Background
Employee share incentive schemes encourage employee participation and loyalty. They can also offer tax savings to employees. But for private Irish enterprise, the use of such schemes is rare.
Even where there is a desire for employee participation, the lack of a ready market for private shares is a significant obstacle. In most cases, it can be difficult to achieve clarity on valuation of shares and exit strategy for the employees. Where there are other investors or plans for a sale in medium/long term then this will be easier as price and exit can be identified.
Once an outline plan has been formulated, then the employer can think about structure and tax.
Share schemes and tax
Irish tax law allows for various types of tax efficient share schemes, including specific Revenue approved plans. Such schemes are generally unsuitable for SMEs because they must be made available to all employees on similar terms.
For SME’s there has been much attention recently on the new Key Employee Engagement P share scheme. This was further enhanced in Ireland’s Finance Act 2019 to make it more workable. It is still fairly restricted and somewhat complicated. As an alternative, a direct award of shares may still achieve all objectives for the SME- with a lot less admin, cost and tax risk.
This article considers both and will be a useful starting point for those in private business thinking of implementing a share scheme.
Tax generally
Generally, full employee taxes (income tax, USC and PRSI) apply to all gains arising on share awards. Share awards are exempt from employer’s PRSI which is currently 11.05%.
Share options and KEEP scheme
The standard tax treatment is that gains on share options are fully taxable once the options are exercised. On exercise, the employee receives the shares. The marginal rate on income taxes for employees is currently 52% so this can be a very significant cost. Given the costs here and indeed difficulties with valuation/exit, it is rare for private business to offer a share option scheme.
To promote share schemes for private enterprise the Key Employee Engagement Programme (KEEP) was introduced.
The main tax benefit is that Capital Gains Tax (at 33% rate, potentially 10% see below) applies for the employee, rather than income taxes. The tax point is triggered only on ultimate disposal of the shares rather than on exercise of the share option. No additional taxes are payable for either the company or the individual participant at grant or exercise.
There are a lot of conditions to meet – probably the most significant are:
The shares option must be awarded at market value. No benefit is provided to the employee upfront; they only benefit if the underlying shares increase in value. For example, if the shares are valued at €10 per share at the date the option is granted, then the employee must pay at least €10 per share on exercise of the option.
The amount of such options issued to each employee can not exceed €300k and annually, cannot exceed the employee’s salary
The total value KEEP options issued by a company can not exceed €3million when granted
The employer must not be carrying on excluded activities. This is broadly cast to include activities such as construction and professional services.
The practical requirement will be for a share valuation each time the company issues KEEP options. This can be onerous and indeed subject to tax risk. If the options are subsequently found not to have been issued at market value, then the favorable tax treatment under KEEP will not apply.
Award of shares outright or at discount
An alternative to Options (whether KEEP or even standard Options) is to simply provide shares to an employee, either for free or at a discount.
The difference between the share value and the price paid for them will be taxable for the employee (at marginal rates so can be up to 52%). As usual for share incentives, no employer PRSI applies.
In order for such shares to be an effective employee retention tool, they are generally provided subject to requirements that they be held for a fixed period before sale. Such shares are known as Restricted Shares, Share clogs or Forefeitable shares; the required retention period is commonly called the ‘clog’ period.
These shares qualify for beneficial tax treatment if certain conditions are met; essentially ensuring the sale restriction operates as intended.
Once a clog is in place, the market value for tax purposes will be reduced based on the restriction period. A 1 year restriction results in 10% reduction, 2 year is 20% and so on. The maximum reduction available is 60% where there is a 5 year plus retention period. Accordingly, rather than a top rate of 52%, an effective tax rate of circa 20% applies to the award of shares which have a lock-in period in excess of 5 years. It may also be possible to reduce the taxable amount to take account of minority interest discounts.
Unlike the KEEP scheme, there is no cap on value of such shares and indeed no cap value provided to any individual employee. All shares potentially qualify and there is no exclusion for certain businesses
One further point to note - the financing of the tax will need consideration as tax is triggered when employee receives the shares (even though they can not be sold). For private enterprise, it is common for the employer to provide a cash bonus to cover this cost. Such a bonus is taxable in the normal manner, which adds to the expense here.
Disposal
The subsequent disposal of the shares will be subject to Irish CGT in the normal manner. It may be possible for the employee to receive full base cost on ultimate disposal and the discount percentage is ignored. This will depend on how the shares were initially awarded.
Where the desire is to retain employees/directors for the long haul then Restricted Shares can work out to be the cheapest for the employee. Where the employee qualifies for the 10% CGT Entrepreneur Relief, the effective tax rate can be very efficient. For shares granted with a restriction of 5+ years, which double in value, the total tax can work out around 15% of final proceeds for the employee.
CGT Entrepreneur Relief
On disposal, any gains on sale of shares is subject to a default rate of 33% on any gain.
The reduced rate of 10% tax known as Entrepreneur Relief can apply for certain full time working shareholders who have held their shares for 3 years. They must hold 5% plus of the ordinary shares and a lifetime limit of €1 million applies for all gains (from 1 January 2016). There are other conditions such as an exclusion for shares in investment companies or companies developing land. However, the relief can still apply widely and for example shares in professional services companies can qualify.
Employees holding shares acquired under KEEP or indeed Restricted Shares can potentially qualify for the 10% on the entire gain on disposal of these shares.
The 3 year holding period for Entrepreneur relief only starts on acquisition of the shares (not when the options are issued). This can be a drawback for KEEP shares which need to have at least a 1 year option period, which does not count for Entrepreneur Relief. The holding period for Restricted shares starts from acquisition date and gains on Restricted shares, even if sold in the clog period can still potentially qualify for the 10% rate.
Exit considerations
For all the share schemes, the exit plan and how the employee cashes in value needs to be considered and planned.
For the employee, like any investor, the most important part of any investment is the Out. From a tax perspective, if there is an independent purchaser then this will be simplest. It may also be possible for the main shareholder to fund the acquisition from their own resources. The employees sell their shares, receive their cash and pay CGT as appropriate.
In some circumstances, the issuing company with sufficient cash reserves may be the only potential purchaser and a share buyback or redemption will be considered. While this achieve commercial objectives, it can very easily give rise to extra tax costs. There can be default income tax treatment for the employee where (for example) the shares have been held for less than 5 years. For CGT treatment in this scenario it will be necessary to satisfy statutory conditions for Share Buyback relief.
Summary
Whilst KEEP does offer savings compared to a standard share option plan, the conditions can be onerous especially the requirement that options are issued at market value. This can give rise to uncertainty and significant tax risk in the event the valuation is ever challenged. The problem is that carrying out a valuation is never an exact science and the law does not contain any safe harbour test. For share schemes, valuation will always be important but for KEEP its accuracy is “all or nothing” and if Options are not issued at market value, then preferential tax treatment is lost. Default (income) tax treatment applies.
If the intention is to retain employees long term then an employer should consider a Restricted Share Scheme, availing of market value reduction for the clog period to reduce the tax. The particular challenges of the KEEP scheme in relation to valuation and thresholds will not arise here. It can also work out cheaper for the employees where shares need to be held for medium term.
There may also be other share scheme variants which can also be explored, depending on the requirements. In certain circumstances, growth (or hurdle) shares may suit objectives. These can be efficient as value on receipt is generally not significant.
Whatever the strategy, robust valuations will always be important and exit strategy will need to be planned for.
