The new ‘shares for rights’ legislation from 1 September 2013 has created a new class of employee - the employee shareholder. The underlying rationale is to enable companies to create a more flexible workforce and it is hoped that the removal of certain employment rights will reduce barriers to job creation. Tax incentives have been introduced to encourage take up amongst employees.
It all sounds great in principle but the new rules have attracted a lot of negative press and are so controversial that they only just made it into law. If you are thinking about creating employee shareholders in your company, our advice is to look very carefully before you leap as there are hidden complexities to think about.
We highlight below what the new legislation will entail and some of the issues your business will need to address from company law, employer and tax points of view.
Changes To Employment Terms
Employees are given fully paid shares worth at least £2,000 in their employer (or its parent company). They may be existing employees who are converting to employee shareholder status, or new recruits. In return, the employees give up certain statutory employment rights, most notably the right to claim unfair dismissal in most circumstances and the right to statutory redundancy pay.
However, the employer can provide equivalent contractual rights if it wishes, which has led to claims that the new rules could be exploited purely as a means of avoiding tax, instead of to further the goal of creating more flexibility in a company’s workforce.
Although unfair dismissal rights are given up, there is a potential loophole since an employee could still bring a claim on termination alleging discrimination or in relation to whistleblowing.
The main tax advantage is that the first £50,000 of shares (as valued on the date they are given) are exempt from capital gains tax when they are sold. The first £2,000 of shares will also be exempt from income tax and National Insurance Contributions (“NICs”). If the shares are worth more than £2,000 on receipt, the excess value will be treated as employment income and income tax will be payable on it. NICs will also be payable on the excess by both employer and employee in certain circumstances.
Neither of these tax reliefs is available for an employee who has a ‘material interest’ in the company. A material interest is, broadly, a 25% interest.
Creating Employee Shareholders
There is a defined process for creating employee shareholders which includes providing the employees with a written statement about employee shareholder status and the rights attached to their shares. They must receive (employer funded) independent legal advice and there is a 7 day cooling off period. If the correct process is not followed, employee shareholder status will not have been achieved and the tax incentives won’t be available.
Employee shareholder shares must be newly allotted – i.e. they cannot be ‘recycled’ from an employee benefit trust or transferred from another shareholder. This means that all other shareholders will suffer a dilution in their shareholding when the new shares are issued. This can be addressed to some extent by limiting the rights to vote and dividends attached to the employee shares. A review of the articles of association and any shareholders’ agreement is highly advisable.
Recent guidance from the Department of Business, Innovation and Skills (DBIS) states that in most circumstances a company will need to use distributable profits to pay up the nominal value of shares issued to employee shareholders.This interpretation of the legislation by DBIS has created uncertainty as to whether a company can treat an employee shareholder's agreement to give up his employment rights as payment in full for the shares, meaning there is no additional requirement for the company to pay them up using distributable profits. The resolution of this point will be especially important for any company which wishes to create employee shareholders and yet doesn’t have enough distributable profits to pay up the shares.
End of Employment
Most employers will want to set up appropriate arrangements for buying the shares back, or forcing a compulsory transfer of the shares to the other shareholders, if employment ceases. These terms will need to be agreed with the employee shareholder when the shares are allotted, and they should be dovetailed with the articles of association and any shareholders’ agreement. It is common to provide for a lower price to be paid for the shares of an employee who is a ‘bad leaver’ (e.g. an employee dismissed for misconduct) compared to a ‘good leaver’.
It will be advisable to create a ‘drag-along’ right in favour of the other shareholders, so that if the company were ever sold the employee shareholder could be forced to join in the sale.
If employee shareholders TUPE transfer to a new employer in connection with a sale of the business, it is not known at present how this will affect their employee shareholder status. In particular, it is uncertain whether they will be entitled to keep their shares or be entitled to shares in their new employer instead, or whether they will revert to being normal employees. Until the position is made clear, purchasers may ask for extra protections and indemnities if they are purchasing a business from a company which has employee shareholders.