HMRC Employee Share Schemes

Share Schemes Training Session
HMRC Shares Valuation
At HMRC Nottingham
7th May 2014
Pett, Franklin & Co LLP
Barry Roland
UK Share Schemes Overview
David Pett
12.30pm- 1.15pm
EMI share options
1.15- 2pm
Black Scholes Accounting and
topical valuation issues
Questions and Discussion
©2014 Pett, Franklin & Co. LLP
2- 2.15pm
William Franklin
2.15- 2.45pm
2.45- 3pm
UK Share Schemes Overview
7th May 2014
David Pett
Pett, Franklin & Co LLP
David Pett
William Franklin
Stephen Woodhouse
‘the Book’ : “Employee Share Schemes” (2-vol looseleaf, pub. Sweet & Maxwell)
The market for advice and implementation assistance
lawyers vs accountants vs ‘consultants’
the roles of :
Share Plan Lawyers’ Group
The Esop Centre
Employee Ownership Association (“EOA”)
tax/company law/employment law/securities laws/trust laws
Largely separate administration industry including offshore trustees
©2013 Pett, Franklin & Co. LLP
(Recent) legislative history
1980: SAYE share options
2000: EMI share options and Share Incentive Plans
2003: Tax law re-write .... immediately followed by:
– change to charging rules for unapproved schemes and arrangements
– MoUs re valuation of ‘management shares’ and ‘carried interests’
– ‘opportunistic’ (ab)use of bankers’ bonuses; ‘employees’ trusts’
used to warehouse funds free of PAYE
2010: Disguised Remuneration : was this the right response ...?
– OTS reports on approved and unapproved schemes
– ‘Shares-for-Rights’ – Geo. Osborne’s idea
– the Nuttall Review of Employee Ownership
– myriad technical ‘relaxations’ of rules re SIPs, CSOPs, SAYE
– ER for EMI option shares
2014: E-filing/registration and further technical changes (eg re takeovers)
©2013 Pett, Franklin & Co. LLP
Practical commercial difficulties
• Avoiding a ‘dry’ tax charge : ERS are charged to IT when acquired, even if
they are not immediately convertible into cash (OTS proposal?)
• Are the shares ‘readily convertible assets’ ? (if the co not independent,
they will always be RCAs)
• ‘founders’ shares’ – are the shares acquired by reason of an opportunity in
the course of a personal relationship ? (s421B(3))
• Is it a ‘close company’ ?
• Assessing ‘hope value’ - the ‘information standard’ (MORE LATER)
• ‘Restricted’ shares :
– inherent characteristics of a share vs restrictions
– UMV vs AMV (given that a s431(1) election has become the universal ‘default’
– the ‘10% rule’ ?
• Companies operating an ‘internal market’ – who determines MV ?
©2013 Pett, Franklin & Co. LLP
Unquoted companies
• Allowing employees to benefit from future
growth in value
• EMI options: if you qualify, is it a ‘no brainer’ ?
• but what of ‘Shares-for-Rights’ ?
• ‘unapproved’ share options
• Joint Share Ownership (“JSOP”) awards
• (so-called)‘growth shares’ ?
©2013 Pett, Franklin & Co. LLP
• Is an ERS acquisition taxed as a “right to
acquire shares” ?...or as an acquisition of ERS
at an undervalue ?
– of concern to internationally mobile employees
• Is it a ‘general earnings charge’, or a Part 7
charge ?
– different rules apply
©2013 Pett, Franklin & Co. LLP
Why is it so complex ?
Private company owned by H & W wishes to allow a key employee to benefit from
growth in c. 9% of company;
If co grants EMI option to subscribe for shares, exercised after 3 years, how does
employee realise the growth in value ?
A sale back to the co will give rise to a ‘dividend tax’ charge on the growth in value
Co sets up an employees’ trust to buy back shares, but a loan to the trust attracts
a penal 25% tax charge ! If co buys back from employee, he gets CGT with ER,
but if co then buys back from trust, deemed MV CGT charge on trust !
