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Share Schemes Training Session for HMRC Shares Valuation Pett, Franklin & Co LLP At HMRC Nottingham 7 th May 2014.

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Presentation on theme: "Share Schemes Training Session for HMRC Shares Valuation Pett, Franklin & Co LLP At HMRC Nottingham 7 th May 2014."— Presentation transcript:

1 Share Schemes Training Session for HMRC Shares Valuation Pett, Franklin & Co LLP At HMRC Nottingham 7 th May 2014

2 Timetable 1.IntroductionBarry Roland 2.UK Share Schemes OverviewDavid Pett12.30pm- 1.15pm 3.EMI share optionsStephen Woodhouse 1.15- 2pm 4.Interval2- 2.15pm 5.Black Scholes Accounting and topical valuation issues William Franklin2.15- 2.45pm 6.Questions and Discussion2.45- 3pm ©2014 Pett, Franklin & Co. LLP

3 UK Share Schemes Overview David Pett Partner 7 th May 2014

4 Introductions Pett, Franklin & Co LLP David Pett William Franklin Stephen Woodhouse ‘the Book’ : “Employee Share Schemes” (2-vol looseleaf, pub. Sweet & Maxwell) The market for advice and implementation assistance – lawyers vs accountants vs ‘consultants’ – the roles of : Share Plan Lawyers’ Group ifsProShare Efes The Esop Centre Employee Ownership Association (“EOA”) tax/company law/employment law/securities laws/trust laws Largely separate administration industry including offshore trustees ©2013 Pett, Franklin & Co. LLP 3

5 (Recent) legislative history 1980: SAYE share options 2000: EMI share options and Share Incentive Plans 2003: Tax law re-write.... immediately followed by: – change to charging rules for unapproved schemes and arrangements – MoUs re valuation of ‘management shares’ and ‘carried interests’ – ‘opportunistic’ (ab)use of bankers’ bonuses; ‘employees’ trusts’ used to warehouse funds free of PAYE 2010: Disguised Remuneration : was this the right response...? 2013: – OTS reports on approved and unapproved schemes – ‘Shares-for-Rights’ – Geo. Osborne’s idea – the Nuttall Review of Employee Ownership – myriad technical ‘relaxations’ of rules re SIPs, CSOPs, SAYE – ER for EMI option shares 2014: E-filing/registration and further technical changes (eg re takeovers) ©2013 Pett, Franklin & Co. LLP 4

6 Practical commercial difficulties Avoiding a ‘dry’ tax charge : ERS are charged to IT when acquired, even if they are not immediately convertible into cash (OTS proposal?) Are the shares ‘readily convertible assets’ ? (if the co not independent, they will always be RCAs) ‘founders’ shares’ – are the shares acquired by reason of an opportunity in the course of a personal relationship ? (s421B(3)) Is it a ‘close company’ ? Assessing ‘hope value’ - the ‘information standard’ (MORE LATER) ‘Restricted’ shares : – inherent characteristics of a share vs restrictions – UMV vs AMV (given that a s431(1) election has become the universal ‘default’ option) – the ‘10% rule’ ? Companies operating an ‘internal market’ – who determines MV ? ©2013 Pett, Franklin & Co. LLP 5

7 Unquoted companies Allowing employees to benefit from future growth in value EMI options: if you qualify, is it a ‘no brainer’ ? but what of ‘Shares-for-Rights’ ? ‘unapproved’ share options Joint Share Ownership (“JSOP”) awards (so-called)‘growth shares’ ? ©2013 Pett, Franklin & Co. LLP 6

8 Is an ERS acquisition taxed as a “right to acquire shares” ?...or as an acquisition of ERS at an undervalue ? – of concern to internationally mobile employees Is it a ‘general earnings charge’, or a Part 7 charge ? – different rules apply ©2013 Pett, Franklin & Co. LLP 7

9 Why is it so complex ? Example: Private company owned by H & W wishes to allow a key employee to benefit from growth in c. 9% of company; If co grants EMI option to subscribe for shares, exercised after 3 years, how does employee realise the growth in value ? A sale back to the co will give rise to a ‘dividend tax’ charge on the growth in value Co sets up an employees’ trust to buy back shares, but a loan to the trust attracts a penal 25% tax charge ! If co buys back from employee, he gets CGT with ER, but if co then buys back from trust, deemed MV CGT charge on trust ! So, have to have (a) an upfront issue of the shares to an offshore trust at par using small loan (with 25% tax); (b) a contingent purchase contract (under CA 2006) to buy back shares from trust at par; (c) a cash contribution to fund the buyback by trust from the employee [co gets CT deduction for share option gain, not cash contribution] ©2013 Pett, Franklin & Co. LLP 8

