Managing the impact of the 50% top rate of income tax on employee incentives
05 December 2011
The continuing political debate around the 50% top rate of income tax gives rise to the question of how companies can manage the impact of that rate on employee incentives
Many companies reviewed their employee incentive arrangements when the 50% top rate of income tax was first announced. While there has been no fundamental change in the way companies structure such arrangements, there are steps that can be taken to help manage the impact of the 50% top rate of income tax. Some of those steps are likely to be advantageous to companies and employees whether the 50% top rate of income tax remains in place or is reduced in the near-to-medium term.
The story so far....
The introduction of a 50% top rate of tax for those earning in excess of £150,000 per year led many companies to review their employee incentive arrangements – particularly long-term incentive plans – with a view to trying to mitigate the tax liabilities they give rise to.
While a minority decided to implement some form of tax-driven long-term incentive structure, the vast majority of companies opted to retain their existing arrangements.
This means that most companies continue to grant long-term incentive awards either as "conditional awards" – where shares are automatically transferred to the employee on vesting – or as "nil-cost options" – where the employee can choose when to exercise the award and receive the shares.
While conditional awards are often easier to administer, they are unlikely to be the most appropriate form of award for many companies. Instead, companies should be taking advantage of the flexibility that nil-cost options provide.
Details of the steps companies should now be taking in respect of their long-term incentive plans are set out below, together with some ideas as to how any cash elements of remuneration might be delivered in a more tax-efficient way.
Long-Term Incentive Plans – What should companies be doing?
Companies currently granting conditional awards
Companies which currently grant long-term incentive awards as conditional awards should consider:
- Whether existing awards should be converted into nil-cost options;
- Whether future awards should be granted as nil-cost options; and/or
- If existing awards are due to vest shortly before 6 April 2012, whether to defer the vesting of those awards until after 6 April 2012.
Companies currently granting nil-cost options
Companies which currently grant long-term incentive awards as nil-cost options may like to consider extending the length of the exercise period. Market practice is now for such awards to remain exercisable until the tenth anniversary of grant rather than for a limited period – typically 6 or 12 months – after vesting. In addition, companies should also consider whether to defer the expiry of any nil-cost options which would otherwise lapse shortly before 6 April 2012.
Rationale
The rationale for the focus on nil-cost options is that they can, so long as the exercise period is an appropriate length, provide employees with the flexibility to manage the impact of the 50% top rate of tax on their long-term incentive awards.
This is because, under the conditional award structure, tax liabilities are automatically incurred on vesting. The employee pays tax at the prevailing marginal rate at this time and has no choice in the matter.
In contrast, under the nil-cost option structure, the employee can choose when to exercise the option, receive the shares and incur the associated tax liabilities.
The nil-cost option structure could, therefore, provide useful flexibility as it allows an employee to choose when to incur the relevant tax liabilities which means that:
- If the employee is subject to the 50% top rate of tax but they thought that a reduction in that rate was imminent, they could decide to only exercise their nil-cost option once the reduction took effect thereby reducing the amount of tax payable; or
- If the employee's income is expected to fall in a future tax year so that they would come within a lower tax bracket, they may decide to defer the exercise of their nil-cost option until that later tax year. This could be particularly attractive if an employee is approaching retirement.
Issues to consider
If a company was minded to take any of the steps described above there are certain issues to consider before doing so including:
- Whether any proposed change could be made without prior shareholder approval;
- The disclosures to be made in the Directors' Remuneration Report; and
- Ensuring that the leaver provisions remain appropriate in the context of the new/amended award structure.
Cash Payments – Some things to think about
Although it is not at all certain that the 50% top rate of tax will be reduced from the start of the next tax year, 6 April 2012, it is a possibility. So far as any cash payments to be made to employees are concerned, it may be worth considering giving employees the chance to elect to:
- Defer the receipt of bonus payments until after 6 April 2012 (although a risk of forfeiture would have to continue to apply until payment);
- Defer bonus (or other cash) payments into awards which are taxed at a later date – e.g. cash warrants or options;
- Defer all or part of their salary payments until after 6 April 2012. This is, of course, an extreme measure to take and it would entail certain risks including the possibilities that HM Revenue & Customs would consider it to be unacceptable tax avoidance and that the employer could become insolvent before payment of the deferred sums was made; and/or
- Make further pension contributions (subject to the applicable limits) or charitable contributions before the top rate of tax reduces, thus maximising the tax relief that the contributions would attract.
Conclusion
The steps described above provide a simple way for companies to manage the impact of the 50% top rate of tax on long-term incentive awards, whether that rate remains in place or is reduced in the near-to-medium term. As to cash-based remuneration, while some of the ideas raised may only be of interest to a limited number of employees, a short-term deferral in the timing of bonus payments may well be a cost-effective step to take if the 50% top rate of tax is reduced.
Please contact your usual New Bridge Street adviser if you would like to discuss the points raised in this briefing.
This update is intended to highlight issues and not be comprehensive, nor provide specific advice. Aon Hewitt Limited does not accept nor assume any responsibility for any consequences arising for any person as a result of them using or relying on the information contained in this briefing.
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