So, have to have (a) an upfront issue of the shares to an offshore trust at par using
small loan (with 25% tax); (b) a contingent purchase contract (under CA 2006)
to buy back shares from trust at par; (c) a cash contribution to fund the
buyback by trust from the employee [co gets CT deduction for share option
gain, not cash contribution]
©2013 Pett, Franklin & Co. LLP
So, we need one more ‘tweak’……
• Allow employee shares to be repurchased by the company itself
with no dividend tax penalty if bought back within 5 years
• avoids need for an offshore employees’ trust
• it would allow an SME to:
grant EMI options
secure CT relief for option gain
buy back shares out of reserves into treasury
thereby ‘ringfence’ employee shares
• Please support the lobbying for change….!
©2014 Pett, Franklin & Co. LLP
Participation in future growth in value
can be achieved by :
• grant and exercise of 'market value' share options
(EMI options; CSOP options; 'unapproved' share
• the creation and issue of a special class of 'growth
• allowing the employee to acquire an interest as 'joint
beneficial owner' on unequal terms under a JSOP
('joint ownership')
• a ‘founders’ SIP’ ?
©2014 Pett, Franklin & Co. LLP
‘Employee Shareholder’ status (“SFR”):
key Features
• Employee is issued with fully-paid shares in employer company (or
holding company) worth at least £2,000 (after taking account of
restrictions) for no consideration other than entering into a written
‘employee shareholder agreement’
• Employee treated as paying £2,000 (so first £2,000 of value is
exempt from income tax and NICs)
• Insofar as the initial value, ignoring restrictions (IUMV), does not
exceed £50,000, gain on sale is completely free of capital gains tax
• Better than EMI where gain is taxed as capital gain, albeit normally
with reduced 10% ER rate
©2014 Pett, Franklin & Co. LLP
‘Employee Shareholder’ status:
key Features
• Employee has to forego certain key statutory employment
• Must be a written ‘employee shareholder agreement’
• Before agreement becomes effective, the employee must
receive Independent Advice (paid by employer) and there
must be a 7-day ‘cooling-off’ period
©2014 Pett, Franklin & Co. LLP
“Employee shareholder status”
(or “Shares for Rights” )
• shares can be in employer company or a parent undertaking
• issuing company does not need to be independent !
– of particular attraction to PE-backed companies
• no exemptions if employee has a ‘material interest’ (25%
voting rights) or, if a close company, 25% of assets on
distribution, winding-up (etc.) at, or within 1 year before,
issue of employee shareholder shares
• no IT/NICs on acquisition/on first £2,000 of AMV
• should company pay cash bonus to cover par value plus
©2014 Pett, Franklin & Co. LLP
Advantages of SFR
• Within a limit, gain is completely free of
capital gains tax
• Shares can be restricted/special class - but this
reduces the IAMV
• Shares can be in a subsidiary
• May be offered on a discretionary basis
©2014 Pett, Franklin & Co. LLP
Disadvantages of SFR
• Statutory employment rights foregone (but rights under contract
• Upfront tax charge (but first £2,000 tax free and value can be agreed
in advance, so tax known)
• Lower limit for CGT relief (£50,000 compared with £250,000 for EMI)
• Shares must be issued (so cannot use EBT shares)...
• ...for no consideration (other than giving up employment rights)
• Company law problems
©2014 Pett, Franklin & Co. LLP
Relief on sale back to company
• A sale back to the issuing company (for
cancellation or to be held in treasury) is exempt
from dividend treatment (even if the shares were
not held for 5 years)
• but only if sold after the employee no longer a
director or employee of that or any associated
• Beware: gain on sale-back by continuing
employee to issuing company is taxed as dividend
income if shares not held for 5 years (etc)
©2014 Pett, Franklin & Co. LLP
JSOPs: a summary
• Not share awards; not options
• Employee jointly acquires shares with co-owner
(usually a trust)
• Held under terms of JOA
• Proceeds of sale unequal
• Employee receives growth (less carry charge)
• Co-owner receives the balance
• Capital gains treatment for employee (like EMI)
• Performance link
©2014 Pett, Franklin & Co. LLP
Employee’s gain
Tax point
[ 2] % p.a. ‘Carrying’ Cost
Co-owner’s gain
©2014 Pett, Franklin & Co. LLP
3 years
JSOP Benefits
Growth taxed as capital not income
Employee pays tax at 28 % not 40 %+
Company saves NICs 13.8 %
Tax analysis repeatedly publicly accepted by
• Flexible
• Same treatment as other shareholders on
©2014 Pett, Franklin & Co. LLP
JSOP Issues
• Shares in existence from start (hence carry
• Surplus shares trapped in conventional EBT if
performance condition fails (use GPT)
• Close company loans to EBT
• No CT relief on growth
• Upfront cost of participation based on initial
market value of employee’s interest (IUMV)
• Need to fix carry charge in advance
©2014 Pett, Franklin & Co. LLP
When is a JSOP appropriate?