10 So, we need one more ‘tweak’…… Allow employee shares to be repurchased by the company itself with no dividend tax penalty if bought back within 5 years avoids need for an offshore employees’ trust it would allow an SME to: – grant EMI options – secure CT relief for option gain – buy back shares out of reserves into treasury – thereby ‘ringfence’ employee shares Please support the lobbying for change….! ©2014 Pett, Franklin & Co. LLP 9

11 Participation in future growth in value can be achieved by : grant and exercise of 'market value' share options (EMI options; CSOP options; 'unapproved' share options) the creation and issue of a special class of 'growth shares' allowing the employee to acquire an interest as 'joint beneficial owner' on unequal terms under a JSOP ('joint ownership') a ‘founders’ SIP’ ? 10 ©2014 Pett, Franklin & Co. LLP

12 ‘Employee Shareholder’ status (“SFR”): key Features Employee is issued with fully-paid shares in employer company (or holding company) worth at least £2,000 (after taking account of restrictions) for no consideration other than entering into a written ‘employee shareholder agreement’ Employee treated as paying £2,000 (so first £2,000 of value is exempt from income tax and NICs) Insofar as the initial value, ignoring restrictions (IUMV), does not exceed £50,000, gain on sale is completely free of capital gains tax Better than EMI where gain is taxed as capital gain, albeit normally with reduced 10% ER rate 11 ©2014 Pett, Franklin & Co. LLP

13 Employee has to forego certain key statutory employment rights Must be a written ‘employee shareholder agreement’ Before agreement becomes effective, the employee must receive Independent Advice (paid by employer) and there must be a 7-day ‘cooling-off’ period 12 ©2014 Pett, Franklin & Co. LLP ‘Employee Shareholder’ status: key Features

14 shares can be in employer company or a parent undertaking issuing company does not need to be independent ! – of particular attraction to PE-backed companies no exemptions if employee has a ‘material interest’ (25% voting rights) or, if a close company, 25% of assets on distribution, winding-up (etc.) at, or within 1 year before, issue of employee shareholder shares no IT/NICs on acquisition/on first £2,000 of AMV should company pay cash bonus to cover par value plus IT/NICs ? 13 “Employee shareholder status” (or “Shares for Rights” ) ©2014 Pett, Franklin & Co. LLP

15 Advantages of SFR Within a limit, gain is completely free of capital gains tax Shares can be restricted/special class - but this reduces the IAMV Shares can be in a subsidiary May be offered on a discretionary basis 14 ©2014 Pett, Franklin & Co. LLP

16 Disadvantages of SFR Statutory employment rights foregone (but rights under contract remain) Upfront tax charge (but first £2,000 tax free and value can be agreed in advance, so tax known) Lower limit for CGT relief (£50,000 compared with £250,000 for EMI) Shares must be issued (so cannot use EBT shares)......for no consideration (other than giving up employment rights) Company law problems 15 ©2014 Pett, Franklin & Co. LLP

17 Relief on sale back to company A sale back to the issuing company (for cancellation or to be held in treasury) is exempt from dividend treatment (even if the shares were not held for 5 years) but only if sold after the employee no longer a director or employee of that or any associated company Beware: gain on sale-back by continuing employee to issuing company is taxed as dividend income if shares not held for 5 years (etc) 16 ©2014 Pett, Franklin & Co. LLP

18 JSOPs: a summary Not share awards; not options Employee jointly acquires shares with co-owner (usually a trust) Held under terms of JOA Proceeds of sale unequal Employee receives growth (less carry charge) Co-owner receives the balance Capital gains treatment for employee (like EMI) Performance link 17 ©2014 Pett, Franklin & Co. LLP

19 18 £ [ 2] % p.a. ‘Carrying’ Cost SaleAcquisition Tax point Employee’s gain Co-owner’s gain 3 years ‘ Threshold amount ’ ©2014 Pett, Franklin & Co. LLP

20 JSOP Benefits Growth taxed as capital not income Employee pays tax at 28 % not 40 %+ Company saves NICs 13.8 % Tax analysis repeatedly publicly accepted by HMRC Flexible Same treatment as other shareholders on takeovers 19 ©2014 Pett, Franklin & Co. LLP

