Employee Ownership Trusts and the Entrepreneur

Tax exemption and employee participation

Which entrepreneur wouldn’t want to sell his or her company at full value, tax free? And even better, without having to find the buyer and negotiate a deal? That is the tantalising prospect if you consider selling your company to an employee-ownership trust (EOT). I recently completed Excello Law’s latest such deal for CDY Ceiling and Partitions Ltd, based in Hull.

The special tax rules were introduced in 2014 to encourage employee ownership, on the John Lewis model. Previous tax reliefs helped business owners to give their company to employees, but there were not many owners willing and able to be so generous. Now the rules allow a sale to an EOT at a full price, funded from the assets and future cashflow of the company. The seller pays no capital gains tax at all on the sale.

What’s not to like? Some of the advantages of selling to an EOT are:

• The CGT exemption.
• The ability to set the price, so long as it is not more than market value, based on valuation.
• No hard-nosed negotiation with a trade buyer or institutional investor over price or warranties and indemnities, saving time and professional costs.
• Deferred payment to match the company’s free cashflow.
• The sellers can stay as directors and keep management control while they are paid out.
• The sellers can retain shares, so long as the EOT has control.
• Employees do not own shares directly and do not have to be paid out if they leave. They do not have to be given a voice in management.
• Improved engagement and incentives for the workforce.
• Income tax free bonuses can be paid to employees of EOT-owned companies of up to £3,600 per person per tax year.
• An EOT can suit even small companies with modest workforces.

There are some possible downsides, depending on circumstances:

• The need to find trustees for the EOT. If professional trustees are used, they will need to be paid and can be costly. Trustees have heavy legal responsibilities and should usually have liability insurance.
• Trustees have to act in the interests of the employees. They may want to negotiate the terms of the sale, even if it is funded entirely by the company. Trustees should have separate legal advice. There may be tensions between the sellers, the trustees, the management and the workforce. There can be conflicts of interests and each group needs to understand its legal responsibilities.
• If the trust is UK resident, the trustees will pay capital gains tax on any future sale of the company, calculated on the original sellers’ base cost. So the tax on the gain has only been deferred, not avoided. Worse, if the sellers would have qualified for business asset disposal relief (the 10% effective rate of CGT) the trustees will be paying CGT at a much higher rate. If it likely that the trustees will eventually seek an exit, an offshore trust should be used – but that may be much more expensive than UK resident trustees.
• Management succession and long-term strategy may suffer. The sellers may be primarily focussed on paying out the deferred price for their shares, and may then retire, or lose interest. External funding may be harder to obtain through borrowing or equity investment.
• If the price is set high, the trustees may struggle to justify the EOT as benefitting employees, or to deliver any actual benefit to them. At least in the early years, any money available is likely to go to fund the purchase price.
• The sellers depend on the future prosperity of the company to enable it to fund the instalments of the sale price. If it does not perform, they could lose their money or have to extend the payment schedule.
• If the sellers retain a shareholding, or management are given equity, they may not be able to realise its full value if the EOT does not want an exit, and the EOT is the only possible buyer for the minority stake.

My 40 years of legal experience acting both on corporate sales and employee share incentives makes me ideally qualified to advise on EOTs. They provide an attractive alternative to a trade sale, an MBO  or an exchange of equity for debt.

Covid-19: who bears the loss? Contracts and Coronavirus

All the news is about Coronavirus and its dangers to people, society and, in third place, the economy. As well as human tragedies, we are facing unprecedented disruption to work and economic activity. We could be facing an unprecedented wave of bankruptcies. But where will the losses fall?

Supply chains and back-to-back contracts

Supply chains and labour markets are complex and often unstructured, and in many cases the effects of Covid-19 losses will be close to random. Businesses may be fighting for survival, and anxious to pass on costs and losses to other parties. Consumers will want their money back for goods and services they can’t use. Demand has fallen, in many cases to levels at which it is uneconomic to continue. Wages and business costs continue to accrue. Suppliers still want to deliver and be paid.

It can come as a huge shock to a business to find itself bearing the loss of the entire supply chain because it is a man-in-the middle, due to mismatches in contract terms. Purchase orders can’t be cancelled unless the contract terms allow that, even if customers cancel their orders or refuse delivery. Consumers may have rights to cancel, return goods or just fail to pay, but a retailer may not be able to pass the cost back up the chain. The loss will often fall at the retail level, because consumers have legal rights (cancellation, returns, refunds) that retailers must respect; trade contracts up the chain will not usually give the buyer the same rights. International contracts may be worse still, with different laws and legal systems applying to each link in the chain.

Imagine a small travel agent, putting together its own packages for holidaymakers on a modest margin: it may have committed to hotels and airlines, or even paid them in advance, but when the FCO advises against travel, or the destination closes borders, the customers will be entitled to their money back. The agency’s contract with the suppliers may not entitle it to a refund, leaving the agency with the full liability. In an ideal world, supply chains are built with back-to-back contracts and pay-when-paid clauses that allocate the loss appropriately across the supply chain, or to parties who are insured, but that is the exception rather than the rule. Often the loss will fall on the weakest link in the chain, the person who has not been able to negotiate let-outs with either its customers or its suppliers.