• If EMI options not available
• Share value meaningful (or not certain that
HMRC will agree its not meaningful)
• IUMV sufficiently low for upfront cost to be
economically feasible
• Growth prospects; if share price can only fall
or flat line not much point as employee gets
©2014 Pett, Franklin & Co. LLP
Comparison of 'growth shares' and JSOPs
• 'growth shares' require changes to the articles,
but a JSOP is all in contract, so easier
• JSOPs require a 'joint beneficial owner' : an EBT
or GPT
– Guernsey Purpose Trust allows surplus assets to be
returned to company
• easier to administer JSOPs on a corporate
transaction/'exit event'
©2014 Pett, Franklin & Co. LLP
There are plenty of reliefs/exemptions
for employee share acquisitions
• EMIs/CSOPs/SAYE share options;
• "Shares-for-Rights';
• Share Incentive Plans
…but not so many upon a disposal of employee
shares :
• 'Shares-for-Rights'
• Share Incentive Plans
• ER for EMI option shares
©2014 Pett, Franklin & Co. LLP
Changes in 2013 for SIPs
• OTS report on tax-advantaged share schemes
– nearly all recommendations accepted
• Removal of pitfalls:
– no ‘material interest’ test
– removal of the penal clawback if company sold within 3
years for cash
– freedom to use restricted shares – but restrictions ignored
for valuation purposes
– restrictions on transfer
– good/bad leaver provisions
– can be non- voting
– removal of need for a specified retirement age
©2014 Pett, Franklin & Co. LLP
What if the company is sold ?
• From 17 July 2013
• No tax on a withdrawal and sale of SIP shares pursuant to:
– general offer to acquire control
– a takeover offer (not defined)
– a scheme of arrangement
• In consequence of which the participant receives cash
(only) for SIP shares
• Must not be an alternative ‘shares- for – shares’ exchange
on offer
• Avoids any risk of clawback if company sold early
©2014 Pett, Franklin & Co. LLP
Changes in 2014 to SIPs
• self certification/registration from 6 April 2014
• increases in limits on tax-free shares
Free shares £3,000 to £3,600
Partnership shares £1,500 to £1,800
Matching shares ( 2 for 1) £6,000 to £7,200
Dividend reinvestment (already no limit)
• annual returns to HMRC to be made electronically
• Partnership shares: may allow obligation to sell on
leaving for at least amount of money used to buy
Partnership shares (or MV, if less)
• new rules for enquiries and appeals
©2014 Pett, Franklin & Co. LLP
New registration and self-certification
regime from 6 April 2014
• To qualify for tax reliefs, every CSOP, SAYE scheme and
SIP must be registered with HMRC through PAYE Online
– registration can only be done by a person with full access rights
• Existing schemes/plans must be registered before 6 July
• All EMI plans and all unapproved schemes or
arrangements must likewise be registered
• EMI grants must be notified online
• Annual returns must be online
©2013 Pett, Franklin & Co. LLP
Advantages of a SIP for founders
(as against “growth shares”)
• Standard-form documentation
• Growth in value of “Founders” plan shares is entirely free of tax
(exempt from CGT)
– Non-SIP shares probably entirely tax-free because of CGT nil-rate band
• Relative ease of administration
– Can normally be undertaken in-house
©2014 Pett, Franklin & Co. LLP
Restricted Shares
• Problem:
– pre-emption of SIP shares of leavers had to apply
to all shares of the class forcing an existing nonSIP shareholder employee to sell
• New regime:
– shares can be subject to restrictions which only
apply to SIP shareholders
©2014 Pett, Franklin & Co. LLP
Employee-ownership Trusts
• Exemption from CGT if individual (or trustee) proprietors sell a
controlling interest to a new-style Employee-ownership Trust
• If a sufficient number of unconnected employees, vendors can
retain up to 49% and rights to all dividends
• Can use company’s own funds to purchase the shares
• If company is later sold, a ‘clawback’ charge to CGT is levied
on the EOT trustee, not the vendor(s)
• To avoid clawback, the EOT must retain indefinitely at least a
51% controlling interest
©2013 Pett, Franklin & Co. LLP
Conditions for CGT exemption
on sale to an EOT
• The company is a trading company (or holding co. of a
trading group)
• the trust only allows benefits on an ‘all-employee/same
terms’ basis
• the trust acquires a 51% controlling interest by the end of
the same tax year
