ECE member question regarding impact of UK tax increases - Can you help?

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.