21 JSOP Issues Shares in existence from start (hence carry charge) Surplus shares trapped in conventional EBT if performance condition fails (use GPT) Close company loans to EBT No CT relief on growth Upfront cost of participation based on initial market value of employee’s interest (IUMV) Need to fix carry charge in advance 20 ©2014 Pett, Franklin & Co. LLP

22 When is a JSOP appropriate? If EMI options not available Share value meaningful (or not certain that HMRC will agree its not meaningful) IUMV sufficiently low for upfront cost to be economically feasible Growth prospects; if share price can only fall or flat line not much point as employee gets nothing 21 ©2014 Pett, Franklin & Co. LLP

23 Comparison of 'growth shares' and JSOPs 'growth shares' require changes to the articles, but a JSOP is all in contract, so easier documentation; JSOPs require a 'joint beneficial owner' : an EBT or GPT – Guernsey Purpose Trust allows surplus assets to be returned to company easier to administer JSOPs on a corporate transaction/'exit event' 22 ©2014 Pett, Franklin & Co. LLP

24 There are plenty of reliefs/exemptions for employee share acquisitions EMIs/CSOPs/SAYE share options; "Shares-for-Rights'; Share Incentive Plans … but not so many upon a disposal of employee shares : 'Shares-for-Rights' Share Incentive Plans ER for EMI option shares 23 ©2014 Pett, Franklin & Co. LLP

25 Changes in 2013 for SIPs OTS report on tax-advantaged share schemes – nearly all recommendations accepted Removal of pitfalls: – no ‘material interest’ test – removal of the penal clawback if company sold within 3 years for cash – freedom to use restricted shares – but restrictions ignored for valuation purposes –restrictions on transfer –good/bad leaver provisions –can be non- voting – removal of need for a specified retirement age ©2014 Pett, Franklin & Co. LLP 24

26 What if the company is sold ? From 17 July 2013 No tax on a withdrawal and sale of SIP shares pursuant to: – general offer to acquire control – a takeover offer (not defined) – a scheme of arrangement In consequence of which the participant receives cash (only) for SIP shares Must not be an alternative ‘shares- for – shares’ exchange on offer Avoids any risk of clawback if company sold early ©2014 Pett, Franklin & Co. LLP 25

27 Changes in 2014 to SIPs self certification/registration from 6 April 2014 increases in limits on tax-free shares – Free shares £3,000 to £3,600 – Partnership shares £1,500 to £1,800 – Matching shares ( 2 for 1) £6,000 to £7,200 – Dividend reinvestment (already no limit) annual returns to HMRC to be made electronically Partnership shares: may allow obligation to sell on leaving for at least amount of money used to buy Partnership shares (or MV, if less) new rules for enquiries and appeals ©2014 Pett, Franklin & Co. LLP 26

28 New registration and self-certification regime from 6 April 2014 To qualify for tax reliefs, every CSOP, SAYE scheme and SIP must be registered with HMRC through PAYE Online Services – registration can only be done by a person with full access rights Existing schemes/plans must be registered before 6 July 2015 All EMI plans and all unapproved schemes or arrangements must likewise be registered EMI grants must be notified online Annual returns must be online ©2013 Pett, Franklin & Co. LLP 27

29 Advantages of a SIP for founders (as against “growth shares”) Standard-form documentation Growth in value of “Founders” plan shares is entirely free of tax (exempt from CGT) – Non-SIP shares probably entirely tax-free because of CGT nil-rate band Relative ease of administration – Can normally be undertaken in-house GAAR? ©2014 Pett, Franklin & Co. LLP 28

30 Restricted Shares Problem: – pre-emption of SIP shares of leavers had to apply to all shares of the class forcing an existing non- SIP shareholder employee to sell New regime: – shares can be subject to restrictions which only apply to SIP shareholders ©2014 Pett, Franklin & Co. LLP 29

31 Employee-ownership Trusts Exemption from CGT if individual (or trustee) proprietors sell a controlling interest to a new-style Employee-ownership Trust (“EOT”) If a sufficient number of unconnected employees, vendors can retain up to 49% and rights to all dividends Can use company’s own funds to purchase the shares If company is later sold, a ‘clawback’ charge to CGT is levied on the EOT trustee, not the vendor(s) To avoid clawback, the EOT must retain indefinitely at least a 51% controlling interest ©2013 Pett, Franklin & Co. LLP 30