• the ‘limited participation requirement’ is met
• the disposals (if more than one) must all be in the same tax
©2013 Pett, Franklin & Co. LLP
Employee-ownership Trusts
• Relief from IhT if C, being a close company, makes a
‘gift’ of, say, cash to an EOT to fund the share
purchase in the same tax year
• No relief from ‘loans to participators’ charge under
s455 CTA 2010 on a loan by a close company to an
• May still need a s701 ITA (“transactions in
securities”) clearance if the EOT not acquiring at least
a 75 per cent interest
©2013 Pett, Franklin & Co. LLP
sells ≥ 51%
of shares to EOT
Hold Co
Note: Vendor can retain
up to 49% (and 100% of
trustees waive their
dividends) provided the
requirement is met
Trading Co
©2013 Pett, Franklin & Co. LLP
The “limited participation”
requirement (s236N)
must not exceed 2/5ths or 40%
NP = no. of 5%+ ‘participators’ (shareholders or loan
creditors) who remain employees or directors
(etc) (+ connected employees or directors)
NE =
no. of group employees
©2013 Pett, Franklin & Co. LLP
• So, vendors (H & W ?) could retain up to 49% of share
capital PROVIDED THAT (if they are the only participators
who remain employees or directors, and they have no
‘connected persons’ who are directors or employees) the
number of group employees is at least 6 (including H &
• If H retains at least 5% and W, son and daughter are
employees (but have no shares), there must be at least 7
other employees (4 + 7 = 11; 4/11 exceeds 2/5ths)
©2013 Pett, Franklin & Co. LLP
Employee-ownership Trust
An EOT must:
• only ever allow the fund to be applied for the benefit
of all eligible employees on a “same terms” basis and
so that all eligible employees then receive benefit
– may allow 12-month qualifying period
– must exclude existing and former 5% participators and their
‘connected persons’
• not allow the creation of any trust of the fund, or making of
loans or by transferring property to another settlement
(except another EOT)
• not include any possibility of amending the trust so as not to
satisfy these requirements
©2013 Pett, Franklin & Co. LLP
Clawback of relief
........ occurs if there is a “disqualifying event”, but the
clawback charge is on the trustees, not the vendor
“Disqualifying event” is:
ceasing to be a trading company (etc)
the trust ceases to hold a 51% controlling interest
the participator fraction exceeds 2/5ths
trustees breach the ‘all-employee’ benefit requirements
• Immediate disposal and re-acquisition at market value
• [What if the EOT trustees are non-UK ? ]
©2013 Pett, Franklin & Co. LLP
“Employee Ownership Trusts”
B. Relief from income tax on employee bonus payments
• Qualifying bonuses of up to £3,600 paid to all qualifying
employees on a “same terms” basis will be exempt from
income tax (but not NICs)
• Only available if the company is owned by an “Employee
Ownership Trust”
• May differentiate on a linear basis according to length of
service, salary level and/or hours worked
• From 1 October 2014
©2014 Pett, Franklin & Co. LLP
Tax-free bonuses paid to all-employees
of an EOT-owned company
• Must be a ‘bonus’ payment by the employer company
• Must be paid on a ‘same terms’ basis to all eligible group
employees and not to only those in a particular member
or function
• Employer must not be a ‘service company’ (ie providing
services outside the group) or a ‘managed service
• No. of office holders (+ connected persons) as fraction of
all employees + office holders must not exceed 2/5ths
• Must be no “salary sacrifice” arrangements
©2013 Pett, Franklin & Co. LLP
Benefits and Requirements
7th May 2014
Pett Franklin/HMRC Seminar
Stephen Woodhouse
Target Companies
• Small companies (defined by reference to
maximum £30m of gross assets)
• Typically
independence requirement
• May also apply for certain private equity
backed companies with no 51% corporate
©2014 Pett, Franklin & Co. LLP
Tax Benefits
• No tax or NIC charges on grant of options
• No tax or NIC charges on exercise of options if
exercise price no less than MV on grant
• Corporation Tax relief on exercise on intrinsic
value on exercise (if relevant conditions for CT
relief are fulfilled)
• CGT on sale but potential for entrepreneur’s
relief to reduce effective rate to 10%
©2013 Pett, Franklin & Co. LLP
Tax Benefits
Fact Pattern
MV of shares subject to options on grant
Total exercise price of option
MV of shares when options exercised