Frustration

What remedies does the law allow when a performance of a contract becomes impracticable? Is a party liable for breach of contract if he simply cannot comply?

If the contract terms provide no let-out (such as an express cancellation right, or an implied right to terminate and indefinite contract on reasonable notice), the only legal escape is the legal concept of frustration. A contract is frustrated if something happens after the date of the contract has been formed that is not the fault of either party and is so fundamental that it strikes at the root of the contract and is beyond what was contemplated by the parties when they entered into the contract. It must render further performance impossible or illegal, or make the obligations radically different from those contemplated by the parties at the time of the contract. Frustration brings the contract to an end immediately, and relieves both parties of any unperformed obligations. Under the Law Reform (Frustrated Contracts) Act 1943, money already paid is normally recoverable, less any expenses incurred by the other party. A party who has gained a valuable benefit under the contract must pay a just sum for that, and a party who has incurred expenses may charge them to the other party. 

Circumstances arising from Coronavirus are certainly capable of amounting to frustration. If it became illegal to ship goods across a border, or particular workforce could not travel or was incapacitated, or an asset (such as hotel or ship) was requisitioned or closed down, that could frustrate a contract specifically relating to that, and applying in the short term. Because frustration ends the contract completely, it cannot help if all that is needed is a temporary suspension or delay. The performance of the whole contract must be completely impossible or radically different to what was expected. The contract is not frustrated just because it becomes more expensive or inconvenient to perform, or if there is another way of performing it, or if it cannot be performed due to a risk that should have been contemplated by the parties, such as supplier failure. There is no frustration if the purpose, rather than the performance, of the contract, is impossible: for instance, the European Medicines Agency’s 25-year lease of its London headquarters was not frustrated by Brexit (Canary Wharf (BP4) T1 Ltd v European Medicines Agency [2019] EWHC 335 (Ch)).

A particular issue arises (at the time of writing) from the UK government’s approach to the social distancing measures required to fight Covid-19. The Government is acting by making strong recommendations, rather than imposing legal banks on events or activities. That means compliance is voluntary, so the advice is unlikely to frustrate contracts. A party complying with the advice, or who cannot perform because his employees or suppliers are complying, risks being sued for breach of contract, or forfeiting his advance payments. Not only will that cause losses to consumers (who may not be able to get refunds for holidays, event tickets etc, and may be sued by desperate businesses unable to fill vacancies), but this could be detrimental to the essential public health objectives. Venues will be tempted to stay open and events to go ahead so as to avoid paying refunds or being sued for failing to deliver promised goods or services, and the public will be tempted to go ahead with activities they have already paid for.

Employment contracts are unlikely to be frustrated, except in the sad event of the death of the employee. Employers will still have to pay salaried staff who are ready and willing to work and will continue to have an obligation to provide paid work for other staff. It seems that employees self-isolating will be deemed to be sick, at least for the purposes of statutory sick pay, though it is not clear whether that relieves employers of paying more generous contractual sick pay, or full pay for salaried workers, who are not in fact sick. Emergency legislation has made statutory sick pay payable from day 1.  There is no automatic right to suspend or stop paying staff if workplaces are closed or customers stop buying. Not all contracts provide for short-time and lay-offs. Cuts to the workforce will have to follow usual redundancy procedures, including consultation, selection and payment of notice pay and redundancy compensation.  Employers will be looking for other cost saving measures that can be implemented swiftly. On the day of writing, Virgin Atlantic has invited its staff to take eight weeks of unpaid leave or face mass redundancies; many workforces would not agree to that, but some may feel that they have little option to keep their jobs when others are unlikely to be recruiting. They are unlikely to qualify for most state benefits if still employed but on unpaid leave. The cost of redundancies could well be as great as paying wages through the crisis, depending on how long it lasts. Further emergency legislation is likely in this area.

Force majeure

Many contracts (including standard terms of business) contain “force majeure” clauses. They usually relieve the parties from performing obligations if they cannot be performed for specified reasons beyond the parties’ reasonable control. They may suspend performance for a period, and/or allow the parties to terminate the contract without liability on either side. Labour shortages, transport disruption or supplier default may (or may not) be listed as a force majeure event, though it would still have to be the main cause of the disruption and outside the party’s control. Whether a public health emergency amounts to force majeure depends on the wording of the clause. 

The situation must still be beyond the control of the affected party. Again, the fact that compliance with Government advice is voluntary might not help to bring the situation within the force majeure clause. Inability to pay money due to loss of income will not be force majeure; nor will obligations that are just more expensive or difficult to carry out, but are not impossible.

Often there are formalities needed to invoke the force majeure clause, such as giving notice to the other party, or taking steps to mitigate the effect of the event. Unlike frustration, force majeure may apply to the obligations of one party only, and can grant a temporary suspension or delay. On the other hand, the presence of a force majeure clause may mean that the contract is not frustrated: if the agreed terms deal with a situation, that situation will not frustrate the contract.

