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Employee share options: Do they contribute to economic success?

Category Technical Articles
AuthorTechnical Department
Article by Sid Singh published in the May 2002 issue of Tax Adviser. Sid Singh is Managing Director of Employee Share Schemes.

The last decade witnessed a surge in the number of companies using share options as an employee incentive.

This development has now crystallised in the notion that the grant of options is de rigueur to the recruitment and reward strategy in the corporate United Kingdom (UK). Its importance has been acknowledged by the Chancellor in the UK government strategy aimed at reducing the productivity gap between the UK and the United States of America (USA), France and Germany.

The two most popular formats for granting options in the UK are the ShareSave scheme (SAYE) and the Company Share Option Plan (CSOP). Both are approved by the Inland Revenue and receive favourable tax treatment. The major difference between these two formats lies in the method of acquisition of shares. Under the SAYE, shares are purchased from savings deducted from an employee’s net salary, and deposited into a bank account for an effective period of between three to five years under a special SAYE savings agreement. In the CSOP, the employee purchases his shares at a price called the ‘option price’. This right to purchase shares can be exercised at any time in accordance with the terms of the option. Another difference is that while it is mandatory for all eligible employees of a company to be invited to participate in the SAYE, the grant of options under the CSOP is discretionary. The scheme lends itself to considerably more flexibility and exercise of the option can be subject to the attainment of demanding performance targets.

SAYE

Severe doubts are currently being cast on the effectiveness of the SAYE as a platform for boosting company productivity. A recent survey* by the eminent labour market economist Professor Freeman reveals that the SAYE has a very negligible impact on the productivity of companies that operate the scheme. In a comparison between firms that had established SAYE schemes, and those operating CSOP, his findings show that the actual value added per worker in the SAYE companies was minus three per cent, while that of the CSOP companies was a positive figure of 12 per cent.

So why is the SAYE so popular? There are a number of reasons. Options can be granted at a discount of up to 20 per cent of the market value of the share. Savings under the SAYE receive a tax-free bonus. The gain on the shares is free from income tax. Providers (i.e. the banks and building societies) of ShareSave contracts see the savings as a cheap source of investment funds and are able to provide a free administration service in return to companies – both the banks/building societies and companies benefit.

So why does the SAYE not contribute to productivity? The simple answer is that the SAYE is too inflexible. The level of participation is driven by the amount of salary (within statutory limits) the employee is able to save in the SAYE and not to his productivity. It is not possible to set individual performance targets. The SAYE therefore rewards those who can afford to save as opposed to those who are productive. The SAYE can properly be described as an employee perk paid for by taxpayers generally.

CSOP

The CSOP was originally introduced in 1984. It has proved to be popular because of its flexibility. A problem that occurred in its early days of operation was that it was too generous in that it provided relief over options worth millions of pounds to a few ‘fat cats’. It could be said that the Churchillian saying of ‘so much been given by so many to so few’ accurately described the enjoyment of its benefits. The government response to this was to reduce the individual limit to £30,000 per employee. Wait, I hear you say, £30,000 is quite a large benefit. No! This is not the benefit. This is what he has to pay for the shares and he has to wait three years before he can exercise his option. If we assume an increase in the value of the shares of ten per cent his benefit will be £3,000 (i.e. £1,000 per annum on his investment of £30,000.) Although income tax would not be chargeable the gain would be subject to capital gains tax (CGT). This is hardly worth having when the tax-favoured Share Incentive Plan (SIP) can provide more than six times the financial benefit. So why are companies not all rushing to set up SIPs? The reason is that it involves the setting up of a trust and the movement of shares with considerable administrative costs. These additional costs are a deterrent to smaller and medium size companies – the companies which the Chancellor is seeking to encourage to establish employee share schemes.

So what can the government do to restore the CSOP to its former glory? We suggest the phasing out of SAYE and use the tax saved to increase the limit of £30,000. A limit of between £50,000 – £75,000 would be a reasonable figure. Such a limit would not be open to abuse and is not large enough for the so-called ‘fat-cats’. Companies can then link performance directly to rewards. The minimal administrative costs would encourage the smaller and medium-size companies to establish CSOPs.

There are a number of other improvements which can be made to the CSOP:

(1)Three-year tax relief rule

The three-year tax relief rule should be replaced by a taper relief. This ‘three years or nothing’ rule acts as a disincentive to companies willing to establish the CSOP for their employees. Smaller and medium-size companies are often subject to a buyout or takeover before the three year period elapses and where the acquiring company is not prepared to have options rolled-over its shares the employee suffers income tax (and occasionally a charge to National Insurance Contributions) through circumstances beyond his control.

Tax relief should be tapered according to the length of time between the grant date and the date the option is exercised.

(b) Exercise of options

The methods permitted for the exercise of options in a tax-approved manner should be relaxed and the legislation amended to provide an alternative for option-holders to exercise their options ‘cash free’ a feature which is very common in the USA. This would also boost the incentive nature of the CSOP.

Shareholders, investors and employees alike are interested in the potential increase in the value of company shares and not the actual shares per se. Under the CSOP, option-holders want to receive their benefits in different ways. Some may wish to retain the shares acquired. Others are interested solely in realizing the cash gain derived from the increased growth in the value of the shares over the option period. The latter category of option-holders invariably sell their shares immediately after they exercise their options.

Under this proposal, the employee will be able to exercise the option without the need to raise finance to pay the option price. He can:


  • make a cashless exercise;
  • exercise by selling sufficient shares to pay the option price and retain the balance of the shares; and
  • pay the option price and keep all the shares.

The advantages of a cash free exercise are:


  • It is flexible;
  • It facilitates the reward process;
  • It is cost-effective as it will obviate the need for an option-holder to first obtain a loan (and pay the attendant interests and other charges) in order to finance his option exercise; and
  • It is administratively convenient and time efficient for the parties.

(3) General abatement of the CSOP rules

Some of the legislative rules governing the CSOP should be relaxed and made similar to that of the Enterprise Management Incentive which has been the subject of extensive consultation. A prime example would be the removal of the unnecessary restrictions on the shares that can be used in the CSOP.

Future of options

The current burst of the dot.com bubble has led to the propagation of the myth by opponents of the CSOP that employees do not want to be granted options under the CSOP, the reason being that currently many options are ‘underwater’ i.e. the exercise price is far in excess of the current market value of the shares.

This myth is fallacious. Data from the National Center for Employee Ownership (NCEO)in the USA reveal that there is an increase in the usage of share option plans by companies granting options to their employees as they continue to ‘provide a way to link employee and corporate fortunes for the long term’**. As Professor Freeman’s research shows the impact of this link is vital to the UK strategy of closing its productivity gap with its major trading partners. Additionally, the resultant effect on UK productivity of a shift in emphasis from the SAYE to the CSOP will no doubt aid economic success.
* When employees have a stake – the impact on productivity and retention. Proshare/QCA lecture delivered by Professor Richard Freeman on 10 September, 2001.

** Five common myths about stock options. Corey Rosen, National Centre for Employee OwnershipNCEO Executive Director. February 2002.

Technical Department
020 7235 9381
May 2002 by Sid Singh

 

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