Tax on grant
Tax/NICs on exercise
Corporation Tax relief on exercise
CGT on sale at £500k
Net Tax position
£45k recoverable from HMRC
©2013 Pett, Franklin & Co. LLP
Main Requirements: Value Limits
• Legislation in Sch 5 of ITEPA
• Para 4 – must be granted for “commercial reasons” to
“recruit or retain” an employee and not for tax
• Para 5 – employee may not hold an option in respect of
shares worth more than £250k by reason of
employment with one company or group;
• Option over excess value is not a qualifying option in
relation to the excess
• Measurement of value includes value of CSOP options
©2013 Pett, Franklin & Co. LLP
Main Requirements: Value Limits
• For these purposes:
– Value = “market value, at the time when the
option is or was granted, of issued shares of the
same class as those that may be acquired by
exercise of the option”
– Market value is CGT definition (Para 55) but
ignoring restrictions (Para 5(8))
– £250k limit extends over three years (Para 6)
©2013 Pett, Franklin & Co. LLP
Main Requirements: Value Limits
• Para 7 – total value of shares subject to
unexercised options must not exceed £3m
(applying same valuation rules as for £250k
©2013 Pett, Franklin & Co. LLP
Qualifying Companies: Independence
• Para 9 = not a 51% subsidiary or controlled by
(a) another company or (b) another company
and any connected person
• No arrangements to become such a subsidiary
or fall under such control (other than
arrangements for a “qualifying exchange of
shares” – i.e. a share for share exchange in the
context of a reorganisation
©2013 Pett, Franklin & Co. LLP
Qualifying Subsidiaries
• Para 10 - all subsidiaries must be “qualifying” if parent is to
issue EMI options
• Subsidiary is any company which parent controls either on
its or with any person connected with it (applying close
company control test)
• Qualifying subsidiary requirement is that subsidiary is:
– 51% subsidiary of parent
– No person other than parent controls the subsidiary
– No arrangements are in existence by virtue of which either of
the first two conditions would cease to be met
• Also, parent must not have a “property managing
subsidiary which is not a 90% subsidiary (paras 11A and
©2013 Pett, Franklin & Co. LLP
Gross Assets/Number of Employees
• Gross Assets Test (Para 12)
– Gross assets of a single company do not exceed £30m
at date of grant)
– With a group, the gross assets test applies to the
aggregate gross assets of each member of the group,
disregarding any intra-group assets or shares or
securities in other group members
– Looking at gross assets shown in the accounts – can
catch small companies with unusual accounting
conventions (e.g. insurance brokers with client
©2013 Pett, Franklin & Co. LLP
Number of Employees
• Number of Employees (Para 12A)
– Full time equivalent number of employees must
be less than 250
– Full time equivalent based on a “just and
reasonable” basis (see HMRC Manual)
– Excludes employees on maternity or paternity
leave or students on vocational training
©2013 Pett, Franklin & Co. LLP
Trading Activities
• Single company (Para 13) – must exist wholly
for the purpose of carrying out one or more
qualifying trades and is carrying on a
qualifying trade or preparing to do so, subject
to being allowed to:
– Hold and manage property used by the company
for one or more qualifying trades carried on by it
– Have purposes having no significant effect on the
extent of the Company’s activities
©2013 Pett, Franklin & Co. LLP
Trading Activities
• Parent Company (Para 14) – at least one group
company satisfies an equivalent to the single company
test: and
• The business of the group does not consist as to a
substantial part in the carrying on of non-qualifying
• Business definition disregards holding shares or
securities or making loans to other group companies,
holding and managing property used by a group
company for the purposes or one or more qualifying
trades carried on by a group company or incidental
©2013 Pett, Franklin & Co. LLP
Qualifying Trade
• Qualifying Trade is (Para 15) conducted on a
commercial basis and with a view to the
realisation of profits and does not consist to a
substantial part in the carry on of excluded
• R&D supported in that R&D from which it is
intended that a connected qualifying trade
will be derived or benefit counts as the
carrying on of a qualifying trade.