32 Conditions for CGT exemption on sale to an EOT The company is a trading company (or holding co. of a trading group) the trust only allows benefits on an ‘all-employee/same terms’ basis the trust acquires a 51% controlling interest by the end of the same tax year the ‘limited participation requirement’ is met the disposals (if more than one) must all be in the same tax year ©2013 Pett, Franklin & Co. LLP 31

33 Employee-ownership Trusts Relief from IhT if C, being a close company, makes a ‘gift’ of, say, cash to an EOT to fund the share purchase in the same tax year No relief from ‘loans to participators’ charge under s455 CTA 2010 on a loan by a close company to an EOT May still need a s701 ITA (“transactions in securities”) clearance if the EOT not acquiring at least a 75 per cent interest ©2013 Pett, Franklin & Co. LLP 32

34 ©2013 Pett, Franklin & Co. LLP 33 EOT Hold Co Trading Co 51% Note: Vendor can retain up to 49% (and 100% of dividends, if EOT trustees waive their dividends) provided the ‘limited participation’ requirement is met sells ≥ 51% of shares to EOT Owner 100% 49%

35 The “limited participation” requirement (s236N) NP must not exceed 2/5ths or 40% NE NP = no. of 5%+ ‘participators’ (shareholders or loan creditors) who remain employees or directors (etc) (+ connected employees or directors) NE = no. of group employees ©2013 Pett, Franklin & Co. LLP 34

36 Example: So, vendors (H & W ?) could retain up to 49% of share capital PROVIDED THAT (if they are the only participators who remain employees or directors, and they have no ‘connected persons’ who are directors or employees) the number of group employees is at least 6 (including H & W) If H retains at least 5% and W, son and daughter are employees (but have no shares), there must be at least 7 other employees (4 + 7 = 11; 4/11 exceeds 2/5ths) ©2013 Pett, Franklin & Co. LLP 35

37 Employee-ownership Trust An EOT must: only ever allow the fund to be applied for the benefit of all eligible employees on a “same terms” basis and so that all eligible employees then receive benefit – may allow 12-month qualifying period – must exclude existing and former 5% participators and their ‘connected persons’ not allow the creation of any trust of the fund, or making of loans or by transferring property to another settlement (except another EOT) not include any possibility of amending the trust so as not to satisfy these requirements ©2013 Pett, Franklin & Co. LLP 36

38 Clawback of relief........ occurs if there is a “disqualifying event”, but the clawback charge is on the trustees, not the vendor “Disqualifying event” is: – ceasing to be a trading company (etc) – the trust ceases to hold a 51% controlling interest – the participator fraction exceeds 2/5ths – trustees breach the ‘all-employee’ benefit requirements Immediate disposal and re-acquisition at market value [What if the EOT trustees are non-UK ? ] ©2013 Pett, Franklin & Co. LLP 37

39 “Employee Ownership Trusts” B. Relief from income tax on employee bonus payments Qualifying bonuses of up to £3,600 paid to all qualifying employees on a “same terms” basis will be exempt from income tax (but not NICs) Only available if the company is owned by an “Employee Ownership Trust” May differentiate on a linear basis according to length of service, salary level and/or hours worked From 1 October 2014 ©2014 Pett, Franklin & Co. LLP 38

40 Tax-free bonuses paid to all-employees of an EOT-owned company Must be a ‘bonus’ payment by the employer company Must be paid on a ‘same terms’ basis to all eligible group employees and not to only those in a particular member or function Employer must not be a ‘service company’ (ie providing services outside the group) or a ‘managed service company’ No. of office holders (+ connected persons) as fraction of all employees + office holders must not exceed 2/5ths Must be no “salary sacrifice” arrangements ©2013 Pett, Franklin & Co. LLP 39

41 EMI Benefits and Requirements Stephen Woodhouse Partner Pett Franklin/HMRC Seminar 7 th May 2014

42 Target Companies Small companies (defined by reference to maximum £30m of gross assets) Typically owner managed due to independence requirement May also apply for certain private equity backed companies with no 51% corporate shareholder ©2014 Pett, Franklin & Co. LLP 41