The cost

The main impact of Coronavirus is the large number of human tragedies. Economic considerations are less important, but the economy also has real effects on keeping people alive and safe. The damage will be spread throughout the economy, but the losses will not be even and will not fall fairly, especially if governments do not intervene. Some individuals and some businesses will suffer disproportionate pain. The English law of frustration and force majeure is not going to help significantly in restoring order or fairness in this crisis. Ultimately, much of the economic cost may be felt through business failures and job losses. Insolvencies result in real and permanent damage, even if new businesses, or phoenix businesses, eventually arise from the ashes to provide the same goods and services. Innocent employees, business owners, shareholders and pension fund members will bear the cost.

Things are changing fast – this article is written on 17 March 2020. Further emergency legislation is very likely – it may include new ways for businesses to suspend or reduce activities.

Stay safe.

IR35 responsibility for worker status transfers to employers

Employee, consultant, worker, director?

Changes to the IR35 tax regime, in force for some time in the public sector, are being extended to private sector employers from 6 April 2020. IR35 Responsibility for deciding tax status is being shifted from the service company to the ultimate employer, under the Off-Payroll Working Rules. 

Many consultants, directors and other workers wanting to have "self-employed" status (or forced by employers to have it) have been engaged through personal service companies. IR35 required personal service companies to operate PAYE in a way that largely eliminated the tax benefits of the structure, but it was left to the individual and service company to decide whether it applied. As there was no risk to the ultimate employer, it did not care if IR35 was ignored, or was interpreted aggressively.

A large or medium-sized company (ie any company not classed as “small”) will have to make its own determination of whether an individual engaged through an intermediary (including his or her own personal service company) would be regarded as an employee (or office holder) for tax purposes, if the services were provided under a contract directly between it and the worker, ignoring the existence of the intermediary. If so, PAYE must be operated on payments to the service company from 6 April 2020. 

Before that date, the company must send the individual and the intermediary a “Status Determination Statement”. 

Note the reference to "office holder" - this includes non-executive directors, who are not normally  employees but are subject to PAYE tax as office holders.

Employers are likely to be far more cautious in making determinations of status than individuals have been, because the risk of failing to operate PAYE falls on the employer. The Check Employment Status Tool (CEST) is the HMRC online tool  to provide guidance, but it has been much criticised in its present form (and found wanting by the courts) and is due to be revised. Employers have to make their own judgements, and may need advice. HMRC is naturally hoping that employers will be conservative and apply PAYE to almost everyone.

The change could well result in many employers ending consultancy company arrangements and bringing consultants fully on board as employees. However, unlike employed/self-employed decisions, deciding to deduct PAYE from payments to service companies does not of itself affect the individual's employment rights status. A person engaged through a service company will not normally have employee's rights against the employer, though they may have rights as a "worker".

I can’t claim any credit for it, but there is a particularly good explanation and Q and A here. All this is subject to any changes resulting from the forthcoming election. 

Penalty clauses are unenforceable - aren't they?

It was never a penalty!

The law has been clear: a clause in a contract imposing a penalty for breach of contract was unenforceable. What was completely unclear was  (1) what amounted to penalty and (2) whether the rule applied beyond the payment of money following a breach of contract. For many years the accepted formulation was that if contract term provided for a payment which was "more than a genuine pre-estimate of loss" it would be an unenforceable penalty; otherwise it was a legitimate "liquidated damages" clause and not a penalty. In more recent years more complex cases have tested the rule, involving more than a straightforward payment for non-performance. the trend seemed to suggest that any clause whose effect was intended to be deterrence rather than compensation was potentially vulnerable to attack as a penalty.

In a judgment today (4 November 2015) these developments of the law on invalid penalty clauses has been rolled back by the Supreme Court. It gave a combined judgment on two cases that could hardly be more different. Cavendish Square Holding v El Makdessi concerned "bad leaver" type clauses  under which Mr El Makdessi, who had sold shares in a company, stood to lose the remaining instalments of the price and to be forced to sell his remaining shares cheap — the last limb alone would cost him $44m — because he had breached non-compete covenants. ParkingEye v Beavis was about an £85 penalty charge for overstaying in a retail car park.

In both cases the Supreme Court said the clauses were not penalties and were valid. The test for a penalty is now "whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract", which will allow far more aggressive terms than some of the cases suggested. Deterrents are allowed, so long as they are not exorbitant or unconscionable, and there is no longer any necessary relationship with the damages that might be awarded by the courts for the breach. Contract writers are likely to become bolder in specifying remedies for breach.

Most “bad leaver” clauses are now probably safe, though still subject to possible equitable relief from forfeiture if the party in breach can provide recompense by other means. 

The £85 parking overstay charge was also held not to be an unreasonable term under the Unfair Terms in Consumer Contracts Regulations 1999 (now Part 2 of the Consumer Rights Act 2015).

