Mark McLaughlin outlines an arrangement allowing a company’s employees to benefit from the growth and success of the business without owning part of it.
Many company owners wish to incentivise and retain key employees by offering share option schemes through the company, or simply by arranging for the company to issue shares to those employees.
Nice idea, but…
However, some company owners may be put off the idea of employee shares diluting the value (and possibly the voting power) of their own shares. There may also be concerns about what happens if the employee leaves (or dies) while owning shares in the company.
In addition, share schemes can be complex (e.g., potentially involving the creation of a new class of employee shares, scheme provisions for ‘good’ and ‘bad’ leavers, adherence to detailed legislation for ‘approved’ tax status, and compliance with HM Revenue and Customs (HMRC) registration and reporting requirements).
Let’s pretend!
Instead of offering employees ‘real’ shares, some company owners may therefore prefer the company to offer employees ‘phantom’ (i.e., hypothetical, or ‘pretend’) shares instead.
A phantom share scheme is broadly an agreement between the company and employee, containing rules to determine how the scheme will operate.
A phantom share scheme typically allows participating employees to benefit from any growth in value of the company’s shares (e.g., on a future sale of the company). In addition, ‘dividend’ payments on phantom shares can be linked to actual dividend payments on ‘real’ shares.
Tax treatment
For income tax and National Insurance contributions (NICs) purposes, HMRC accepts there is no payment of earnings when the company awards phantom shares, i.e., the employee is only receiving the possibility of future payments in respect of the phantom shares (see HMRC’s Employment Income Manual at EIM01600).
Payments by the company in respect of phantom shares (e.g., ‘dividends’, or in respect of increases in the notional value of phantom shares based on increases in the company’s value) are treated in the same way as bonuses, so the employee is liable to income tax and employee’s NICs on such payments. The company will normally be able to claim a corporation tax deduction on the phantom share payments, plus employer’s NICs.
A phantom share option is not normally treated like a ‘real’ share option, so the grant of the phantom share option is not subject to the employment-related securities tax regime as securities or securities options (see HMRC’s Employment Related Securities Manual at ERSM110020).
Give it some thought
Phantom share schemes offer simplicity and flexibility. However, there are several issues to consider beforehand. For example, the company will need to have a sufficiently strong cash position to satisfy its payment obligations in respect of the phantom shares.
In addition, company valuations will be necessary from time to time where phantom shares are linked to increases in the company’s value (e.g., when phantom shares are first awarded, and on occasions requiring payments based on the notional value of the phantom shares, such as if the company is subsequently sold).
Furthermore, phantom share schemes may not be as efficient for tax and NICs purposes as ‘real’ share schemes, or alternative employee benefits (e.g., certain benefits-in-kind may be more tax-efficient).
Practical tip
Phantom share schemes are relatively straightforward to set up and administer. Nevertheless, it would be prudent to seek expert advice on the tax, company, employment and commercial law implications of running a scheme.