©2013 Pett, Franklin & Co. LLP
Excluded Activities
• Dealing in land, commodities, futures, shares,
securities or other financial instruments or goods
“otherwise in the course of an ordinary trade of
wholesale or retail distribution”
• Banking, insurance (but not insurance broking), money
lending, debt factoring, HP financing or other financial
• Leasing including letting ships on charter or other
assets on hire
• Receiving royalties or licence fees
• Providing legal or accountancy services
• Property development
©2013 Pett, Franklin & Co. LLP
Excluded Activities
• Farming or market gardening
• Holding, managing or occupying woodlands, any
other forestry activities or timber production
• Shipbuilding
• Producing coal or steel
• Operating or managing hotels
• Operating or managing nursing homes or
residential care homes
• Provision of business facilities
©2013 Pett, Franklin & Co. LLP
Advance Assurance
• Facility for company to write to Small
Company Enterprise Centre to seek assurance
before options are granted before the grant
• If full facts are given and are accurate, this
assurance will mean that the Company is a
qualifying company for as long as those facts
remain unchanged
©2013 Pett, Franklin & Co. LLP
Employee Requirements
• Employment (Para 24)
– Must be employed by the company granting the options or
a qualifying subsidiary of that company
– Concept of “committed time”; employee must have
“committed time” of at least 25 hours per week or 75% of
employee’s “working time”
– Working time means time spent as an employee or selfemployed person on remunerative work which for an
employee means work the remuneration from which are
general earnings for tax purposes
– Working time includes absences for injury, ill health,
disability, pregnancy, childbirth, maternity, paternity or
parental leave, reasonable holiday or notice periods
©2013 Pett, Franklin & Co. LLP
Employee Requirements
• No material interest (Para 28) in any group company by
employee or associated person
• Material interest threshold is 30% in the company or, if a
close company, the assets of the company, covering
beneficial ownership or in case of assets, 30% of assets
available for distribution on a winding up
• Shares includes shares which may be acquired on the
exercise of an option but excluding shares subject to
qualifying EMI options and shares held in a SIP in
accordance with the plan but which have not been
appropriated or acquired by an individual
• Also, excludes EBT shareholding except where individual
has had a 30% interest
©2013 Pett, Franklin & Co. LLP
Option Requirements
• Type of shares (Para 35)
– Part of the ordinary share capital
– Fully paid up (with an undertaking to pay not making
the shares fully paid up)
– Not redeemable
• Option to be capable of being exercised within 10
years of grant and any performance conditions
must be capable of being fulfilled within that 10
year period (para 36)
• Option terms must be in writing (see later)
©2013 Pett, Franklin & Co. LLP
• Part 7 of Schedule 5 provides for relief where
acquiring company:
– Acquires control of EMI company through a general
offer or acquires all shares of the class subject to EMI
relief through a general offer
– Obtains control of EMI company through a court
compromise or arrangements
– Becomes entitled or bound to acquire to buy out
shareholders through “squeeze out” procedure
– Obtains all the shares in EMI company through
“qualifying exchange”.
©2013 Pett, Franklin & Co. LLP
• Facility (Para 41) for the grant of replacement
options on tax protected basis where
replacement options:
– Granted within six months of acquirer obtaining
– Satisfy the normal EMI requirements for the
purpose of granting options, value of options and
Para 5 requirements relating to options
– Other detailed requirements relating to the
replacement options are satisfied
©2013 Pett, Franklin & Co. LLP
HMRC Notification
• To be a qualifying option, the employer must
notify HMRC of the grant of the option in the
specified form within 92 days of the grant of
the option
• Subject to reasonable excuse for delay, failing
to notify within 92 days results in the options
not being qualifying for EMI purposes (Para
©2013 Pett, Franklin & Co. LLP
• In order to qualify, the option must be “in the form of a written
agreement between the person granting the option and the
employee” meeting certain conditions (Para 37)
• Question whether to use individual option agreements with
individual terms or single set of plan rules with option agreement
incorporating terms
• In either case, the option agreement must state:
The date on which the option is granted;
That it is granted under the provisions of Sch 5 of ITEPA
The number or maximum number of shares that may be acquired
The price (if any) payable by the employee to acquire them, or the
method by which that price is to be determined; and
– When and how the option may be exercised
©2013 Pett, Franklin & Co. LLP
• Also the option agreement must:
– Set out any conditions, such as performance
conditions, affecting the terms or extent of the
employee’s entitlement
– Where the shares are restricted shares (within the
normal meaning of Part 7, ITEPA), details of the
• Overall, while the share rights are contained in
the Articles, the option agreement needs to
provide a comprehensive description of the key
option terms.
