Capital Gains Tax Reforms – Impact on employee share plans

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Significant changes to the UK capital gains tax (CGT) regime were announced in the Pre-Budget Report in October 2007. Those changes will take effect when the Finance Bill 2008 receives Royal Assent, which is expected to be in July 2008. We highlight in this briefing the key features of the new CGT regime and some of the advantages and disadvantages of those features in the context of employee share plans.

Flat rate of CGT

Under the previous CGT regime, in circumstances where business asset taper relief was unavailable, CGT could be payable at a rate of up to 40%. However, where full business asset taper relief was available, the effective maximum rate of CGT was 10%. The new CGT regime will introduce a flat rate of CGT of 18%.

UK employees with options granted under HM Revenue and Customs (HMRC) approved Company Share Option Plans or Savings-Related Share Option Plans who exercise their options and sell their shares immediately will benefit from the new regime. Previously, the CGT charge arising on exercise of those options would have been taxed (for higher rate taxpayers) at 40% (given that the shares would not have accrued taper relief). As a result of the changes, CGT on exercise will be payable at a rate of only 18%.

Holders of options under non-HMRC approved plans (including nil-cost options granted under Long Term Incentive Plans) who exercise their options and sell their shares immediately will not usually realise a capital gain for CGT purposes and therefore the changes to the CGT regime are unlikely to impact significantly upon those employees.

Taper relief

Taper relief will be abolished under the new CGT regime.

Options granted under an enterprise management incentive share option plan currently accrue taper relief from the date of grant of the options. All other options accrue taper relief from the date of acquisition of the shares following exercise. As such, under the previous regime:

(a) holders of enterprise management incentive options who exercised qualifying options held for more than two years since grant and sold their shares immediately; and
(b) holders of other options who exercised their options and held the shares acquired for more than two years

may have accrued full business asset taper relief with the result that CGT would have been payable at a maximum effective rate of 10%. As a result of the abolition of taper relief, those employees will pay CGT at a rate of 18%, unless entrepreneurs’ relief is available (see below).

It should be noted that as a result of the interaction of taper relief with the annual exemption (£9,600 for the 2008/2009 tax year), the amount of CGT payable on the basis of the new 18% rate may be surprisingly high compared to the amount that would have been payable if business asset taper relief were to continue to apply. For example, under the previous regime, a gain of £100,000 which attracted full business asset taper relief would have resulted in CGT at 40% being payable on £15,400 resulting in a payment of tax of £6,160 (applying the annual exemption for the 2008/2009 tax year). However, under the new regime, a gain of £100,000 will result in CGT at 18% being payable on £90,400 resulting in a payment of tax of £16,272 (again applying the annual exemption for the 2008/2009 tax year).

Entrepreneurs’ relief

Entrepreneurs’ relief is a new relief from CGT which will apply to gains made on disposals of shares or securities in a trading company provided that, throughout the period of one year ending with the date of the disposal, the following conditions are satisfied:

(a) the company is a trading company (or the holding company of a trading group);
(b) the company is the individual’s personal company, which means that the individual must hold at least 5% of the company’s ordinary share capital and that the individual must be able to exercise at least 5% of the voting rights; and
(c) the individual is an officer or employee of the company (or if the company is a member of a trading group) of one or more companies which are members of the trading group.

In practice, the requirement that the individual holds at least a 5% shareholding in the company (which did not apply to business assets taper relief) is likely to limit severely the availability of the relief in the context of employee share plans. However, employees or officers of trading companies who dispose of shares acquired on the exercise of options (or otherwise) and who are able to satisfy the above criteria will be able to claim entrepreneurs’ relief to reduce the amount on which CGT on capital gains is charged so that an effective rate of 10% is payable. However, it should be noted that entrepreneurs’ relief can, in any event, only be claimed in respect of the first £1million of lifetime qualifying gains.

Share identification rules

The previous CGT regime contained a complex set of rules, the statutory identification rules, which operate where a shareholder disposed of only part of his or her shareholding to determine which of the shares were treated as sold for CGT purposes. Under the previous rules, shares sold would be identified first with shares acquired on the same day, then with shares acquired in the subsequent 30-day period and then on a “last in, first out” basis.

However, changes to the share identification rules will come into force when the Finance Bill 2008 receives Royal Assent, with the result that shares which would have been identified on a “last in, first out” basis, will instead be treated as forming part of one share pool and each share in that pool will be treated as having a base cost equal to the average base cost of the shares in the pool as at the date of the disposal.

So, for example, if an individual acquires 300 shares at a base cost of £1 per share in April 2007 and 200 shares at a base cost of £3 per share in April 2008 and the individual sells 100 shares in July 2008, the base cost of the shares sold will be £180 (on the basis that the average base cost per share is £1.80 and assuming that no other shares are acquired on or within thirty days after the date of the disposal). Applying the previous share identification rules, the aggregate base cost of the shares sold would have been £300. This may be particularly relevant to existing employee shareholders who exercise options to acquire further shares and authorise a proportion of the shares acquired to be sold to fund the exercise price or tax liabilities. In those circumstances, it may be important that the shares to be sold are sold on the date of acquisition to avoid the base cost of those shares being “tainted” by the base cost of the existing shares held.

For further information please contact:

Graham Muir
Partner
NABARRO LLP
T +44 (0)20 7524 6917
g.muir@nabarro.com

Laura Wise
Associate
NABARRO LLP
T +44 (0)20 7524 6489
l.wise@nabarro.com