Winning the “War for Talent”
By Chris Page of Vantis Tax Limted
1. The War for Talent
Mounting research, including a year long study by McKinsey & Company has highlighted that the most important corporate resource over the next 20 years will be talent. It is also the resource in shortest supply.
Research shows that over the past decade, talent has become more important than capital, strategy and R&D. In reviewing the sources of competitive advantages that companies have:
(i) capital is accessible today for good ideas and good projects;
(ii) strategies are transparent, as even smart strategies can simply be copied by others; and
(iii) the half-life of technology is growing shorter all the time.
For many companies, that means that people are the prime source of competitive advantage. Talented people, in the right kind of culture, have better ideas, execute those ideas better – and even develop other people better.
So the question is, what can companies do to best arm themselves to fight for their fair share of talent?
The answer - implement an effective employee share incentive strategy
2. Employee incentivisation
Attracting, retaining and incentivising the right people to drive the business forward, is now accepted as being fundamental to the success of the business. However, effective remuneration is no longer just about competitive salary levels.
Successful companies are actively engaging their employees at a level that delivers fair reward by using employee share incentive arrangements, to ensure that by linking employee and shareholder interests, they can be best placed to achieve their business and human resource objectives.
3. Motivating employee performance through share incentive plans
There are a number of ways of incentivising through share plans, covering all sections of the employee group, from the directors down. Share plans can either be in the form of share options (which provide the employee with the right to acquire shares in the company at a pre-determined price at some time in the future), or can deliver shares to the employee directly.
Certain share plans are capable of delivering significant tax benefits for employees when they acquire the shares in the company. These are referred to as tax approved plans. However tax approved plans are more restrictive than non-tax approved plans, in that there are certain requirements to be met by the company and the type of shares that can be used, as well as the restrictions that can be attached to those shares. In addition, tax approved plans also place financial limits on the value of share awards (grant value) that can be made to employees.
Broadly, the types of share plans available can be put into 4 categories:
Enterprise Management Incentive scheme (“EMI”)
- All employee tax approved share plans
- Unapproved share plans
- Discretionary – Executive Long-Term Incentive vehicles
4. Enterprise Management Incentive scheme
The EMI is a tax favoured scheme that was introduced in July 2000, to make small companies more attractive places in which to work. The EMI’s aim is to enable Small to Medium Sized Entities (“SMEs”) to attract, motivate and retain high calibre employees. The rationale being, that these high fliers will be motivated to push the businesses forward and run them more successfully.
Current rules allow companies with gross assets of less than £30 million and with fewer than 250 employees to award up to £3million worth of share options to their employees in total, with a maximum grant of £120,000 per employee (market value of shares at the time of grant). Unlike other types of tax approved share schemes, for added flexibility, the company can limit voting rights, provide pre-emption or set other conditions in respect of the shares that will be acquired on the exercise of the EMI option. Additionally, unlike other tax approved share plans, prior approval from Her Majesty’s Revenue and Customs is not required for EMI schemes. This reduces both the cost and the timescale for implementing EMI schemes.
4.1 Tax benefits of EMI options
No income tax or national insurance contributions to pay when shares are acquired
Broadly, as long as the EMI option is granted with an exercise price equal to the market value of the underlying share on the date of grant, NO income tax or National Insurance contributions are payable on the value of any “gain” made (i.e. the difference between the exercise price the employee pays to exercise the option and market value of the shares acquired on the date of exercise), when the option is exercised and the shares are acquired.
Capital Gains Tax (“CGT”) charged on any gain realised on the sale of shares
Any gains made on the sale of shares derived from the exercise of an EMI option, will incur a CGT liability at a flat rate of 18%.
5. All employee share plans
5.1 Company Share Option Plan
This Plan is a tax approved option plan approved by Her Majesty’s Revenue and Customs. The principal features are:-
A maximum of £30,000 (grant value) of subsisting options can be held by an employee at any one time. An employee may only carry out one tax efficient exercise in any three year period. On the exercise of an option there is NO income tax or national insurance contributions liability. On the sale of the shares the employee is liable to CGT on the difference between the sale proceeds and the aggregate exercise price.