43 Tax Benefits No tax or NIC charges on grant of options No tax or NIC charges on exercise of options if exercise price no less than MV on grant Corporation Tax relief on exercise on intrinsic value on exercise (if relevant conditions for CT relief are fulfilled) CGT on sale but potential for entrepreneur’s relief to reduce effective rate to 10% ©2013 Pett, Franklin & Co. LLP 42

44 Tax Benefits Fact PatternValues MV of shares subject to options on grant£50k Total exercise price of option£50k MV of shares when options exercised£500k Tax on grantNil Tax/NICs on exerciseNil Corporation Tax relief on exercise£90k CGT on sale at £500k£45k Net Tax position£45k recoverable from HMRC ©2013 Pett, Franklin & Co. LLP 43

45 Main Requirements: Value Limits Legislation in Sch 5 of ITEPA Para 4 – must be granted for “commercial reasons” to “recruit or retain” an employee and not for tax avoidance Para 5 – employee may not hold an option in respect of shares worth more than £250k by reason of employment with one company or group; Option over excess value is not a qualifying option in relation to the excess Measurement of value includes value of CSOP options ©2013 Pett, Franklin & Co. LLP 44

46 Main Requirements: Value Limits For these purposes: – Value = “market value, at the time when the option is or was granted, of issued shares of the same class as those that may be acquired by exercise of the option” – Market value is CGT definition (Para 55) but ignoring restrictions (Para 5(8)) – £250k limit extends over three years (Para 6) ©2013 Pett, Franklin & Co. LLP 45

47 Main Requirements: Value Limits Para 7 – total value of shares subject to unexercised options must not exceed £3m (applying same valuation rules as for £250k limit) ©2013 Pett, Franklin & Co. LLP 46

48 Qualifying Companies: Independence Para 9 = not a 51% subsidiary or controlled by (a) another company or (b) another company and any connected person No arrangements to become such a subsidiary or fall under such control (other than arrangements for a “qualifying exchange of shares” – i.e. a share for share exchange in the context of a reorganisation ©2013 Pett, Franklin & Co. LLP 47

49 Qualifying Subsidiaries Para 10 - all subsidiaries must be “qualifying” if parent is to issue EMI options Subsidiary is any company which parent controls either on its or with any person connected with it (applying close company control test) Qualifying subsidiary requirement is that subsidiary is: – 51% subsidiary of parent – No person other than parent controls the subsidiary – No arrangements are in existence by virtue of which either of the first two conditions would cease to be met Also, parent must not have a “property managing subsidiary which is not a 90% subsidiary (paras 11A and 11B) ©2013 Pett, Franklin & Co. LLP 48

50 Gross Assets/Number of Employees Gross Assets Test (Para 12) – Gross assets of a single company do not exceed £30m at date of grant) – With a group, the gross assets test applies to the aggregate gross assets of each member of the group, disregarding any intra-group assets or shares or securities in other group members – Looking at gross assets shown in the accounts – can catch small companies with unusual accounting conventions (e.g. insurance brokers with client money) ©2013 Pett, Franklin & Co. LLP 49

51 Number of Employees Number of Employees (Para 12A) – Full time equivalent number of employees must be less than 250 – Full time equivalent based on a “just and reasonable” basis (see HMRC Manual) – Excludes employees on maternity or paternity leave or students on vocational training ©2013 Pett, Franklin & Co. LLP 50

52 Trading Activities Single company (Para 13) – must exist wholly for the purpose of carrying out one or more qualifying trades and is carrying on a qualifying trade or preparing to do so, subject to being allowed to: – Hold and manage property used by the company for one or more qualifying trades carried on by it – Have purposes having no significant effect on the extent of the Company’s activities ©2013 Pett, Franklin & Co. LLP 51

53 Trading Activities Parent Company (Para 14) – at least one group company satisfies an equivalent to the single company test: and The business of the group does not consist as to a substantial part in the carrying on of non-qualifying activities Business definition disregards holding shares or securities or making loans to other group companies, holding and managing property used by a group company for the purposes or one or more qualifying trades carried on by a group company or incidental activities. ©2013 Pett, Franklin & Co. LLP 52

54 Qualifying Trade Qualifying Trade is (Para 15) conducted on a commercial basis and with a view to the realisation of profits and does not consist to a substantial part in the carry on of excluded activities. R&D supported in that R&D from which it is intended that a connected qualifying trade will be derived or benefit counts as the carrying on of a qualifying trade. ©2013 Pett, Franklin & Co. LLP 53

