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How to Structure Deferred Bonus Plans - "Net" or "Gross"

David Tuch

Lovells

22 July 2005

This is a very important issue for senior executives as nearly half of the companies in the FTSE 350 now operate some form of deferred annual bonus plan where part or all of an executive's annual bonus can or must be deferred into shares which are released typically after three years. In some cases the company provides further matching shares. As these plans can be structured in a number of different ways, this article looks at how the UK tax implications of these plans vary depending on the structure adopted. The last five years has shown a doubling in the number of listed companies that have adopted some form of deferred annual bonus plan with nearly half of the companies in the FTSE 350 now operating some form of deferred bonus plan. Before considering how these plans are or could be structured in terms of the delivery mechanisms used I have briefly set out below some examples of the commercial features of these plans. Initial Shares In all of these plans participants effectively give up some or all of their annual cash bonuses in return for receiving shares at some time in the future . In nearly one quarter of the plans the participants choose whether to take their bonus in cash or whether to "invest" part or all of it in shares. In the remaining plans whilst there may be some element of choice the deferral into shares is compulsory. Compulsory deferral plans are becoming more common. In the majority of cases the Initial Shares are released after three years. If the participant ceases employment before then these Initial Shares are normally released early . Matching Shares In less than half of these plans, participants may receive additional shares at the end of the deferral period with the number of shares linked to the number of Initial Shares acquired. The most common level of matching is one for one . In some plans the Matching Shares are received if the participant remains in employment and has not taken his/her Initial Shares out of the plan early - this approach is most common with the voluntary deferral plans. In the rest of the plans the Matching Shares are only received to the extent that pre-determined performance conditions are satisfied. Deliver Mechanism for Initial Shares There are two main ways in which the Initial Shares are delivered to participants - these are commonly referred to as net deferral and gross deferral. Net deferral is where the participant receives a bonus and part or the entire bonus net of any income tax and employees' NIC is used to acquire the Initial Shares on behalf of the participant. Legal title to the Initial Shares is usually held by the trustees of an employee benefit trust although the participant has beneficial ownership of the shares from the outset. Example 1 A participant is required to or elects to defer 50 per cent of annual bonus. The gross bonus before deferral was £200,000. Under the net deferral method the participant receives 50 per cent of the bonus in the normal way and the remaining net bonus of £59,000 is used to acquire £59,000 of shares on behalf of the participant. Example 2 A participant is required to or elects to defer 50 per cent of annual bonus. The gross bonus before deferral was £200,000. Under the gross deferral method the participant's entitlement to a bonus is reduced to £100,000. This is payable in cash in the normal way after deduction of income tax and NIC . The balance of the bonus that would have been payable had the deferral arrangements not been in place is paid by the company to the trustees of an employee benefit trust. This is then used to acquire £100,000 of shares . In most cases the trustees then grant the participant a nil cost option under which the participant can exercise the option and take full ownership of the Initial Shares at the end of the retention period. UK Tax Implications of Net and Gross Deferral Net deferral As illustrated in example 1 above, participants are taxed at the outset on their cash bonus. However, this also means that they should, for capital gains tax purposes, be treated as having acquired the Initial Shares at the outset and therefore any increase in value should then be subject to capital gains tax and not income tax and NIC. As the Initial Shares should qualify as a business asset for taper relief purposes providing they are held for at least two years the maximum effective rate of tax on any increase in value should only be 10 per cent. In addition, participants will be able to make use of their annual exemption for capital gains tax purposes . Gross deferral As illustrated in example 2 above, participants suffer no tax at the outset on the bonus deferred into shares . This means that the participant will have an interest in a greater number of shares than under the net deferral method. In addition no tax charge arises on the grant of the nil cost option. However, when the participant exercises the nil cost option and acquires the shares, they will be subject to income tax and NIC on the value of the shares at that time. At current tax rates this is likely to result in an effective maximum rate of tax and NIC of 41 per cent. The Company's Tax Position Turning to the company's tax position we see that there is a potentially significant difference in the cost of operating the two types of deferral. With the net deferral, the company suffers employers' NIC on