The employee can set-off his/her taxable gain utilizing various CGT planning strategies for example, offsetting other losses against the gain made, the utilising his/her annual exemption and spouse transfer.
5.2 SAYE (Share Save plan)
The SAYE involves an employee entering into a savings contract for 3, 5 or 7 years. In addition, the employee is granted an option for which the savings will provide the exercise price. The exercise price of the shares subject to the option can be set at a discount (the maximum discount is 20%). Principal features:-
- Maximum amount of monthly savings £250 (minimum £5);
- Bonuses added to the employee's savings depending upon the length of the contract.
- NO income tax or national insurance on the exercise of the option.
On the sale of the shares the employee is liable to CGT on the difference between the sale proceeds and the aggregate exercise price. - The employee can set-off his/her taxable gain utilizing various CGT planning strategies for example, offsetting other losses against the gain made, the utilising his/her annual exemption and spouse transfer.
5.3 Share Incentive Plan (SIP)
The SIP is the newest of Her Majesty’s Revenue and Customs tax efficient all employee share plans. The principal features of the Plan (each element can be used separately) are:-
- Partnership Shares - An employee may purchase a maximum of £125 a month of company shares out of pre-tax salary. If the shares are held for five years and the employee remains with the company they are completely tax free. If they are held for three years the employee pays tax on the lower of the purchase price and the market value when they are withdrawn from the Plan.
- Matching Shares - The company may provide a maximum of 2 matching shares for each partnership share. The company can impose forfeiture provisions on the matching shares if the employee leaves the company within three years or sells the underlying partnership shares. If the shares are held for five years and the employee remains with the company they are completely tax free. If they are held for three years the employee pays tax on the lower of the market values at the date of award and the date they are withdrawn from the Plan.
- Free Shares - The company may award free shares to employees which may be based upon their performance. The maximum value of free shares that can be awarded in any year is £3,000. The taxation of free shares is the same as for matching shares.
- Dividend Shares - These are shares acquired with dividends paid on the other forms of Plan shares. Dividend shares are tax free after they have been held in the Plan for three years.
The Plan has various rules on cessation of employment. If an employee leaves because of injury, disability, redundancy, retirement, death, TUPE transfer or sale of part of the business all Plan shares are released tax free.
6. Unapproved Share Plans
Some times the nature of the company or its particular requirements do not fit in with the constraints of operating an tax approved arrangement. For example:-
- The articles of the company contain good leaver/bad leaver provisions which the Majesty’s Revenue and Customs will not accept.
- The features of the shares of the company do not fit within the statutory requirements.
- The company wants to adopt terms for commercial reasons that are contrary to the legislative requirements for the tax efficient schemes.
- The company is a subsidiary of an international company which has schemes designed to meet its local requirements.
- The company has determined that its share schemes will operate the same way throughout the world rather than adapt them to different legislative environments.
7. Discretionary - Long-Term Incentive vehicles
There are numerous types of Long-Term Incentive vehicles (some of which are described in the table below). These arrangements are aimed at the company’s executive management. The appropriate plan, or mix of plans, will depend on an organisation’s business strategy.
