employee share incentives – David Pett, Tax Barrister

Court of Session upholds an employee’s TUPE entitlement to equivalent benefits from the transferee employer to those which the employee enjoyed under the transferor employer’s Share Incentive Plan

The Inner House of the Court of Session in Scotland has confirmed a decision of the Employment Appeal Tribunal that an employee who had been a participant in his former employer’s Share Incentive Plan (“SIP”) is, under Reg 4(2)(a) of the Transfer of Undertakings (Protection of Employment) Regulations 2006, entitled to participate in a substantially equivalent scheme operated by the transferee employer or to benefits which are of comparable value.

Mr Gallagher had been an employee of a company within the Total group and had participated in a SIP established by a member of that group by entering into a Partnership Share Agreement under which deductions from his salary were applied in the acquisition of Partnership Shares (in Total) with awards of Matching Shares. He was potentially also entitled under the SIP to performance-related awards of Free Shares. When, in consequence of the sale of a group company in which he was engaged, his employment was transferred to the buyer, Ponticelli Limited, he ceased to participate and was offered a one-off sum of £1,855 as compensation for the loss of entitlement to do so. He declined and sought a determination that he was entitled to participate in an equivalent SIP operated by the transferor company.

The court rejected arguments by the transferee employer (Ponticelli) that Reg 4 (2)(a) did not apply to a discrete contractual arrangement voluntarily entered into otherwise than by reference to the contract of employment, and that the 1987 decision of the Court of Appeal in Chapman v CPS Computer Group (1987) was authority for the proposition that the TUPE regulations did not apply to employee share schemes – that case was simply concerned with the proper interpretation of the rules of such a scheme. Other grounds, including (i) that the decision of the EAT, in Mitie Managed Services Limited v French and others (2002), was not in point, and (ii) that Reg 4 (2)(a) should be narrowly interpreted, were also rejected.

Participation in the SIP was “in connection with” the employment, the language of the regulation being very wide (per Alamo Group (Europe) Ltd v Tucker (2003)). Rights under the SIP were “an integral part of the [employee’s] overall financial package”. Where, as here, it was not open to the transferor to oblige the transferee employer to replicate the scheme, the effect of the regulations is to oblige the transferee to implement a substantially equivalent scheme so as to protect the employee’s full range of remunerative benefits (per Mitie).

The decision did not address how the transferee could or should replicate those benefits. Given that (i) the effect of a SIP is to enable participants to benefit from the value of shares in the scheme company, and that not every employee to whom TUPE applies will have chosen to participate, and (ii) the transferee (even if it be a company) may not be eligible to establish a SIP and/or may not be in a position to provide share-related benefits in any form, it is difficult to see how a transferee who cannot offer participation in a similar scheme is able to replicate the benefit otherwise than by providing a cash payout. But how should such a sum be calculated?

Even if the transferee does have, or may establish, a SIP, the fact that the share price performance of that scheme company may be very different from the historic share price performance of the transferor’s shares will mean that the value of participation in the transferee’s SIP is not equivalent to that of participation in the old one.

The decision leaves transferee employers of employees who have participated in employee share schemes of the transferor employer company in a difficult and uncertain position with the risk of applications being made to the Tribunal if they do not offer acceptable equivalent pay-outs.

Ponticelli Limited v Anthony Gallagher [2023] CSIH 32 (Decision dated 15 August 2023)

A company under the control of another company cannot grant EMI share options and, unless it is under the control of either an employee-ownership trust or a fully-listed company, cannot establish a tax-favoured Share Incentive Plan or SAYE share option scheme. Given that (according to the BVCA) an estimated 515,000+ individuals are employed by UK companies owned by private equity and venture capital funds (which invariably hold their interests through a corporate vehicle), this excludes a substantial proportion of the workforce from participation in such plans.

Whilst members of the BVCA are keen to provide employee share incentives in investee companies, they are presently faced with having to incur significant fees to establish bespoke plans with uncertainty as to the quantum of any liabilities to tax and NICs on share awards. They seek a ‘well-trodden path’ which, if followed by investee companies, will allow employees to benefit from future growth in value on a similar basis to that of other investors.