The Supreme Court did close one loophole: in deciding whether the clause is a remedy for a breach of contract, the courts will look at the substance of the obligations and not just at how they are expressed. Writing the contract so that there is no breach, but just a conditional obligation, will not get round the rule on penalties if the substance is that one is the primary obligation and the payment is a secondary compensation: so if instead of saying "you must supply the goods; if you do not supply the goods you will pay me £1m" you say "you can either supply the goods or pay me £1m", the court can still decide that the supply of the goods is the primary obligation and the payment is a penalty for breach of it.

The case is a victory for traditional freedom of contract and for certainty, at the expense of the introduction of concepts of fairness, proportionality and the protection of the weaker party into contract law.

US stock option plans subject to English law?

Courts clash on jurisdiction over employees 

It will come as a great surprise to many international employers that their US stock option plans are subject to the exclusive jurisdiction of European courts, as the plans apply to employees in Europe.

Many American companies offer stock option plans or other share incentives on a global basis, with employees having conditional rights to receive stock in the US holding company, or stock issued by a vehicle created for the purpose in the USA. The stock option plan will be established in a state of the USA and subject to its laws, and may or may not be tailored through sub-plans to meet tax requirements in other countries, such as the Enterprise Management Incentive Scheme in the UK.
Rights are granted under a contract direct between the American entity and the employee. 

The Brussels Regulation (recast) governs the jurisdiction of all courts in the EU to hear cases, and says that an employer may bring proceedings only in the courts of the Member State in which the employee is domiciled. At first glance, the stock plan is not an "individual contract of employment" and the US entity is not the employer, so the special rules for contracts of employment in would not apply. As an English lawyer I have no difficulty with the concept of a separate contract with a third party dealing with stock options or incentives, and I would not consider it to be a contract of employment, or the incentive provider to be an employer. Indeed, in English law it has been held that a share option is not a term of the contract of employment: Micklefield v SAC Technology Ltd [1990] 1 W.L.R. 1002. 

But Samengo-Turner v J & H Marsh & McLennan (Services) Ltd held that words used in EU legislation must be given an autonomous (European) meaning so that each Member State will apply it consistently and not interpret it in accordance with its own national law. The terms of the Brussels Regulation are essentially an employment protection measure, to stop employees being sued anywhere other than than their own home jurisdiction, and the English courts would give effect to that: not only by including any contract relating to employment as an "individual contract of employment" and the benefits provider as an employer, but also by granting an anti-suit injunction preventing the foreign company from taking proceedings in its own country.

In the recent case Petter v EMC Europe Ltd the English Court of Appeal became engaged in an unseemly scramble to establish jurisdiction either in England or in Massachusetts, with both courts being asked to grant injunctions preventing a party from continuing proceedings in the other place. Courts of different countries usually try to respect each other and not fight over jurisdiction, but in this case the Court of Appeal decided it had to grant an injunction effectively overturning the decision of the Massachusetts court, in order to protect the employment rights of UK employees.

A fight over the choice of court is not the end of the matter: an English court will still apply foreign law if that is the law chosen in the contract: the Rome I Regulation on the law applicable to contractual obligations allows the parties to choose the applicable law, even for a contract of employment, and an English court can apply foreign law if presented with evidence of what the foreign law is. However, this is subject to the application of mandatory rules of local law. Whilst the courts of England and Massachusetts should theoretically apply the same laws in reaching their decision, a court in England is likely to give far greater weight to English employment rules such as the duty of trust and confidence between employer and employee, principles of English law banning contractual penalties and granting relief from forfeiture of assets, restrictions on deductions from pay and the requirements for non-compete restrictions not to be unreasonable restrains of trade. The legal environment in the UK is far more friendly to the employee than in the USA, so employees may be very keen indeed to have any litigation heard here.

Data protection: enforced subject access requests

Demanding CRB checks now an offence

Employers and service providers requiring individuals to obtain and disclose certain protected data, such as criminal records checks or barring records, will commit an offence from 1 December 2014.
Only employers in certain sensitive occupations can lawfully obtain enhanced criminal record checks from the Disclosure and Barring Service (still often called "enhanced CRB checks"). Some employers and service providers, such as insurance companies, have developed a practice of insisting that applicants exercise their rights under the Data Protection Act to obtain their own sensitive personal data, then provide a copy of the report to the company. The report might be from the Disclosure and Barring Service (which replaced the Criminal Records Bureau and the Independent Safeguarding Authority), the police or the government.

Many businesses will have to change their practices as a result. Some unfortunately have not realised that rights to privacy are now real and are here to stay, even relating to important matters such as serious criminal records or preventing insurance fraud.

There are exceptions where the company is authorised by law to obtain the information or where obtaining them is in the public interest, but in most cases it will no longer be possible to circumvent the restrictions on who can access this sensitive data.

TUPE reform and the small workforce

Reform of TUPE consultation in the small business

Just occasionally, as your lawyer, I find myself having to advise you to do something really absurd, because an absurd law requires it. One of those is where I am helping you with the sale of your business with, say, just one employee. I have to tell you that in order to comply strictly with TUPE, you have to ask that single employee to elect a representative, for you to consult about the transfer of his employment. You are not allowed to consult the workforce directly, even if you can get all of them round a table in the pub. The collectivist approach is compulsory and elections have to be held, potentially delaying the sale transaction. In practice, most small employers have still carried out direct consultation, but it did not comply with the legislation.