55 Excluded Activities Dealing in land, commodities, futures, shares, securities or other financial instruments or goods “otherwise in the course of an ordinary trade of wholesale or retail distribution” Banking, insurance (but not insurance broking), money lending, debt factoring, HP financing or other financial activities. Leasing including letting ships on charter or other assets on hire Receiving royalties or licence fees Providing legal or accountancy services Property development ©2013 Pett, Franklin & Co. LLP 54

56 Excluded Activities Farming or market gardening Holding, managing or occupying woodlands, any other forestry activities or timber production Shipbuilding Producing coal or steel Operating or managing hotels Operating or managing nursing homes or residential care homes Provision of business facilities ©2013 Pett, Franklin & Co. LLP 55

57 Advance Assurance Facility for company to write to Small Company Enterprise Centre to seek assurance before options are granted before the grant occurred If full facts are given and are accurate, this assurance will mean that the Company is a qualifying company for as long as those facts remain unchanged ©2013 Pett, Franklin & Co. LLP 56

58 Employee Requirements Employment (Para 24) – Must be employed by the company granting the options or a qualifying subsidiary of that company – Concept of “committed time”; employee must have “committed time” of at least 25 hours per week or 75% of employee’s “working time” – Working time means time spent as an employee or self- employed person on remunerative work which for an employee means work the remuneration from which are general earnings for tax purposes – Working time includes absences for injury, ill health, disability, pregnancy, childbirth, maternity, paternity or parental leave, reasonable holiday or notice periods ©2013 Pett, Franklin & Co. LLP 57

59 Employee Requirements No material interest (Para 28) in any group company by employee or associated person Material interest threshold is 30% in the company or, if a close company, the assets of the company, covering beneficial ownership or in case of assets, 30% of assets available for distribution on a winding up Shares includes shares which may be acquired on the exercise of an option but excluding shares subject to qualifying EMI options and shares held in a SIP in accordance with the plan but which have not been appropriated or acquired by an individual Also, excludes EBT shareholding except where individual has had a 30% interest ©2013 Pett, Franklin & Co. LLP 58

60 Option Requirements Type of shares (Para 35) – Part of the ordinary share capital – Fully paid up (with an undertaking to pay not making the shares fully paid up) – Not redeemable Option to be capable of being exercised within 10 years of grant and any performance conditions must be capable of being fulfilled within that 10 year period (para 36) Option terms must be in writing (see later) ©2013 Pett, Franklin & Co. LLP 59

61 Reorganisations Part 7 of Schedule 5 provides for relief where acquiring company: – Acquires control of EMI company through a general offer or acquires all shares of the class subject to EMI relief through a general offer – Obtains control of EMI company through a court compromise or arrangements – Becomes entitled or bound to acquire to buy out shareholders through “squeeze out” procedure – Obtains all the shares in EMI company through “qualifying exchange”. ©2013 Pett, Franklin & Co. LLP 60

62 Reorganisations Facility (Para 41) for the grant of replacement options on tax protected basis where replacement options: – Granted within six months of acquirer obtaining control – Satisfy the normal EMI requirements for the purpose of granting options, value of options and Para 5 requirements relating to options – Other detailed requirements relating to the replacement options are satisfied ©2013 Pett, Franklin & Co. LLP 61

63 HMRC Notification To be a qualifying option, the employer must notify HMRC of the grant of the option in the specified form within 92 days of the grant of the option Subject to reasonable excuse for delay, failing to notify within 92 days results in the options not being qualifying for EMI purposes (Para 44) ©2013 Pett, Franklin & Co. LLP 62

64 Documentation In order to qualify, the option must be “in the form of a written agreement between the person granting the option and the employee” meeting certain conditions (Para 37) Question whether to use individual option agreements with individual terms or single set of plan rules with option agreement incorporating terms In either case, the option agreement must state: – The date on which the option is granted; – That it is granted under the provisions of Sch 5 of ITEPA – The number or maximum number of shares that may be acquired – The price (if any) payable by the employee to acquire them, or the method by which that price is to be determined; and – When and how the option may be exercised ©2013 Pett, Franklin & Co. LLP 63

65 Documentation Also the option agreement must: – Set out any conditions, such as performance conditions, affecting the terms or extent of the employee’s entitlement – Where the shares are restricted shares (within the normal meaning of Part 7, ITEPA), details of the restrictions. Overall, while the share rights are contained in the Articles, the option agreement needs to provide a comprehensive description of the key option terms. ©2013 Pett, Franklin & Co. LLP 64

