive arrangements that relate to UK taxpayers must be registered online with HMRC by 6 July following the end of the tax year in which UK taxpayers first participate in the share incentive arrangement. In addition, each EMI option must be individually notified to HMRC online: within 92 days after date of grant for options granted before 6 April 2024; and by 6 July following the end of the tax year in which the option was granted for options granted on or after 6 April 2024.

Annual reporting will then need to be made online with HMRC in respect of each tax year in which the share incentive arrangement remains in existence. All "reportable events" must be reported including the grant, vesting and forfeiture of awards. If no reportable events occur in respect of a tax year, a "nil return" must be filed.