the bonus being deferred. However, the company will be entitled to a corporate tax deduction on the amount of the gross bonus together with the amount of the employers' NIC in the year that the bonus is charged . With the gross deferral there is no corporate tax deduction when the bonus is deferred and the money is paid to the trustees to acquire the shares. However, when the option is exercised the company will have to account for employers' NIC on the full value of the shares at that time on which a corporate tax deduction will be available. In addition, providing the company qualifies for corporate tax deductions on the exercise of options which will normally be the case provided the shares are: - Listed; or - in a company that not under the control of another company; or - in a company that is under the control of a listed company then the company will also get a corporate tax deduction on the gross gain that the participant makes. Other issues that might influence the decision Having demonstrated above that the participant should probably be indifferent as to whether the bonus deferral is net or gross from a tax perspective but that the company will probably favour a gross deferral we finally need to consider other factors that might/should influence the decision. These might include: - entitlement to dividends; - accounting costs. Whilst entitlement to dividends could in principle favour a net deferral, there is no problem with the company paying a dividend equivalent if it wanted to on a gross deferral . Turning to the accounting costs we see that the impact of the potentially improved corporate tax position flows through with the "cost" of the bonus deferral under the gross method reducing as a percentage of the net gain made by the participant as the share price increases. Dealing with employers' NIC Assuming that you have now decided that gross deferral is better than net deferral, you might be asking the question "does it make sense to pass the employers' NIC onto the participant or is there another way of effectively hedging this exposure?" In terms of the pure tax effectiveness of the arrangements passing on the employers' NIC to the participants clearly makes sense even if the company then decides to "gross up" the bonus to put the participants in the same position they would have been in. With employers' NIC currently at 12.8 per cent this would require a bonus of £100,000 to be "grossed up" to a bonus of £114,965. This arrangement could be made even more tax effective if the employers' NIC is passed on to the participant by setting the exercise price of what would have been the nil cost option at 12.8 per cent of the value of the shares when the option is exercised as the receipt by the company of the cash to pay the employers' NIC would be tax free. However, many companies would probably start to struggle with explaining the simple gross up let alone the second approach with a variable exercise price to both participants and to shareholders. An alternative approach to dealing with the employers' NIC worth considering is for the employee benefit trust to acquire an additional 12.8 per cent of the shares used for the bonus which it sells in the market on exercise of the nil cost option to cover the employers' NIC. Providing the share price rises, this approach gives a very similar result to passing on the NIC and then grossing up. Matching Shares In theory it would be possible to provide the Matching Shares upfront with a risk of forfeiture built into them hence replicating the net arrangement. These would then be akin to what are commonly known as an award of restricted shares. However, based on the above analysis there seems little point in doing this and, not surprisingly companies do not do this. The most common ways of providing the Matching Shares are through the: - grant of an additional nil cost option at the outset; - making of a contingent award under which the trustees of the employee benefit trust will simply - deliver the requisite shares once any conditions have been satisfied; - grant of a nil cost option over the requisite number of shares once the conditions have been met at the end of the retention period for the Initial Shares. The choice between these three mechanisms for delivering the Matching Shares is more one of personal choice than one influenced by the tax treatment and therefore I have not consider this issue any further. Conclusion In this article we have concentrated on the different tax implications of the two key ways of structuring the award of Initial Shares under a deferred bonus plan - "net" or "gross". This analysis suggests that "gross" will be more efficient when one looks at the overall position however it is important to remember that there are other issues that need to be considered before any decision can be made . In addition a key question that I have not considered at all is the source of the shares. Should they be newly issued, issued from treasury or purchased in the market? Ultimately the most important thing is to ensure that the plan incentivises participants to take actions which help the company achieve its overall business strategy and therefore issues such as the type of performance condition to use and the way that the plan is communicated to participants might in reality be more important than the effective tax cost of operating the plan. However, where substantial cost savings are potentially achievable, it does seem foolish not even to consider them.