Stephen Hester’s bonus: how not to structure exec remuneration

Tax and bonuses in shares

Sorry if you’re expecting a polemic about the level of bankers’ bonuses. There’s been far too much of that in my view: I have the old-fashioned view that if the Government negotiates a contract it’s probably not a good thing for it to renege on it.

What I wanted to tell you about is the tax treatment of such a bonus, and how smaller companies can do much better. This is an area in which those poor oppressed bankers really have been losing out.

The Government has been keen to see bonuses paid in shares rather than cash, but it has made no tax concessions to encourage it. An employee receiving free shares as a bonus is taxed on their value as if they were cash. Listed company shares are “readily-convertible assets” so the tax has to be paid through the PAYE system, and national insurance is payable. Mr Hester is not allowed to sell his shares, so he will have to find over £500,000 out of his net salary to pay the tax on his £963,000 bonus. On his reported salary of £1.2 million, that will leave him with about £85,000 net [1]. The taxpayer-controlled bank will have to pay national insurance contributions of almost £300,000. So in total for 20011-12 Stephen Hester gets £85,000 and George Osborne gets £1.425 million! RBS does get a corporation tax deduction for the salary, the value of the shares and employer’s NIC (if RBS makes a profit) but the Exchequer still gets £785,000 net.

The position changes, of course, when the shares are eventually sold. If they go down in value, there is no tax to pay, but no credit for the tax already paid. If they halved in value, Mr Hester would make a net of tax loss (the tax paid would be more than the proceeds of sale). If the shares go up, there is no tax on the first £963,000 (on which he has paid tax already) but the profit will be chargeable to capital gains tax. But of course the taxpayer loses out through dilution of the Treasury’s shareholding: if the shares double in value, the bonus will have cost the shareholders twice as much as if they had paid the bonus in cash.

Mr Hester may be able to afford to pay £520,000 of tax and NIC out of other salary and resources, but most employees are not likely to be grateful for a bonus in shares they can’t sell, which lands them with a large tax bill they can’t pay. This makes bonuses in shares very unattractive.

Fortunately private companies have a much better route available to them. We can thank the LibDems (in the 1970’s [2] for starting a range of tax-approved employee share schemes. Best of these now is the Enterprise Management Incentive (EMI) Scheme [3]. Its tax advantages remain amongst the best of any tax relief. Complete exemption of gains from tax or NIC and a full corporation tax deduction for the value of the shares mean the net tax rate is often actually negative!

I have been setting up EMI schemes for private companies for many years. They are wonderfully flexible, and can be structured to avoid diluting owners’ equity until the company is sold. If you would like more details please contact me.

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[1] assuming he uses his allowances and basic rate tax band elsewhere

[2] actually they were still Liberals then

[3] under Schedule 5 of ITEPA 2003