UK share vests get whacked by 10% more - Response to increased UK tax rates in April 2010

Some companies are bringing forward the vesting of restricted stock awards and also are considering measuring the results of performance share awards somewhat earlier if the performance period ends shortly after the start of the new tax year.  There is a risk of loss to the Company if an employee leaves prior to normal vesting date and Companies are looking at the normal pattern of departures and forfeitures to assess the risk.  There may be an increase of cost for accounting purposes in the financial year by bringing forward vesting but this is unlikely to be material.

A much smaller number of companies is considering paying salaries in advance to reduce the impact of the 50% tax rate.  There is very little difference between bringing forward the vesting date of restricted stock and giving an advance payment of basic salary and I expect consideration of this to grow.

Some Companies are changing future share option grants to be taxable on grant at a relatively low value with the future growth in value of the share being liable to capital gains tax instead of income tax.  The disadvantage for the Company is that it loses the deduction for corporation tax purposes on the amount taxed as a capital gain and not income in the hands of the employees.

We all hope that the 50% income tax rate will have a very short life.

Like Alan, I think we all hope that the 50% income tax rate will have a very short life as it has thrown up issues of trust and is not good for UK plc, although it (together with the changes to the UK pension regime, in particular the withdrawal of higher rate tax relief for high earners) is good for our business.  Alas, I think it will be with us for at least 4-5 years or longer (in part determined by the result of the forthcoming UK election).

By "RSU", I take it that you mean a promise to deliver shares at a future specified date, subject to continued employment and perhaps performance conditions.  In the UK, a tax liability arises on the delivery of shares pursuant to the RSU, either as the receipt of general earnings (ie, like the tax treatment of cash) or under the securities option regime (which now applies to the acquisition of shares pursuant to an employment related right - a positive act of an employee such as exercise is no longer required).

The problem with RSUs is that in effect they bring the "investment" in company stock to an end (at least in part, to discharge liabilities for UK tax and social security) at a fixed date in the future (ie, on vesting) - it is impossible to know whether this date is good or bad from an employee wealth creation perspective at the point of RSU award.  As it transpires, the vesting dates of existing RSU awards that will vest after 5 April 2010 have a bad exit point from a UK tax perspective.

My experience is that some employers are bringing forward RSU delivery, but most are shying away from it because of the consequences of accelerating vesting on retention, etc.

If employers want to take positive action as a response to the forthcoming increase in the UK tax rate without changing vesting conditions, there are two alternative approaches:

1.  Accelerate the tax liability into 2009/10.

2.  Defer the tax liability so that share delivery can take place later than the vesting date, at a time when the individiual's effective tax rate may have fallen.

Because there is no UK tax liability unless and until shares are delivered pursuant to the RSU, employers are able to substitute existing RSUs for other forms of award that have exactly the same substance, for example

1.  An award of restricted stock subject to divestment if vesting conditions are not met (in respect of which employers and employees are able to make an election (under section 431(1) ITEPA) to accelerate the income tax and NIC liability into 2009/10 (based on the unrestricted market value on delivery), or

2.  A grant of options to acquire a number of shares equal to the number of RSUs that will continue beyond the original vesting date, so that tax and NI liabilities are deferred until the employee chooses to exercise. 

In other words, the form of the award can be changed with tax impunity without changing the substance of awards.  There are consequences of taking these steps for the employer (for example, the timing of corporation tax relief and of employer's NI liabilities may be accelerated or delayed relative to current state).  I am not an accountant, but I am told that changing of the form of award may not affect the accounting treatment already applied to existing awards to any significant extent on the basis that there is no material change to substance.

In addition, the beauty of the UK system is that, if the employer decides to adopt one or both of these approaches, employees can be offered the opportunity to influence the employer's choice (this may not apply to UK-based US taxpayer employees, because of IRC section 409A).  In this way, for employers prepared to offer this flexibility, communication can include a message to the effect that choice is being offered with a view to retaining and motivating.

In relation to market practice, a number of my clients in the financial services sector have substituted RSUs for restricted stock.  Some have done so unilaterally, but left it to employees as to whether they wish to make section 431(1) ITEPA elections; others have offered the choice to swap RSUs for restricted stock, on the basis that the section 431(1) ITEPA election is a mandatory condition.  Evidence is that very few employees have wished to make the election, on the basis that tax is due immediately (usually out of personal after-tax funds) but shares may not vest.

Those that have offered extended deferral have done so on the basis that any liability for any additional employer NI due in the future is transferred to the employee (employer NI rates are due to go up by 1% in 2011/12).

I have one alternative investment manager client that was prepared to explore all possible alternatives.  From a tax perspective, assuming awards vested, the best tax outcome in all scenarios was the substitution of RSUs for restricted stock, together with a section 431(1) ITEPA election.  However, for cash-flow reasons, that client used the technique Alan referred to in his response ("Some Companies are changing future share option grants to be taxable on
grant at a relatively low value with the future growth in value of the
share being liable to capital gains tax instead of income tax") for appreciation and a flexible deferred award for present value.

There are techniques available for accelerating the tax point of cash remuneration but making it subject to vesting.  There hasn't been much appetite for this approach.

Post 5 April 2010, I expect the demand for deferral to rocket, especially for those with the highest marginal rates of tax (not necessarily those with income in excess of £150,000, but also those earning around £100,000).  As pension funding becomes less viable, there will be a demand for alternative structures.