Even in a one-man company, the sole director-employee should supposedly elect himself as representative before he informs and consults himself, in a scene reminiscent of Blackadder in the Dunny-on-the-Wold by-election.

Fortunately that particular absurdity is going, when the proposed reforms to TUPE are enacted. Businesses with ten or fewer than employees will be allowed to consult employees direct, without the rigmarole of elections, where there is no union and there are no existing representatives. However, this will apply only to “micro-businesses”, so the absurdity remains when a larger enterprise transfers a business with a small workforce.

The obligation to inform and consult on a TUPE transfer remains important. Employers have to provide the workforce (or their representatives) with information about the proposed transfer and, when “measures” are proposed in respect of the workforce, consult them. There are no fixed time limits, but the consultation must be a sufficient time before the transfer to enable the views of the employee representatives to be taken into account. Failure to comply with these obligations can result in a Tribunal award of up to 13 weeks’ pay to the affected employees.

The intended reforms to TUPE include a number of other (largely pro-employer) technical changes, but the general principles remain unchanged. The Government has abandoned proposals to abolish the “change of service provision” aspects of TUPE which are probably its most controversial aspect, requiring a new contract or to take on the old contractor’s workforce when a contract is re-tendered.

TUPE gets a bad press, but I am old enough – just – to remember how difficult it was to deal with business and assets sales before TUPE came into force in 1982. There was no means of forcing the workforce to transfer, so the transferring employer stood the risk of redundancy or unfair dismissal claims. On the day of completion, the new employer had to write to all staff offering them jobs on the same terms, which could be accepted by turning up for work on Monday morning. The whole thing was complicated and risky, so the legal process for automatic transfer made things a great deal easier for sellers and corporate lawyers, even if not for contractors and employment lawyers.

Reasonable restrictive covenants

The trend in the cases favours the employer 

The courts continue to take a more employer-friendly view of restrictive covenants in employment contracts (and by extension, in other forms of agreement such as business sales and shareholders' agreements). In Coppage v Safety Net Security Ltd the Court of Appeal was forgiving toward features of the covenant once thought fatal: a non-solicitation clause (an agreement not to poach customers) was upheld even though its wording would include former customers, with no retrospective time limit, and could potentially apply to customers with whom the employee had no personal dealings. The court seemed to be prepared to accept what might otherwise be unreasonable restrictions, if the period for which they applied was short - in this case six months. The short period was a "fundamental consideration of reasonableness" and "a powerful factor in assessing the overall reasonableness of the clause".

The case was about non-solicitation clauses; the attitude to non-compete clauses (excluding the employee from a business sector completely) might well be less sympathetic.

Covenants must always be carefully crafted for the particular situation, but the court will look at the overall facts as much as the wording of the covenant. The law says that the reasonableness of the covenant must be judged when it is entered into, but the court seemed to stretch that rule where it believed the employee had behaved badly and the claimant was a small business protecting a few customers against blatant poaching.

Another EMI options tax break

Is this the most generous tax relief we have?

Another big boost for EMI share options: the Treasury has relented and will now extend entrepreneurs' relief - the effective 10% rate of CGT - to almost all EMI options. Previously they had said that the employee would have to hold the shares for at least a year - difficult in many schemes.  From April 2013, the relief will be available if the option (rather than the shares) has been held for a year, and the employee has remained employed for that time.

EMI options are almost ludicrously tax-efficient, with an effective negative tax rate. Any company that could be using them probably should be.

Frequently asked questions:

Why was it hard to get the relief previously? Until the 2012 Budget, entrepreneurs' relief was not available unless the employee had held shares amounting to 5% of the company for at least 12 months. Few EMI options amounted to 5%, so most were excluded on that ground alone. But the 2012 budget removed the 5% requirement for EMI options. The 12 month rule remained.

Why was that a problem? Most EMI options are exercised (converted from an option to real shares) only immediately before the shares are sold. There are a number of reasons for this:

• The employee doesn’t have to find or borrow the money to pay the exercise price
• The employee is not at risk of losing money if the value of the shares falls or the company fails
• If there is tax to pay on exercise (usually only if the exercise price was set at below market value at the date of grant) the employee has the money to pay the tax if he has sold the shares – otherwise he may have it deducted from pay under PAYE
• Option exercise can remain subject to conditions being met. Most popular is condition making options exercisable only when the company is sold – which ruled out holding the shares for 12 months
• The company has not issued real shares until shortly before sale, removing all the issues surrounding small employee holdings in private companies – how to buy the shares back if someone leaves, upsetting voting balance, inhibiting owners remunerating themselves by way of dividends…
• Corporation tax relief is maximised: it continues to accrue on the rising value of the shares until the moment before the shares are sold

Until this change, in order to benefit from entrepreneurs’ relief, the employee would have had to exercise his option and get real shares at least a year before sale. If sale was going to be on sale of the company, that meant accurately predicting an exit a year in advance!

Why is there a negative tax rate?