©2013 Pett, Franklin & Co. LLP
Project Plan for EMI Scheme
Responsibility Deadline
Provide information requested for COMPANY
share valuation
Prepare note on targets in order COMPANY
for PF to draft performance
Determine quantum of awards
Review Articles to establish if
amendments might be necessary
Prepare draft EMI scheme rules
and option certificates
©2014 Pett, Franklin & Co. LLP
Responsibility Deadline
Prepare draft share valuation report
Review draft valuation report and supply written
comments with telephone call if necessary
Prepare and submit final valuation report to HMRC
Review draft scheme rules and in particular:
- Definition of “good leaver”/”bad leaver”
- Meaning of “exit event”
- Performance targets
- Time-based vesting conditions for possible future
Consider comments and feedback (possible
©2014 Pett, Franklin & Co. LLP
Prepare amended scheme rules
Draft employee communication
including letter explaining risk of
disqualifying events
Prepare draft board/shareholder
minutes and resolutions for
establishing scheme
Follow up valuation with HMRC
Second review of draft scheme
documentation (written feedback)
©2014 Pett, Franklin & Co. LLP
Responsibility Deadline
Prepare final versions of scheme rules and
ancillary documentation
Assume valuation agreed by HMRC (Note this
timetable assumes HMRC agree valuation within 2
weeks of submission).
Prepare individual option documentation including
Form EMI1s
Issue option documentation to employees
Execute documentation and grant options to
©2014 Pett, Franklin & Co. LLP
Responsibili Deadline
G -2
G Date
Responsibility Deadline
Review executed documents and
submit Forms EMI1 to HMRC
Prepare document bible including
company proforma documentation
suitable for future awards and copies
of the actual awards
©2014 Pett, Franklin & Co. LLP
Black Scholes Accounting etc
7th May 2014
Pett Franklin/HMRC Seminar
William Franklin
“Something must be done”
• Mid 1990s in US CEO pay controversy, growth
delivered by share options.
• Some investors (e.g. Warren Buffet) complain
no expense in companies accounts for this
compensation: Accountant’s fault
• Something must be done- US Financial
Accounting Standards Board (FASB) proposes
an expense based on “fair value” of options“Share Based Payment”
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• Private sector non- profit organisation run by
accountants to set accountancy standards in the US.
• Very proud, very independent institution
• FASB Share Based Payment expense greeted by horror
by US corporates.
– If US companies are forced to adopt this and the rest of
the world (particularly UK) does not then US companies
will relocate to the UK etc.
• Congress lobbied
– Threatened to withdraw funding
• FASB- backs down
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Shock at politicisation
• Leading accountants around world plan counter attack (including
UK: David Tweedie)
• Have to deal with accounting standard in one country problem
• 2000 G4 +1
– discussion paper
• Drive to International standards
• But US standards very legalistic in style
• Enron shakes confidence in US Accounting Standards generally.
Result :
– The unthinkable happens US accountants co-operating with
accountants around the world.
– Manifested by a joint convergence project on Share Based Payments.
• Outcome IFRS2 (FRS20) FAS123
©2014 Pett, Franklin & Co. LLP
Share Based Payment
• Problem : How do you get a “cost” for the
issue of an option when there is no payment
of cash
• Answer : use market value of options
• Problem : but do not exist
• Answer : Work out a theoretical figure
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• Does not say use Black Scholes
• Says must calculate a “fair value” using 6
assumptions which are the 6 assumption of
Black Scholes and disclose these 6 assumption
in the Financial Accounts
• Bizarre... Standards do not normally require
assumptions of accounting values to be
disclosed. Policing assumptions is why there
are independent auditors.
