Finance: Sharing the risks and the rewards

The Chancellor, Gordon Brown, has just set out two main objectives for increasing employee share ownership. In his pre-Budget report earlier this month, Mr Brown said he wanted to reward long-term commitment by employees and encourage a new enterprise culture of teamwork. He said he also wanted to encourage high-quality managers to share in the risks and rewards of running small and medium enterprises. There will be consultation on how to achieve these objectives, with a view to including them in the Budget.

The Chancellor's first objective is to double the number of companies in which all employees have the opportunity to own shares and thus become "stakeholders". So what does he have in mind?

There are two Revenue-approved share schemes designed to benefit all employees, rather than just being tailored for selected ones. The first is the Save As You Earn scheme, of which the Chancellor might seek to improve the terms. Under such a scheme, an employee can invest up to pounds 250 a month in a savings scheme that gives a tax-free bonus after three, five and seven years. When entering the scheme, the employee is granted an option to acquire shares in the company at no less than 80 per cent of the then share price. After the savings period has elapsed, the employee either takes the cash or uses it to acquire shares in the company by exercising the option. Contrary to the normal rule that applies to employee shareholdings, there is no tax to pay on exercising the option, and the profit on the eventual sale of the shares is charged to capital gains tax (subject to tapering and the annual exemption), not income tax.

So how might this scheme be made more attractive in order to ensure that more companies offer them and more employees take them up? Ideas that the Revenue might include in its consultative document are: widen the initial discount from 20 per cent to, for example, 30 per cent; give the company tax relief on that discount, even though the cost really falls on the shareholders; reduce the savings periods; reverse the reduction in the rate of bonus introduced last month.

But none of these is anything more than a tinkering with the rules, which are already quite generous, having gradually been made more so by previous chancellors. We do not expect any further improvement in the tax rules to make more than a marginal difference to these schemes.

Then there are profit-sharing schemes. Under these, the company pays money to trustees who acquire shares and appropriate them to individual employees to a limit of the greater of 10 per cent of salary and pounds 3,000, subject to a maximum of pounds 8,000. Providing the shares are held for at least three years, there is no income tax charge on either appropriation to the employee or sale by the employee, and the cost for calculating the capital gain on sale is the initial value of the shares, even though the employee originally got them for free. Once again, it would seem that tinkering with the rules wouldn't make the scheme more widely adopted. As an additional objective, the Treasury says that both this scheme and the SAYE scheme "might be redesigned to provide stronger incentives for longer-term shareholding by all employees". The context of this statement is that only one-third of SAYE scheme participants hold onto their shares.

So how could the Chancellor encourage people to hold onto their shares longer? One way is that he could treat the shares as being business assets for taper relief, even though the holding is below the 5 per cent threshold. The shares would then qualify for the higher rate of taper, and after one year rather than three. This may not make very much difference, however, because for many people, the annual exemption, which is currently pounds 6,800, is sufficient to avoid any tax liability on the gain.

Once again, the Chancellor's hands are somewhat tied if he wants to achieve anything meaningful. So, on to the second objective: attracting entrepreneurs to small and medium enterprises.

In its paper, the Treasury says it wants to "encourage more high calibre managers to join and stay with smaller companies, particularly early stage, high-technology companies".

Microsoft is perhaps the most obvious example of a company using equity to retain key employees, having created thousands of dollar millionaires among its workers. But in Britain, too, the idea has won support, with FI Group, the information technology support company founded by Steve Shirley, long owned by its largely female workforce.

The Treasury paper also asks whether tax incentives "might tilt the risk- reward balance to encourage entrepreneurial ambition and focus the incentives where they can be most effective. Limiting any incentives to key managers in a targeted group of smaller companies could avoid problems of earlier executive share option schemes which were indiscriminate in the tax advantages they provided and were often unrelated to the risks taken by managers benefiting from the options."

This last part is a reference to Revenue-approved "executive" option schemes. Previously, the limit was the greater of four times salary and pounds 100,000. There were certain highly-publicised events late in 1995, particularly among privatised utilities, which led to the Greenbury Committee and former chancellor, Kenneth Clarke, initially wanting to do away with the scheme altogether.

Mr Clarke had second thoughts when he realised that it was not only high- earners but also middle management and supermarket check-out staff who would be affected, so he tightened the rules and brought in the cap of pounds 30,000. Clearly, from the Treasury's reference to these schemes, we should not anticipate any general improvement to their tax treatment. If the improvement is confined to small and medium enterprises, however, the scope for abuse is much reduced. So what lines might such an improvement take?

If the shareholding is limited to, for example, 5 per cent of the company's capital, the Chancellor might consider: lifting the cap to, for example, pounds 100,000 again; or treating the shares as business assets for taper relief, even where the holding is 5 per cent or less.

However, the Chancellor might possibly take an even bolder step: for unapproved option schemes, the income charge that would otherwise apply on the exercise of the option would be postponed until the sale of the shares. In this way, the employee would then be encouraged to retain the shares rather than immediately sell them to pay the tax charge. This postponed income tax charge might be converted into a capital gains tax charge, providing that the shares are retained for a minimum period after exercise of the option, thus giving a further fillip to longer-term holding.

Alternatively, the company itself would get tax relief, perhaps by giving it a discount on its corporation tax if, for example, a given percentage of its shares were held by employees who had relatively small individual holdings.

What about thinking the unthinkable? The boldest step of all would be for any kind of share incentive scheme, and not just an option scheme, that would do away with the income tax charge altogether. An employee in a small- or medium-sized enterprise could be given a relatively small shareholding without paying income tax on the receipt, so there would be just capital gains tax to pay (by reference to the nil cost) when shares were sold.

Providing the Chancellor is bold enough, he could succeed in his aim of encouraging high-calibre people to work for small and medium enterprises and help them grow. This could be achieved through the tax system. Whether he can achieve his aim of doubling the coverage of all-employee share ownership plans is much more doubtful. Past chancellors have tried to do this before. There is no magic formula and whatever is attempted, the law of diminishing returns tends to set in.

Gordon Brown should be looking for incentives that lie outside the tax system. For instance, a government-backed loan scheme for employees where they can buy shares that are not repayable until those shares are actually sold.

The writer is a tax partner at Deloitte & Touche