On options granted at market value, there is normally no income tax (or NICs) payable on grant of the option , exercise of the option or sale of the shares. The only tax paid by the employee is CGT on the gain on sale of the shares, to the extent that it exceeds the annual CGT allowance – and the CGT will now usually be at 10%. But the company gets corporation tax relief on the gain[1], even though it has not incurred any cash cost. As the rate of corporation tax is higher than the employee’s effective rate of CGT, the Treasury is paying you!
 

I have been advising companies on employee share incentives for 30 years. If I can help with EMI options or any other kind of share scheme, do get in touch.








Published December 2012
Updated February 2013

 

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[1] Assuming exercise of the option and sale of the shares are at the same value. All tax reliefs mentioned are subject to conditions, and the tax position described is the usual one, but there could be exceptions; always take proper professional advice, ideally from me!

 

 

Trading shares for rights

How will George Osborne’s new share scheme work?

"Workers will be asked to surrender employment rights in return for shares in their company under plans to boost enterprise announced by George Osborne. People who accept the shares will have to waive their rights to redundancy or to sue for unfair dismissal and will not be able to request flexible working hours. The Treasury will not levy capital gains tax when workers sell their shares, which can be worth between £2,000 and £50,000." - Daily Telegraph

 

I don’t wish to enter the political debate on whether employees in small businesses should be able to opt for reduced employment rights, or whether they should have full rights at all. But how would this proposal work on the shares side? I strongly suspect that if it ever sees the light of day, this will be one of those schemes that languishes largely unused – unless it becomes a bonanza for tax avoidance.

 

Of course there are few details available beyond what George Osborne said in his Conference speech. A Government press release adds a couple of points, and promises a consultation, so the promise to “rush through” legislation to be in force by April 2013 looks unlikely to be fulfilled.

So what are the issues that would have to be addressed?

 

·         Under present legislation, the value of the shares (between £2,000 and £50,000 we are told, assuming this means value when they are given) would be immediately charged to income tax, and usually national insurance, when the shares were given. But the new “owner-employee” would have no money to pay the tax, other than his other earnings. Mr Osborne says there will be an exemption from CGT, but doesn’t mention income tax. Will there be an exemption?

 

·         If so, HMRC has been tightening up on employers finding was to confer tax-free benefits on employees, including through employee shares, and this could blow a hole in their strategy. What will stop a senior employee waiving his bonus (and his employment rights) and instead receiving £50,000 in tax-free shares, which he then sells back tax free?

 

·         Further income tax charges can arise if the shares are subject to restrictions or risks of forfeiture. If these rules are waived, further tax planning opportunities open up.

 

·         If the company buys back its own shares within five years of their issue, the gain made by the employee is normally charged to income tax and not CGT, so the promised exemption from CGT looks a bit hollow.

 

·         Most small businesses are very reluctant to part with equity in the company. Minority shareholdings can be a significant brake on the development of the business, especially if they remain after an owner-employee has left and ceases to contribute. But an open-ended commitment to buy shares for cash if an employee leaves would be unaffordable as well as unacceptable. Where is the cash going to come from? Most successful private companies could not easily fund an obligation to buy a significant proportion of their own share value.

 

·         In a start-up micro business the shares are worth very little, so you get an awful lot of shares to make up a minimum market value of £2,000. Entrepreneurs could find they have given away equity that becomes extremely valuable once the business takes off.

 

·         It is an important part of employee share scheme planning to avoid creating incentives for employees to leave. The press release makes it clear that owner-employees must be entitled to full value for their shares and cannot forfeit them as “bad leavers”. This is one of the many attractions of employee management incentive scheme (EMI) options: the employee does not get the shares until their value has been earned.

 

·         Unless a small business is looking for an exit through sale, there will be no visible route for owner-employees to realise their shares except by selling them back to the employer at a valuation. Companies are reluctant to commit to buying shares at someone’s opinion of value. Employee shares can become negative incentives if they fail to grow in value, or if there is no realistic prospect of selling them.

 

 

EMI share options boost

By far the most tax-efficient incentive

EMI share options (the Enterprise Management Incentive scheme) were given a huge boost in the 2012 Budget, and they are by far the most tax-effective incentive available to unquoted companies to reward and incentivise employees. Most importantly for the majority of participants, Entrepreneur’s Relief – an effective 10% rate of capital gains tax – will now apply to options exercised after 6 April 2012. That restores the attractions of the EMI scheme before the abolition of taper relief a few years back. Participants with no other relevant gains could receive up to £10m of gains at a 10% tax rate. The overall tax rate is actually negative: the corporation tax relief, at (say) 22%, exceeds the tax the employee pays at 10%. So the Treasury is actually subsidising the benefit.

The limit on the value of options that can be granted to any one employee is also to be more than doubled, from £120,000 to £250,000. The limit applies to the value of the shares at the date of grant of the option. This change is not yet in force, because it requires EU approval as “state aid”.

