UK: Partly Paid Shares: A Legal Update

A number of companies are currently considering “nil paid” or “partly paid” employee share schemes for their employees and directors. Under these schemes, participants acquire shares up-front but do not pay their acquisition price until the shares are sold or other agreed circumstances arise.

Not only does this have favourable cash-flow consequences for participants, but the tax treatment can be attractive. The downside is that the participant must pay up the relevant amount at some stage, and so the element of personal risk can make these arrangements less appealing than option schemes, even if they have more beneficial tax treatment.

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A number of companies are currently considering “nil paid” or “partly paid” employee share schemes for their employees and directors.  Under these schemes, participants acquire shares up-front but do not pay their acquisition price until the shares are sold or other agreed circumstances arise.

Not only does this have favourable cash-flow consequences for participants, but the tax treatment can be attractive.  The downside is that the participant must pay up the relevant amount at some stage, and so the element of personal risk can make these arrangements less appealing than option schemes, even if they have more beneficial tax treatment.

What Are “Nil Paid” Or “Partly Paid” Shares?

Normally, shareholders pay the full amount for new shares when they subscribe for them from a company.  However, it is possible under company law for subscription monies to be left outstanding until the monies are called for by the directors.

If nothing is paid up-front the shares are normally termed “nil paid”; if something less than the full subscription price is paid, the shares are termed “partly paid”, although the term “partly paid” will be used to cover both types of arrangements in this article.

When Do The Relevant Monies Have To Be Paid Up?

Traditionally, these schemes required monies only to be paid up as and when the directors called for the shares to be paid up but it is now common for participants to have more certainty on when they will be required to put up cash, eg just before a sale of a company (when cash for the shares should be paid by a purchaser, meaning that the participant does not have to dig into his own pocket to fund the payment) or on leaving employment.  The point to emphasise though is that the shares will have to be paid up at some stage.

How Much Is Payable?

To avoid any unnecessary tax charges, the amount payable should ideally be the market value of the shares at the time they are acquired.  Company law also prevents shares being issued for less than nominal value.

What Rights Do The Shares Have?

The voting, dividend and other rights are as set out in a company’s articles of association, but leavers would normally be expected to sell their shares on ceasing employment.  The amount which a leaver would receive in those circumstances can be freely determined, as can the amount which can be received on a sale.

Often, a company’s articles and shareholders’ agreement may have to be amended to provide for or disapply provisions for nil or partly paid shares, but the mechanics of this should not be problematic.

What Are The Advantages Of These Arrangements?

Aside from the tax benefits (see below) the main benefit is cash flow.  An employee does not have to provide cash up-front and this can indeed lead to him receiving a larger number of shares than he would otherwise be able to afford.  In company law terms, leaving monies outstanding in this way is not a loan.

What Are The Disadvantages Of These Arrangements?

The risk to participants is the key concern.  The participant is almost always liable to pay up the subscription monies at some stage.  If he leaves he may have to pay up what he originally agreed to pay even though the shares may have fallen in value. 

Some schemes we have seen purport to waive payment obligations in certain cases.  However, these (if set out up-front) are ineffective in law and so are unlikely to prevent a liquidator from claiming subscription monies either from the participant or the directors who issued the shares.  Any amount waived at the time of ceasing employment is treated as additional employment income in most cases, even though the participant would not feel as if he has received a real benefit, and so the participant will at the very least probably have to pay some tax even if he is relieved of his obligation to pay up his monies to the company.  With small numbers, the tax exposure may not be considerable and is still better for the individual than paying the whole amount.

If the choice is between these arrangements and paying in full up-front, the participant is still better off acquiring partly paid shares as he ends up paying later what he would have paid anyway.  However, if the choice is between these arrangements and options (which are risk free but otherwise share many characteristics with these arrangements), options may be preferable. 

What Is The Tax Treatment Of These Arrangements?

Unless Revenue approved arrangements can be used (eg EMI options), although there is no up-front charge on the grant of options, the gain when the options are exercised will be fully subject to income tax and NICs. 

With nil or partly paid shares, there should also be no up-front charge and, although there is normally a small annual charge until the shares are sold, the gain on sale of the shares should be taxed as a capital rather than income gain.

To illustrate the differences, assume a company’s share is worth £1 when it is set up and 3 years later is worth £5, and

• one employee was granted an option to acquire 100 shares at £1 per share;
• another employee agreed to buy 100 shares for £1 each with payment to be deferred until the sale of the company.

On the sale, the first employee will have 40% tax to pay on a gain of £400.  However, the second employee will only pay 10% tax on the same gain as his gain will be a capital gain and, under current rules, full taper relief will apply.  It is the prospect of much more favourable tax treatment on any gain that may well make the risk of partly paid shares worthwhile.

A small annual charge may also arise with partly paid shares.  The annual charge arises because the employee is taxed as if he had been lent the difference between what (if anything) he has actually paid for the shares and their market value when he acquired them.  If that difference is (say) £10,000, then the employee is taxed each year as if he had an employer loan of £10,000.  When taxing employer loans, the Revenue uses a set interest rate, currently 6.25% and so the annual taxable amount would be £625, and with a higher rate taxpayer therefore only paying 40% in tax, i.e £250, this should be de minimis.

The annual charge will not arise where the notional loan amount when added together with any other loans extended by the employer comes to less than £5,000 in that year or the participant works full-time for the company or a subsidiary in a senior managerial role and the company is controlled by five or fewer shareholders or its directors.

Although these arrangements are becoming increasingly popular, their tax treatment is well established, and so they have not so far been seen as particularly aggressive.

Can Quoted Companies Use These Arrangements?

Yes, they can.  In most cases though, the scheme would have to be operated through an employee trust for technical reasons (with the shares issued fully paid to the trust but then transferred on deferred payment terms to the participant), but this should make no difference to the tax treatment.

What may be more complicated, however, are corporate governance issues.  Many remuneration committees may feel options or other arrangements are more appropriate for quoted companies.  Certainly, very few have operated these arrangements so far.  Quoted companies are generally more conservative, which means that there are special issues to address here, but those which have used the arrangements have been able to overcome these. 

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 05/10/2007.