66 Project Plan for EMI Scheme ResponsibilityDeadline Provide information requested for share valuation COMPANYG-30 Prepare note on targets in order for PF to draft performance conditions COMPANYG-30 Determine quantum of awardsCOMPANYG-23 Review Articles to establish if amendments might be necessary PF G-23 Prepare draft EMI scheme rules and option certificates PFG-23 ©2014 Pett, Franklin & Co. LLP

67 ResponsibilityDeadline Prepare draft share valuation reportPFG-22 Review draft valuation report and supply written comments with telephone call if necessary COMPANYG-20 Prepare and submit final valuation report to HMRCPFG-19 Review draft scheme rules and in particular: - Definition of “good leaver”/”bad leaver” - Meaning of “exit event” - Performance targets - Time-based vesting conditions for possible future awards COMPANYG-19 Consider comments and feedback (possible meeting/telcon) PF/COMPANYG-16 ©2014 Pett, Franklin & Co. LLP

68 ResponsibilityDeadline Prepare amended scheme rulesPFG-14 Draft employee communication including letter explaining risk of disqualifying events PFG-14 Prepare draft board/shareholder minutes and resolutions for establishing scheme PFG-14 Follow up valuation with HMRCPFG-12 Second review of draft scheme documentation (written feedback) COMPANYG-12 ©2014 Pett, Franklin & Co. LLP

69 Responsibili ty Deadline Prepare final versions of scheme rules and ancillary documentation PFG-5 Assume valuation agreed by HMRC (Note this timetable assumes HMRC agree valuation within 2 weeks of submission). HMRCG-4 Prepare individual option documentation including Form EMI1s PFG-3 Issue option documentation to employeesCOMPANYG -2 Execute documentation and grant options to employees COMPANYG Date ©2014 Pett, Franklin & Co. LLP

70 ResponsibilityDeadline Review executed documents and submit Forms EMI1 to HMRC PFG+3 Prepare document bible including company proforma documentation suitable for future awards and copies of the actual awards PFG+4 ©2014 Pett, Franklin & Co. LLP

71 Black Scholes Accounting etc William Franklin Partner Pett Franklin/HMRC Seminar 7 th May 2014

72 “Something must be done” Mid 1990s in US CEO pay controversy, growth delivered by share options. Some investors (e.g. Warren Buffet) complain no expense in companies accounts for this compensation: Accountant’s fault Something must be done- US Financial Accounting Standards Board (FASB) proposes an expense based on “fair value” of options- “Share Based Payment” ©2014 Pett, Franklin & Co. LLP

73 FASB Private sector non- profit organisation run by accountants to set accountancy standards in the US. Very proud, very independent institution FASB Share Based Payment expense greeted by horror by US corporates. – If US companies are forced to adopt this and the rest of the world (particularly UK) does not then US companies will relocate to the UK etc. Congress lobbied – Threatened to withdraw funding FASB- backs down ©2014 Pett, Franklin & Co. LLP

74 Shock at politicisation Leading accountants around world plan counter attack (including UK: David Tweedie) Have to deal with accounting standard in one country problem 2000 G4 +1 – discussion paper Drive to International standards But US standards very legalistic in style Enron shakes confidence in US Accounting Standards generally. Result : – The unthinkable happens US accountants co-operating with accountants around the world. – Manifested by a joint convergence project on Share Based Payments. Outcome IFRS2 (FRS20) FAS123 ©2014 Pett, Franklin & Co. LLP

75 Share Based Payment Problem : How do you get a “cost” for the issue of an option when there is no payment of cash Answer : use market value of options Problem : but do not exist Answer : Work out a theoretical figure ©2014 Pett, Franklin & Co. LLP

76 Standard Does not say use Black Scholes Says must calculate a “fair value” using 6 assumptions which are the 6 assumption of Black Scholes and disclose these 6 assumption in the Financial Accounts Bizarre... Standards do not normally require assumptions of accounting values to be disclosed. Policing assumptions is why there are independent auditors. ©2014 Pett, Franklin & Co. LLP

77 Black Scholes and Merton In 1970s some academic economists propose that a 19 th Century Formula for heat transfer could be used to value options. Win Nobel prize for Economics (Note Not Maths) Barack Obama said some strange people receive Nobel prizes ©2014 Pett, Franklin & Co. LLP