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Black Scholes and Merton
• In 1970s some academic economists propose
that a 19th Century Formula for heat transfer
could be used to value options.
• Win Nobel prize for Economics (Note Not
• Barack Obama said some strange people
receive Nobel prizes
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“any colour as long as it is black”
Black Scholes
price of financial derivative
rate of change
1 2 2V
V V
 S
 rS
 rV  0
S t
price of commodity
with respect
risk-free interest rate
Hard maths
• Maths developed by Newton
• Beyond understanding or training of
99% of accountants
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Black Scholes Six
• Share price at date of option grant
• Exercise price of option
• Expected Life of option
• Expected future dividend yield
• Risk free rate of return
• Expected future share price volatility
Note – Nothing about future expectation of share
price performance or past trends in share price.
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Fundamental Problems
• How do you predict future volatitlity ?
– relevance of different past volatilities
– business changes over time
• Assumes shares follow normal distribution
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Normal Distribution
Features of Normal Distribution
• Mean Average = most frequent
• Spread = standard deviations (“volatility link)
66% = within 1 SD
95% = within 2 SD
99.7%= within 3 SD
• Lots of physical phenomena follow Normal
Distributions (e.g. Heights of people)
• Lots of maths developed
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Shares do not follow Normal Distributions
Remember Black Friday
Share prices moved by 20 SDs
Average American women 163 cm
SD of 10 cm
Like finding an American woman 363cm tall
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Tall woman
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In meantime
• No evidence that SBP charges actually reflect
reality of costs of employee options
• Credit crunch
– Failure by banks to value derivatives
• Black Scholes
– Tested ideas to limit LTCM – another
government bail out.
©2014 Pett, Franklin & Co. LLP
Why did standards setters press on ?
Had no alternative were committed
Davos debate
Actually proud they did not understand the maths.
Claimed they left calculations to companies but weasle
words because of the Black Scholes 6 Assumptions
• Black Scholes used by banks to value financial
• In fact for short life option (few months) there is a
traded market which sets price- implied volatility
poorly correlated
• Volatility smile
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• Standard setters did not really care what the figure was
as long as there was a figure
• Analysts could ignore the expense or recalculate it by
changing the assumptions (why there is disclosure). In
fact they now usually disregard it as a non-cash
• Now largely ignored: Accountants who don’t
understand the maths do not care, knowing it does not
matter and subcontract the calculations to actuaries
who have been looking for work with abolition of final
salary pension schemes in the private sector continue
but do not understand financial accounting.
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Employee Share Option’s
• Employees can’t exploit volatility like traders
• Interested in long term growth prospects
• High volatility overstates value of an option to
an employee
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Zero Volatility
Company A’s share price does not move over time
Share price
Time 1
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Time 2
High Volatility
Company B’s share price does not show an overall increase but is highly volatile
Share price
Time 1
Time 2
Although, the expected growth in the share prices of both companies is the same
(nil), Company B is much more volatile and so its Black Scholes value would be
©2014 Pett, Franklin & Co. LLP
Ball park only
• Black Scholes for Employee options can only
give a broad ball park value at best
• Need to look at other methods e.g. Capital
Asset Pricing Model
• In future Game Theory and Quantum
Mechanics may provide better methodologies
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Information Standard
• Valuing growth or hope potential
• Access to confidential
information: forecasts
• Lack of consistency
–sick founder confidential
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Discounts for Minority Interest
Shares in subsidiaries
Examples in SFR
Is the normal 70%+ discount applicable ?
Does existence of corporate controlling
shareholder automatically make minority
holding in a company more marketable ?
• We do not assume this for an individual
majority shareholder so why should we for a
corporate shareholder ?
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Hope Value
Enterprise value
£10 million
Debt: external and shareholder £15 million
Negative Equity
(£5 million)
How can the equity have any value ?
Any hope value is already reflected in
Enterprise value
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• Questions and Discussion
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Contact details
David Pett
William Franklin
[email protected]
mobile: 07836 657 658
[email protected]
mobile: 07889 726767
Stephen Woodhouse [email protected]
mobile: 07836 756031
0121 348 7878
For lots of information, go to our website:
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