As a reminder, EMI options give an employee a right to acquire shares at a future date at a fixed price, often the current market value. The right can be conditional: it can be exercisable only on sale of the company, so that the owners do not lose and control or suffer dilution until an exit. Or it can depend on meeting performance targets. The usual tax treatment will be:

·         No tax of any kind on grant of the option

·         No income tax or NI (including employer’s NI) on exercise of the option, if the option is granted at market value

·         The company gets corporation tax relief (say 22%) on the notional gain made by the employee at the date of exercise, even though the company has paid nothing out

·         When the employee sells the shares he or she pays 10% CGT on the gain above the annual CGT exemption (with Entrepreneur’s Relief).

In most cases exercise of the option, issue of the shares and sale of the shares are more or less simultaneous.

The Office of Tax Simplification recently published recommendations for simplifying employee share schemes, including merger of the CSOP into EMI and the introduction of self-certification instead of HMRC prior approval of scheme rules (which is already the process in EMI schemes, greatly reducing cost). But merging the two could bring restrictions on the current freedom of EMI, so it may be wise grant EMI options before that happens.

With private company share values still low in a depressed M&A market, there has never been a better time to grant EMI options. Anyone about to exercise an option should consider deferring until after 6 April. If your company has granted unapproved options to key staff because you had used the £120,000 EMI limit, it may be worth considering cancelling the unapproved option and re-granting it within EMI, especially if the share price has not increased much – but only after the new rules come into force.

I have been advising on employee share schemes for 30 years. If I can help with EMI schemes, give me a call.

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

Salaried partner or employee?

When is a partner not a partner? When he’s an employee. When is a salaried partner an employee?  When he’s not a partner, of course.

Or when the Employment Appeal Tribunal says he’s not. The EAT has decided two recent cases concerning solicitor salaried partners – in opposite ways.

The status of “salaried partner” or “fixed share partner” has been very useful for law firms. Clients like to deal with partners, so salaried partners are given the title as a badge of confidence by the firm, without all the financial consequences of admitting an equity partner.

Firms treat salaried partners in different ways. At one end of the scale, there is the person who is clearly an employee, but who is held out to the public as a partner. He has a contract of employment, he is paid under PAYE and he takes no significant part in the firm’s overall management. He gets no profit share but is indemnified against any losses. At the other end is the fixed-share partner who takes a full part in partnership decisions, gets paid only if there are profits to distribute, perhaps contributes capital to the firm, and often has a small share of profit, which might be linked to individual or team performance. In between are a variety of other arrangements, often poorly thought through, which try to treat the person as an employee whilst making him self-employed for tax purposes. The documentation often looks like an employment contract, with varying degrees of lip-service to the partnership ideal.

In Stekel v Ellice [1]  Megarry J. said that a salaried partner on a fixed salary, not dependent on profits, could still be a true partner, at least if he was entitled to a share in the profits on a winding-up. The relationship is a question of fact, and is not determined by what the parties call it.

Employment protection  Self-employed status can be attractive to the salaried partner who is taken outside the PAYE system. But it is a lot less attractive when the relationship ends, and salaried partners may be tempted to claim employment rights when they are dismissed, as Jeremy Briars did recently in Williamson & Soden v Briars [2]. He won comprehensively. The Employment Appeal Tribunal upheld the Tribunal’s ruling that there was no doubt that Mr Briars was an employee for the purposes of the definition in the Employment Rights Act (ERA) [3]. The question was not whether he was truly a partner within the definition of the Partnership Act 1890 [4], but whether he was an employee within the ERA definition. He had made a seamless transition from employed status with very little change in his role or terms. He received a fixed salary, not dependent on profits, plus a small profit share. He did not share in losses. The documents did not demonstrate acceptance of the heavy burden of partnership. And perhaps most importantly, he was subject to the control and direction the equity partners in a manner appropriate to an employee rather than a true partner.  

It is often said that someone who has been treated as self-employed and has reaped the tax benefits could not easily convince a tribunal that he was in fact an employee when it suited him. But this point was not even mentioned in the judgment in Williamson & Soden, despite Mr Briars having been treated as self-employed for tax purposes for about six years.

Tiffin v Lester Aldridge LLP [5] went the other way. There, the fixed share partner had signed documents and received a benefits package that more clearly pointed to partnership; he received a small profit share, and he was entitled to a small share of surplus on a winding-up; he had limited votes at partners’ meetings, and he contributed a small sum as capital. The Tribunal and EAT both found that Martin Tiffin was a partner, and not an employee, and the Court of Appeal agreed. There was no minimum share of profits, surplus or voting required.

The position in an LLP ought to be slightly different. Whether or not two or more people are in partnership is a test of the relationship: as a matter of fact, are the partners carrying on business in common with a view of profit? In an LLP, though, the question of who is a member of the LLP is more defined: a member is a subscriber to the incorporation document or someone admitted by and in accordance with an agreement with the existing members [6]. There should be no room for arguing that a member of an LLP, recorded as such and registered at Companies House, is not in fact a “true” member of the LLP. But it seems you can be both a member and an employee of an LLP: “A member of [an LLP] shall not be regarded for any purpose as employed by the [LLP] unless, if he and the other members were partners in a partnership, he would be regarded for that purpose as employed by the partnership.”[7]

That looks odd, and it is. True partnership and employment are mutually exclusive, it seems; so if he and the other partners were truly partners in a partnership, he could not be an employee; though if they were not truly partners, and he was just called a partner, he could be an employee. What does the section add? Is it not effectively saying that a member of the LLP can never be an employee? Apparently not. In Tiffin v Lester Aldridge and in Kovats v TFO Management LLP [8] the section was assumed to mean the opposite of what it says: that if he and the other partners would not have been partners in a partnership, he could be an employee. In Kovats the EAT specifically recognised the possibility that a person could be both a member of the LLP and an employee.