The aim of Long-Term Incentive vehicles should be to drive shareholder value, not just to mirror practice in other firms. Companies should consider the following issues when determining the optimum type of Long-Term Incentive vehicle:
- Stage in business cycle
- Nature of industry
- Company’s strategic focus
- Dilution of existing stock value
7.1 Types of Long-Term Incentive Vehicles available
| Plan Type | Definition | Pros | Cons |
|---|---|---|---|
| Investment plans | Attempting to mirror private equity models, executives are invited to participate in a plan into which they first invest money either from salary, bonus or other funds. Depending on the achievement of certain financial or share price-related criteria, a company will reward an executive with some multiple of the original investment | Gives a feeling of ownership as executives invest their own money | Some executives may invest more than others, which may create equality issues |
| Deferred annual bonus matching plans | Part, or all, of an executive’s annual bonus is deferred for some period, typically three years. The company undertakes to provide a conditional match of shares dependent on the achievement of certain performance conditions | Improved line of sight between corporate performance and personal reward | Emphasis on short-term performance |
| Performance share plans (also known as LTIPs) | A conditional award of shares is made to executives subject to the achievement of certain financial measures like profits, or share price-related performance criteria such as total shareholder return (TSR) | Retain value if share price is static or falls (unlike options) | Payouts can occur even if shareholders lose money |
| Share options | Employees have the right to purchase shares at a specified exercise price during a defined period of time (i.e. the time to expiry). Vesting is often dependent on performance criteria | Increased leverage on share price increases | Higher share dilution and no downside so reduced alignment with shareholders |
| Stock appreciation rights | Similar to a share option but the holder does not pay the exercise price, and instead receives the option gain in cash or shares. Vesting is often dependent on performance criteria | Lower dilution than share options | No downside, so reduced alignment with shareholders |
7.2 Strategic focus
The Long-Term incentive vehicle chosen needs to emphasise a company’s stated strategic direction. The right plan can link a company’s messages from management to the desired behaviours from executives. Companies that wish to focus on company growth, for example, should make options, a significant part of the executive remuneration package.
8. Dilution of existing stock value
The Association of British Insurers (which represents the interests of institutional investors in listed companies) have established guidelines which limit the amount of share options companies can issue to protect the value of stock held by existing shareholders. Options are more prone to value dilution than performance shares, but if they meet all other criteria, then stock appreciation rights settled in shares could be a solution. However, companies need to be careful if they use stock appreciate rights with US-based employees because of new deferred compensation legislation in the US.
9. Expensing of share options as a result of Financial Reporting Standards 20 (“FRS 20”)
FRS 20 bought about changes to the accounting procedures for listed and private companies (who report under FRS 20). Such companies are now required to account for the cost of providing all share based benefits to their employees, including share options.
Before, the imposition of FRS 20, there was no requirement for a company to expense the provision of share options to its employees. Now however, valuing the cost of providing share options at the time of grant and properly expensing those costs in the accounts over the life of the option, needs to be undertaken.
When considering the type of share based incentive to use, companies need to consider the cost of options, together with the possibility that they may not deliver an equivalent value, if share prices fail to increase enough. Companies should look closely at how to best use their compensation resources, whether equity or cash and how to best design programmes to encourage high employee performance.
FRS 20 will have an impact on the type of long-term equity vehicle chosen by companies. Long-term incentive vehicles, if properly structured, can cost the same under FRS 20, but can also have different payouts in certain scenarios. Companies need to factor in the risk-reward argument from both a cost and employee perspective.
10. Conclusions
10.1 EMI Schemes
For qualifying SME’s this should be the employee share incentive arrangement of choice.
10.2 All Employee plans
With the variety of tax beneficial all-employee plans now available, many more companies beyond the larger listed companies are seeing the value that employee wide share participation can add to the success of the business, with the aligning of employee and shareholders interests. All employee share plans allow for the attraction, motivation and retention of talent throughout the workforce.
10.3 Unapproved Share Plans
Allow for employee share incentivisation where for commercial, company structure or group policy reasons, tax approved plans cannot be implemented.
10.4 Long-Term Incentive vehicles
Many larger companies are likely to use a portfolio approach to long-term incentives for their executives and senior management, with share options, performance shares and deferred bonus arrangements used simultaneously. Of course, once the right vehicle has been chosen, appropriate performance measures need to be adopted, with traditional measures such as total shareholder return and earnings per share becoming quickly outdated.
The trick is to determine the right long-term incentive vehicles and corresponding performance measures to drive consistent and focused messages to executives and institutional shareholders.
Chris Page is Head of Employee Incentives at Vantis
Email: chris.page@vantisplc.com
Vantis Group Ltd, trading as Vantis, is a Vantis plc group company regulated by the Institute of Chartered Accountants in England and Wales, for a range of investment business activities.