78 “ any colour as long as it is black” Black Scholes volatility price of commodity risk-free interest rate with respect to time price of financial derivative rate of change 77

79 Hard maths Maths developed by Newton Beyond understanding or training of 99% of accountants ©2014 Pett, Franklin & Co. LLP

80 Black Scholes Six Share price at date of option grant Exercise price of option Expected Life of option Expected future dividend yield Risk free rate of return Expected future share price volatility Note – Nothing about future expectation of share price performance or past trends in share price. ©2014 Pett, Franklin & Co. LLP

81 Fundamental Problems How do you predict future volatitlity ? – relevance of different past volatilities – business changes over time Assumes shares follow normal distribution ©2014 Pett, Franklin & Co. LLP

82 Normal Distribution

83 Features of Normal Distribution Mean Average = most frequent Spread = standard deviations (“volatility link) 66% = within 1 SD 95% = within 2 SD 99.7%= within 3 SD Lots of physical phenomena follow Normal Distributions (e.g. Heights of people) Lots of maths developed ©2014 Pett, Franklin & Co. LLP

84 Nonsense Shares do not follow Normal Distributions Remember Black Friday Share prices moved by 20 SDs Average American women 163 cm SD of 10 cm Like finding an American woman 363cm tall ©2014 Pett, Franklin & Co. LLP

85 Tall woman ©2014 Pett, Franklin & Co. LLP

86 In meantime No evidence that SBP charges actually reflect reality of costs of employee options Credit crunch – Failure by banks to value derivatives properly Black Scholes – Tested ideas to limit LTCM – another government bail out. ©2014 Pett, Franklin & Co. LLP

87 Why did standards setters press on ? Had no alternative were committed Davos debate Actually proud they did not understand the maths. Claimed they left calculations to companies but weasle words because of the Black Scholes 6 Assumptions Black Scholes used by banks to value financial derivatives In fact for short life option (few months) there is a traded market which sets price- implied volatility poorly correlated Volatility smile ©2014 Pett, Franklin & Co. LLP

88 But Standard setters did not really care what the figure was as long as there was a figure Analysts could ignore the expense or recalculate it by changing the assumptions (why there is disclosure). In fact they now usually disregard it as a non-cash expense Now largely ignored: Accountants who don’t understand the maths do not care, knowing it does not matter and subcontract the calculations to actuaries who have been looking for work with abolition of final salary pension schemes in the private sector continue but do not understand financial accounting. ©2014 Pett, Franklin & Co. LLP

89 Employee Share Option’s Employees can’t exploit volatility like traders Interested in long term growth prospects High volatility overstates value of an option to an employee ©2014 Pett, Franklin & Co. LLP

90 Zero Volatility ©2014 Pett, Franklin & Co. LLP Company A’s share price does not move over time

91 High Volatility ©2014 Pett, Franklin & Co. LLP Company B’s share price does not show an overall increase but is highly volatile Although, the expected growth in the share prices of both companies is the same (nil), Company B is much more volatile and so its Black Scholes value would be higher.

92 Ball park only Black Scholes for Employee options can only give a broad ball park value at best Need to look at other methods e.g. Capital Asset Pricing Model In future Game Theory and Quantum Mechanics may provide better methodologies ©2014 Pett, Franklin & Co. LLP

93 Information Standard Valuing growth or hope potential Access to confidential information: forecasts Lack of consistency – sick founder confidential ©2014 Pett, Franklin & Co. LLP

94 Discounts for Minority Interest Shares in subsidiaries Examples in SFR Is the normal 70%+ discount applicable ? Does existence of corporate controlling shareholder automatically make minority holding in a company more marketable ? We do not assume this for an individual majority shareholder so why should we for a corporate shareholder ? ©2014 Pett, Franklin & Co. LLP

95 Hope Value Enterprise value£10 million Debt: external and shareholder£15 million Negative Equity(£5 million) ©2014 Pett, Franklin & Co. LLP How can the equity have any value ? Any hope value is already reflected in Enterprise value

96 Questions and Discussion ©2014 Pett, Franklin & Co. LLP

97 Contact details David Pett mobile: 07836 657 William Franklin mobile: 07889 Stephen Woodhouse mobile: 07836 Office: 0121 348 7878 Twitter: For lots of information, go to our website: ©2014 Pett, Franklin & Co. LLP

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