Employee Shareholder Status: post-election update

Employee Shareholder Status (ESS) divided opinion between the main political parties in the run-up to May’s General Election. Both Labour and the Liberal Democrats had pledged to scrap this Conservative-backed tax relief scheme – which offers tax exemptions to qualifying employees on the acquisition and disposal of shares in their employer, in return for sacrificing certain statutory employment rights – and companies were understandably wary of committing resources to implementing ESS given the tight polling data in the run-up to the election.

However, under the new Conservative government, companies can be more confident that ESS is here to stay, at least in the medium term. We have advised on the implementation of several ESS transactions in recent months and this is an opportune time to use this practical experience to re-examine the potential benefits of the regime and some hurdles to overcome in implementing it.

Background and controversy

ESS was implemented by the Growth and Infrastructure Act 2013, with the aim of encouraging more companies to offer shares to employees. The motivational effect of share ownership in the workforce is widely acknowledged, with John Lewis being the best known example. To illustrate this, the Employee Ownership Index (EOI) (an index of companies quoted on the London Stock Exchange’s Main and AIM Markets which have at least 3% of shares in the hands of employees other than main board directors) has outperformed the FTSE All Share index in nine of the 12 years since its inception, often by large margins. Funds are now being set up specifically to track the EOI.

The critics of ESS, however, point out that ESS shares have predominantly been taken up by senior management-level employees, who would have acquired shares in their employers anyway and are simply using the regime to pay less tax on those shares. They also argue that these individuals are less likely to be affected by losing statutory employment rights than the lower-level employees for whose benefit the scheme should be designed to operate.

Tax advantages

• On disposal, the first £50,000 worth (when issued) of ESS-qualifying shares are fully exempt from Capital Gains Tax. As the £50,000 limit refers to the unrestricted market value of the shares on issue, the value on disposal may be considerably higher, particularly in high-growth companies.
• On acquisition, the first £2,000 worth of qualifying shares are not subject to Income Tax or National Insurance Contributions because the individual is deemed to have paid £2,000 for them (although in reality he or she must not actually do so).

Lost employment rights

ESS is a distinct employment status. Employee shareholders are subject to contracts which are largely the same as normal employment contracts, but the law does not afford them the following rights:

• not to be unfairly dismissed (except for automatically unfair dismissals or dismissals in breach of the Equality Act 2010);
• to a redundancy payment;
• to request flexible working arrangements; or
• to request leave for study or training.

In addition, employee shareholders on parental leave must give their employers an increased period of 16 weeks’ notice of their intention to return to work.

There is nothing to stop employers from agreeing to reinstate some or all of the lost statutory employment rights into the employee shareholders’ employment contracts, typically by means of a side agreement. If employers are prepared to do this, it removes the biggest disincentive to ESS.

Implementation: headline criteria

There are few restrictions on the types of companies that can use ESS. In particular, there are no restrictions on the size of the company or the type of trade it can undertake. This makes ESS attractive to companies that cannot qualify for other government approved tax incentives such as EMI.

The headline qualifying criteria set out in the legislation are:

• the company and the individual must agree that the individual is to be an employee shareholder;
• either the company or its parent company must allot or issue fully paid up shares in itself to the individual, with a value at the time of allotment or issue of at least £2,000;
• the company must give the individual a written statement of the particulars of ESS and the rights which attach to the ESS shares;
• the individual must not pay or give any consideration other than agreeing to become an employee shareholder; and
• the individual must be provided with independent legal advice about the effect of becoming an employee shareholder at least seven days before the employee shareholder agreement is entered into (and the reasonable costs of this advice must be met by the company).

Implementation: issues in practice

Implementing the above criteria raises a large number of corporate, tax and employment-related issues. Some of the main issues on which we have recently advised are as follows:

• Availability of shares: an ESS issue generally requires a new issue of shares, diluting existing holders and, accordingly, requires shareholder authority unless done as part of a formal employee share scheme.
• Valuation: in early-stage or highly-leveraged companies, it can be difficult to issue shares worth at least £2,000 without unacceptable dilution. If needed, additional rights can be given to the ESS shares to clear this hurdle.
• Paying for the shares: as the par value needs to be paid up but the employee shareholder cannot do this, another solution is needed. Typical solutions are:
  • a third party pays for the shares, perhaps an employee benefit trust or an institutional investor – the shares can be allotted to the third party but issued to the individual;
  • the company capitalises reserves (there are complex company law issues with doing this); or
  • the directors resolve that the loss of the statutory employment rights is “money’s worth” consideration – this may be difficult to prove and will not work if the issuing company is not the same as the employer.
• Material interest: employees who have held at least 25% of voting rights or (for close companies) return of capital rights in their employer or its parent cannot claim the ESS tax reliefs. If this applies, consider which company should be the employer.
• Timing and impact on deal structure: if ESS shares are to be issued as part of a transaction, the deal timetable will be affected by the seven day cooling-off period.

To remove these factors from the key negotiating period, the deal can either be agreed subject to completion of them or the parties can agree to deal with them after completion – depending on how important ESS is to the protagonists.

Conclusion

Implementing an ESS scheme and ensuring it complies with the range of applicable corporate, tax and employment legislation is not straightforward. As companies and advisers become more accustomed to the issues, however, the implementation process is becoming increasingly smooth and more companies are likely to adopt ESS as a means of promoting employee share ownership.

Jamie Hamilton, Senior Associate, Fladgate LLP (jhamilton@fladgate.com)