Inland Revenue 36
17 March 1998
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REMUNERATION IN SHARES SUBJECT TO FORFEITURE OR
CONVERSION
Shares subject to the risk of forfeiture or conversion awarded
to employees or directors will be taxed at the point at which
the risk of forfeiture is lifted or conversion occurs, under
proposals announced by the Chancellor today. These changes,
together with a minor change to the tax rules on the grant of
share options, will help businesses by giving them legislative
certainty and reducing their administrative burden.
Additionally, by acting now, the Chancellor will prevent a
potential loss of revenue in excess of 100 million pounds
from exploitation of the present position. If he had not
acted, schemes involving remuneration in shares subject to
forfeiture or convertible shares could have been specially
set-up to enable employees or directors to avoid income tax.
The changes will apply to shares awarded on or after Budget
day and to share options granted on or after 6 April 1998.
DETAILS
1. There are three separate proposals on the tax treatment
of remuneration in shares. These relate to remuneration in
shares subject to forfeiture, remuneration in convertible
shares, and share options.
Remuneration in shares subject to forfeiture
2. Many companies offer their employees shares in the
company they work for as part of their remuneration. Often
these shares can form part of a long-term incentive plan (or
LTIP), where the award of the shares is dependent on meeting
certain performance criteria.
3. Usually such schemes involve an agreement that if the
targets are met the employee will receive the shares.
Sometimes, however, the employee is given the shares at the
outset but subject to the condition that he or she will
forfeit the shares if the targets are not met. If they are
met, the risk of forfeiture is lifted, and the employee
becomes the unconditional owner of the shares.
4. For many years the Inland Revenue accepted that the
employee was liable to income tax when the risk of forfeiture
was lifted. It is at this point that the value of the shares
can most easily be determined, and that the employee is often
able to realise the value of the shares.
5. However, recent legal advice suggests that the income tax
charge arises at the time when the shares are first awarded
on a value reduced by the risk of forfeiture.
6. The proposals will have the broad effect, for shares
awarded on or after Budget day, of ensuring they are taxed in
accordance with what was the original understanding of the
tax rules. There will normally be no charge to income tax on
the employee when shares subject to the risk of forfeiture are
first awarded. But there will be a charge to income tax when
the risk of forfeiture is lifted or, if sooner, when the
shares are sold.
7. There will also be a charge to income tax when shares
subject to the risk of forfeiture are first awarded if the
shares can still be subject to the risk of forfeiture more
than five years after they are first awarded. This is
necessary to prevent the tax charge from being postponed
indefinitely. As most LTIPs run for five years or less, few
employees will, in fact, pay income tax when the shares are
first awarded.
8. As well as creating a fairer tax regime for shares
subject to the risk of forfeiture, this change will also help
businesses which are planning to introduce this kind of LTIP
by providing legislative certainty as to the tax treatment.
9. By acting now, the Chancellor has also prevented schemes
being specially set-up to exploit the new understanding of
the tax rules. Had he not acted, the potential loss to the
Exchequer would have been in excess of 100 million pounds.
10. The Inland Revenue will be issuing guidance shortly on
the tax treatment of shares subject to the risk of forfeiture
that were awarded before Budget Day.
Remuneration in convertible shares
11. Many companies issue shares of different classes which
may, for example, have different voting or dividend rights.
They may also allow their shares to convert to shares of
another class. While there are many legitimate reasons why a
company will allow shares of one class to convert to another
class, such convertible shares may also be used to enable
employees or directors to avoid income tax.
12. Schemes can be set up where an employee receives Class A
shares which have a low value and later these shares can
convert to Class B shares with a much higher value. Under
the current tax rules there will normally be no charge to
income tax on the increase in the value of the shares when
they convert. This loophole could be used to give employees
remuneration in high value shares, and income tax would only
have to be paid on a fraction of their value.
13. The Chancellor's proposals mean that there will be an
income tax charge on the value of the new class of shares,
less an allowance for any income tax already paid, when such
conversions takes place. This charge will only apply to
shares that are first awarded on or after Budget day. The
charge will not apply if the majority of the shares of the
class converting are held by people who are not employees or
directors. So employees should not be charged to income tax
when the conversion happens as a result of, say, a company
reconstruction.
Share Options
14. Under normal tax rules, when an employee is granted an
option over shares, he or she pays no income tax at the time
of grant, but instead pays income tax when the option is
exercised and the shares acquired. It is at this latter
stage that the employee receives the benefit of the option.
15. However, when share options are granted that can be
exercised more than seven years after the date of grant,
there is a charge to income tax if the option price is less
than the market value of the shares. This "seven year rule"
is to prevent options with a high value being granted and left
unexercised for very long periods.
16. Many companies offer share options that can be exercised
three to ten years after grant. In many cases the intention
is to offer these options at the market value of the shares,
but changes in the share price over the short period between
setting up the arrangement and the date of grant, can bring
them into the income tax charge. Although very little income
tax is usually paid at this stage, determining the precise
amount of that tax can be a significant administrative task.
17. The Chancellor proposes to extend the "seven year rule",
so that there is an income tax charge on the grant only of
options that can be exercised more than ten years later.
This will take most options outside the income tax charge on
grant, reducing the administrative burden on business, while
continuing to protect the Exchequer. This change will apply
to share options awarded on or after 6 April 1998.
18. Share options granted and exercised in accordance with
the rules of an approved share option scheme will continue to
be eligible for exemption from income tax and will be
unaffected by these proposals.
Consequential changes
19. Consequential changes will be made to the capital gains
tax rules to ensure that there is no double taxation of gains
when the shares chargeable under these proposals are sold.
20. Where the shares subject to the risk of forfeiture, or
conversions are readily convertible assets, the employer will
be required to operate PAYE at the time a Schedule E charge
arises (see Inland Revenue 32).
INLAND REVENUE PRESS OFFICE