HM Treasury is alive to the difficulties experienced by PE and VC fund managers in implementing a simple, easily-understood, and cost-effective employee share scheme in a manner which affords both capital treatment for employees in relation to future gains and security for the employer against HMRC enquiry or compliance challenge. One solution would be to allow a trading company controlled by a “PE vehicle” – if such a term were exhaustively defined – to grant EMI share options and establish a SIP or SAYE share option scheme. However, there are obvious difficulties in identifying and then defining the types of PE and VC funds and their investee companies which should enjoy such privileges.

Earlier this year, representatives of the BVCA and the ESOP Centre met with officials at HMT to propose a solution to this conundrum which I have been developing with those bodies. The idea builds upon the concept of ‘joint share ownership’ first developed in 2001, which has since been widely implemented by British companies. The tax treatment of that concept has long been settled with HMRC.

In brief, the proposal is as follows:

A trading company (or holding company of a trading group) under the control of another body corporate (and not otherwise eligible to make awards under a qualifying SIP) may from time to time invite all employees having a qualifying period of employment to accept the award of interests as beneficial joint owners of a given number of ordinary shares in the company, being shares of the largest class in issue and of the largest class held, or ultimately owned, by the PE or VC fund. Such an interest would entitle the employee participant to growth in value of the jointly-owned shares above a threshold level which is not lower than the pro rata value of such shares at the time of award. Crucially, HMRC SAV should – it is suggested – be willing to agree the value of an investee company for these purposes. Provided that such interests are awarded on an ‘equal terms’ basis (broadly as per Share Incentive Plan participation), and subject to a limit on individual participation, the initial taxable value of an employee’s interest would be taken to be zero. (Given that no discount for minority interest, etc., would be applied, the value of such an interest would otherwise have been determined as a ‘premium-priced option’ and therefore it is suggested that any loss to HM Treasury of ‘up-front’ tax would be relatively modest – if any.) A deemed s431 tax election would then ensure that, in the absence of any tax avoidance feature, gains realised upon the disposal of such interests would fall to be taxed as capital gain (and, if the Government were particularly generous, might qualify for the reduced 10% rate of CGT by way of Entrepreneurs’ Relief, as in the case of certain disposals of EMI option shares).
By way of an inducement to qualifying companies to establish such a plan, such certainty of tax treatment might also be extended to similar awards made on a selective basis to key employees over greater numbers of such shares, provided that such number of jointly-owned shares does not exceed a specified multiple (of, say, 8 times) of the number of shares in respect of which awards are made to all eligible employees on the same occasion.

The perceived attractions of such a plan include:

its relative simplicity to establish and document: the co-owner could, for example, be the holding company of the company whose shares are used, and the relationship with participants would be governed by contract. The co-owner could easily repurchase interests from participants who leave at a price determined on a ‘good/bad leaver’ basis;
the fact that, unlike a SIP, a participant benefits only from future growth in value of the jointly-owned shares and, unlike a ‘market value’ share option, the employee is not put to the expense of funding the acquisition of the shares, only for the shareholders then to be burdened with the cost of funding the repurchase of shares from ‘good leavers’ – rather, it is only the growth in value to which the participant ever becomes entitled;
the fact that only if and insofar as there is growth in value will benefit accrue to both employees and, to the extent that a charge to CGT arises, to HM Treasury – most existing forms of ‘growth share’ plans or JSOP arrangements involve an initial charge to tax at a time when any real growth in value has yet to accrue;
setting the threshold level (above which the participant benefits from growth in value) at the ‘pro rata’ value of an ordinary share, and acceptance that the initial unrestricted market value of such an interest is nil, would avoid the complex and expensive process of estimating the value of a ‘growth interest’; the valuation exercise would normally be confined to a valuation of the whole of the issued share capital or of the class of share used.

It should be emphasised that this is merely a proposal made to HM Treasury officials who are understood to be ‘kicking the tyres’. It is not claimed to be a panacea, and others may come up with better solutions, but it does address the concerns of private equity and VC-backed companies excluded from existing tax-favoured government sponsored share plans and has the support of the BVCA. Thus far, no fundamental objection or technical obstacle has been raised, although as it will require primary legislation, we should not perhaps hold our breath…