When Good Incentives Go Bad: The Hidden Pitfalls in UK Share Schemes

Employee share schemes are a popular and effective way to attract, reward and retain good people.

Used properly, they give employees a real stake in the future success of the business, in a tax-efficient way. That’s why they’re used across everything from start-ups to well-established companies.

That said, there are times when things don’t play out as intended. Not because the idea is wrong, but because the detail matters. A funding round can shift the valuation. An employee can move overseas. What looked straightforward at the outset can quickly become more complicated.

There’s also the usual housekeeping. Section 431 elections are often sensible. Employment related security (ERS) reporting needs to be dealt with each year. Valuations need to be supportable. But stepping back, two areas in particular are worth careful thought.

1. Funding rounds and valuations

In most employee share arrangements, there’s a fairly obvious objective: keep the market value of the shares being acquired by employees as low as reasonably possible. The lower the valuation, the lower the risk of an unaffordable upfront cost or employment tax charge, and the greater the potential future benefit to the employee.

That objective can appear difficult to achieve in the presence of a recent or anticipated funding round.

During a funding round, the company is usually seeking to maximise its valuation in order to attract investment and support the next stage of growth. At first glance, that sits uneasily alongside the desire to deliver employee equity at a lower price, particularly where share incentives are an important tool for attracting and retaining talent in early stage cash-constrained businesses.

In practice, however, the position is often more nuanced.

When HMRC considers the value of employee shares, a recent third-party investment can be the starting point. But the price paid by external investors should not automatically be applied to employee shares. Not all shares are created equal, and those differences matter for valuation purposes.

For example, employee shares may carry more restrictions or more limited economic and control rights than the shares issued to investors. There may also have been changes in market conditions, trading performance or the company’s prospects since the investment round completed. Taken together, those factors can either justify a discount to the funding round price or support using normal valuations principles for the employee shares.

Structured properly, this can allow a company to achieve both objectives: raising investment at a commercially attractive valuation whilst still delivering employee equity at a lower and more accessible value.

But it does need to be thought through and documented properly so the position stands up to scrutiny.

Our role is to help join the dots. We work with clients and their advisers to structure share classes in a way that reflects the commercial deal and supports an appropriate valuation, without overcomplicating things.

2. Overseas moves and unexpected tax outcomes

Tax-advantaged share schemes such as EMI, SIP and CSOP are popular for good reason.

Take EMI. At its simplest, an EMI option gives an employee the right to acquire shares at a fixed price in the future. There is no tax charge on grant.

If, on exercise, the employee pays at least the actual market value at the date of grant, there is generally no UK employment tax charge either. Any growth in value is then taxed as a capital gain when the shares are sold.

That is a very attractive outcome.

The complication is that this is a UK tax treatment, and it does not necessarily carry across to other jurisdictions.

We’ve seen situations where an employee moves overseas before exercising their options. The assumption is often that the UK treatment will continue to apply. In practice, the other jurisdictions look at the position differently.

For example, the US compares what the employee pays for the shares with their market value at the date of exercise. If the shares are worth more, that difference can be taxed as employment income in the US.

That creates a mismatch. From a UK perspective, there may be no employment tax charge on exercise. From a US perspective, there may be one.

A further complication is that a valuation may be needed at grant and exercise for US purposes. And where the employee has worked in both the UK and the US during the life of the option, the increase in value may need to be apportioned between the two. That can lead to different parts of the growth in value being taxed in different countries, under different rules and at different times.

The result is that what was expected to be a straightforward, tax-efficient arrangement can become more complex and, in some cases, more expensive.

How we can help

These issues tend to arise in ordinary situations. A funding round is taking place. A business wants to bring in or retain key people. An employee is relocating.

What matters is making sure the share scheme keeps pace.

We help clients think through the tax and practical implications of issuing shares or options. That includes advising on how share rights can be used to support a lower valuation and ensuring the documentation reflects that position.

We also support clients where employees move between jurisdictions, helping them understand how the UK position interacts with overseas tax systems, including valuation and apportionment issues.

And we help with the ongoing compliance, from preparing Section 431 elections to ERS reporting.

These arrangements are not just about tax. They are about rewarding and retaining people. Getting the detail right helps ensure they do exactly that.