On 8 October, the Chancellor of the Exchequer announced a new kind of employment contract for employee-owners and shortly after BIS issued a consultative document outlining the proposals together with draft legislation intended to amend the Employment Rights Act. In summary, employee shareholders will not have some generally available UK employment rights, but will hold shares in the business they work for, any gains on which will be exempt from capital gains tax (CGT).
The proposals raise some significant concerns. The intention is that the new arrangements will be available from April 2013.
What’s proposed for employee-owners?
Employee-owners will have a new kind of contract with their employers. They will not have certain statutory employment protection rights: not to be unfairly dismissed (except for certain dismissals which are regarded as automatically unfair and rights relating to anti discrimination), rights to a statutory redundancy payments, rights to request flexible working and training. They will also have to give longer notice to return from maternity or adoption leave (16 weeks instead of 8 weeks).
In return, employee-owners will receive shares in their employing company worth between £2,000 and £50,000 (at the choice of the employer). These shares will be subject to income tax (and national insurance contributions if relevant) on acquisition (unless the employee-owner pays market value for them), but will be exempt from CGT on a later disposal. The company can require employees the pay for the shares.
The new employment status is to be available from April 2013 for new employees and any existing employees who agree to become employee-owners. It is not possible at this stage to determine how many employers will wish to utilise the new shares-for-rights employment arrangement. It is likely that it will have more benefits for high earners such as executives, rather than low earners.
The trouble with the proposals
This would appear to be a back-door implementation of one of Adrian Beecroft’s recommendations (in his report of October 2011) to remove unfair dismissal rights so as to make it easier to fire underperforming employees. However, Beecroft did not include the idea of share ownership in return for giving up employment rights, rather just a straightforward payment on termination.
This new proposal is odd, given that the Government indicated in September that it would not adopt this Beecroft recommendation and a majority of respondents to the report did not support it. Moreover, the employee-owner proposals are fraught with difficulties.
BIS indicate that the proposals are intended primarily for start up and fast growing companies that want to benefit from the apparent flexibility of the new status. However, it is not clear that the new status is flexible. Some of the issues are listed below:
- The position of employee-owners who leave is unclear. BIS state that employers may require them to forfeit the shares, but that in order to protect them they should get “reasonable value” for the shares. Is a distinction to be made between good leaver and those who resign or are sacked for misconduct or other reasons? If employees will always be assured of receiving market value for their shares, what is there to retain and motivate them to perform and contribute towards the success of their employing company? Employers are at risk of having exchanged the cost of unfair dismissal/redundancy payments with having to pay market value for the shares, which could be a higher cost in many cases. On the other hand, the risk of not receiving full market value for shares for which the employee had already paid or on which he was taxed as employment income could make employee-owner status unattractive to employees.
- It is also unclear whether an employee owner who leaves will retain this status until he receives “reasonable value” for the shares or whether he can be dismissed with immediate effect and leave the matter of valuation of the shares for agreement or litigation in a costed forum. Employers would wish to avoid this situation.
- To ensure that the limits on the value of the shares are met, for income tax purposes and in order to pay for any forfeited shares of leavers, it will be necessary to value the shares on hire, on termination and possibly on an on-going basis. For private companies this could be an unacceptable and expensive burden which would make the proposal unattractive.
- The tax advantage of the proposal only kicks in if the shares grow significantly in value, beyond the usual available shelters from CGT, such as the generous annual exemption (currently £10,600, doubled if shares are transferred to spouses or civil partners). This growth is unlikely to occur in large listed companies. However, they may well adopt the new employment status, not necessarily to provide a capital-gains-tax-free growth in the value of the shares, but to have a workforce which is not covered by current employment protection rights.
- It’s unclear whether employee-owners who leave but retain their shares will lose all or part of any CGT exemption when they eventually sell them for example on a later sale or listing of the company. If so, the tax advantages are significantly reduced.
- No employee has the right to claim unfair dismissal or a statutory redundancy payment until they have been employed for more than two years anyway so the employer is not gaining anything by giving share ownership at the beginning of employment. The new status is therefore only going to be relevant for employees coming to the 2 year time limit. Having a workforce with different individual employment rights will make for difficult HR management.
- The right to claim discrimination and a variety of automatically unfair dismissals, e.g. whistleblowing will remain. Dismissal of an employee-owner may therefore still be as problematic as an ordinary employee.
- There are likely to be discrimination issues with a refusal to consider flexible working, or imposing lengthier notice periods to return from parental leave, even if the employee has signed up to the new status.
- The new status only removes the right to a statutory redundancy payment whereas many companies will offer more generous redundancy terms which an employee owner will continue to receive.
- The new status is probably going to be most attractive to senior employees, CEO and executive directors, of new start ups, who will gain the CGT advantage in return for giving up rights that are never going to be used against them, given that they control the company.
- Information for the employee will be key to making the status work. There will have to be clear and comprehensive guidance to avoid any claims of misrepresentation, particularly with regard to any future value of the shareholding.
- For companies in the financial sector who are obliged to comply with the FSA Remuneration Code, employee-owner shares are likely to be regarded as part of the variable remuneration element of the pay package. How will the required clawback and deferral provisions apply alongside the desire for employee-owners always to have some value from these shares?
- We understand it is suggested that employers will be free to give additional rights to employee-owners, including replacing the rights they have given up. However, it is not possible to give an employee statutory rights by contract. What could be done is to give a contractual right to a fixed sum on termination, perhaps an estimate of the likely award in an employment tribunal. However that was exactly the Beecroft proposal made for compensated no fault dismissals, rejected by the Government in September. It also raises the question of why an employer would want to give back a right which had been given up in return for the allotment of shares. There is therefore a risk that this structure will be used in this manner solely to take advantage of the CGT exemption, without any loss of rights to compensation on leaving.
Mirit Ehrenstein, Linklaters employment lawyer, said: “We have real concerns about how this proposal will work in practice, particularly for start up companies whose shares may be tricky to value. Employers may well be replacing a low-level potential liability for statutory unfair dismissal payments with significant costs involved in providing the shares and buying out employee shareholders who leave.”
Gillian Chapman, Linklaters head of employment and incentives, said: “In practice large companies may simply use this arrangements to have only employee shareholders without any of the statutory employment protection rights.”
Simon Kerr-Davis, Linklaters employment lawyer, said: “Companies wishing to offer this type of arrangement should ensure they do not come up against some difficult discrimination issues, which it is not possible to contract out of. The risk of claims remains.”
Simon Kerr-Davis, Linklaters employment lawyer, said: “There could be some tricky HR management issues when dealing with a workforce having different employment rights.”
Mirit Ehrenstein, Linklaters employment lawyer, said: “The tax advantage of the proposal only kicks in if the shares grow significantly in value beyond the usual reliefs from capital gains tax which enable most employee shareholders to shelter gains from tax. It’s likely that only executives of start up companies which become successful will benefit.”
Simon Kerr-Davis said: “Managing the disciplinary procedures and performance issues properly can significantly reduce the risk of a successful unfair dismissal claim by an employee and in practice may well be more cost effective than implementing and operating an employee shareholder arrangement such as the one proposed, which can become quite cumbersome.”
For further information, please contact Rupert Winlaw on 0207 456 3219.