Tax benefits  But there is one important difference in an LLP. A member of an LLP is always taxed as self-employed, even if he is, in law, an employee. His taxation status does not depend on whether he is an employee within the meaning of the ERA, but on whether he is a member of the LLP. For income tax purposes, in a trading LLP all the activities of the LLP are treated as carried on in partnership by its members.[9] There is no exception for members who are also employees. So we have a potential category of salaried partners (members) in LLPs who are employees for employment protection purposes, but taxed as self-employed. This is very useful, as it allows firms to confer the taxation benefits of LLP membership (and gain exemption from employer NICs) without any real pretence at making the salaried partner a true partner. So long as he is admitted as a member in accordance with the LLP members’ agreement, and perhaps has a small profit share (so that the membership is not a sham or blatant tax avoidance), he can have a contract that resembles an employment contract, and be subject to control and supervision as an employee, without losing the beneficial tax treatment. The potential for tax planning here is considerable, and we could see increasing use of LLP member status intended mainly to save tax.

[IMPORTANT NOTE: With effect from 1 April 2014, major changes have been made to the taxation of LLP members where their status amounts to "disguised employment". It is now very difficult to take salaried and fixed share LLP members out of PAYE. The legislation affects tax (including national insurance) treatment but not employment rights. This article was written before the 2014 legislation and the above paragraph is no longer correct.] 

By the same token, the taxation status of an LLP member ought to be irrelevant to his status for employment rights purposes, though this point does not seem to have been considered in Tiffin or Kovats. In a Partnership Act partnership, unlike an LLP, the tests for employment rights and tax purposes are the same, so a person treated as an employee for employment rights purposes should also be subject to PAYE.

Restrictive covenants  It is said that post-termination restrictions will be harder to enforce against employees than partners, and that restrictions on employees must be narrower in scope if they are to be reasonable. But in fact it is the position and role of the individual that affects the enforceability of the covenant, not his status as employee or partner. Covenants have been enforced against senior employees [10] which might well not have been enforceable against junior partners. In all cases there must be a legitimate interest to protect and the restriction must be no more than is reasonable to protect it, but it is relevant to look at the respective bargaining power of the parties, their mutuality of obligation, and the extent to which the individual would have expected to benefit from the goodwill protected by the covenant.

Having the salaried partner sign new covenants in the same form as the equity partners may well help, both in demonstrating the reasonableness of the mutual obligations and in showing that the partner is a true partner.

What lessons can be learned from the cases? Many salaried partners will be employees, with employment protection rights, if no special effort is made to ensure that they are genuine partners. To make them genuine partners, consider making their remuneration depend on the availability of profits, so they share in risk; having them bear a small share of losses, and/or share in capital profits; having them contribute capital; making them parties to the main partnership or LLP agreement; giving them a benefits package appropriate to a partner; giving them votes at partners’ meetings; and generally treating them as far as possible as partners.

In a partnership, if those things (or many of them) are not done, the firm is at risk of being charged PAYE if HMRC alleges that the individual is not a partner, so it may be safer to operate PAYE from the start. In an LLP you are on safer ground from a tax perspective, so long as the salaried partner has been admitted as a member in accordance with the members’ agreement and the membership is not a sham or an artificial step for the purposes of tax avoidance.

The overall look and feel of the relationship and the documents is important. When reading Williamson & Soden v Briars and Tiffin v Lester Aldridge, it strikes you that the Tribunal’s first impression was important. Jeremy Briars’ engagement looked like employment; Martin Tiffin sounded like a partner. Displacing that initial impression is going to be difficult.

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[1] [1973] 1 WLR 191

[2] [2011] UKEAT 0611_10_2005

[3] ERA 1996 Section 230: an individual who has entered
into or works under a contract of service

[4] PA 1890 sections 1 and 2: carrying on a business in common with a view of profit,
and receipt of a share of the profits is prima facie evidence that he is a partner, but
does not of itself make him a partner; and the remuneration of a servant (employee)
by a share of the profits does not of itself make the servant a partner.

[5] [2010] UKEAT 0255_10_1611 Court of Appeal [2012] EWCA Civ 35

[6] Limited Liability Partnerships Act 2000 section 4

[7] Limited Liability Partnerships Act 2000 Section 4(4)

[8] [2009] UKEAT 0357_08_2104

[9] Income Tax (Trading and Other Income) Act 2005 section 863

[10] eg in Thomas v Farr PLC [2007] EWCA Civ 118