Equity based compensation in the UK Legal update

Janet Cooper

Head of Employee Incentives

Linklaters & Alliance

What a year!

• Who should pay social security on option gains?

• Will the accounting issues hold us back?

• Government tries to boost employee share ownership in UK

• Overview of developments in Europe

• Changes to the London Stock Exchange

• Impact of e-conomy

National Insurance

• Is there a problem?

1 National Insurance on option gains

What’s the problem?

since April 1999, employer pays NI at 12.2% of option gain

potentially large amount (new economy companies)

uncertainty large and variable provisions in accounts

National Insurance on option gains

What’s the solution?

• pass this cost to employees

• transfer of liability

• recovery of cost

• settle NI liability in advance

National Insurance on option gains

Transfer of NI liability

• effective for US GAAP

• form of joint election must be approved by UK Revenue

• can transfer all or part of liability

National Insurance on option gains

Recovery of NI cost

• not effective for US GAAP

• liability remains with employer

• informal arrangements for employee to refund cost

• no approval necessary

National Insurance on option gains

• Tax deduction for employee

• 47% not 52.2% tax

National Insurance on option gains

Accounting treatment in the UK

• future liability estimated and provided for in accounts

• no provision if election in place

National Insurance on option gains

So what’s to be done …. Ask

• is the company prepared to pick up cost?

• how will it look in accounts?

• do you want to transfer liability?

National Insurance on option gains

To transfer liability

• look at plan rules

• prepare letter and agreement

• get Inland Revenue approval

• speak to accountants

• “cost” of options should be recognised in company accounts

2 Accounting for share-based payments

Accounting for share-based payments

• UK, Australia, Canada, New Zealand and US ASBs

• heard this before?

Accounting for share-based payments

IASBs’ reason for change:

• Company is receiving value of services

• Accounts should reflect cost of this “transaction”

• Not happening under current rules

Accounting for share-based payments

IASBs’ proposals:

• “Fair” value should be charged

• Include existing shares as well as new issue shares

• Includes share-based payments to non-employees

Danger - might make options too “expensive” for some companies

Accounting for share-based payments

What’s “fair” value?

• Calculated using option pricing model (eg Black Scholes)

• Fair value to be determined at vesting

• But:

– options not transferable

– what about unlisted companies?

Accounting for share-based payments

What’s the accounting period?

• Charge to be spread over performance or

vesting period

• Adjustments to be made to reflect

– likelihood of vesting and

– changes in option “value”

Accounting for share-based payments

Financial impact

• double hit to shareholders

• some companies become insolvent overnight

• makes share awards/options very unattractive

• lose edge in “war for talent”?

Accounting for share-based payments

Proposals are wrong

• Options are incentives not salary

• Cost is a dilution cost to shareholders not a profit cost

• Valuation methods arbitrary and unrealistic

Keep very close eye on your ASB!

These proposals are coming your way

Keep very close eye on your ASB!

These proposals are coming your way

Accounting for share based payments

3 Budget 2000 and 2001

Boost for share ownership?

• 2 new qualifying plans for UK employees

• Greater taper relief on capital gains

New qualifying all employee share ownership plan

• Flexible - free, partnership and matching shares (no options)

• To be offered to all UK employees

• Can be related to performance

• But administration burdensome

• Tax benefits if shares held for 5 years

EMI options

• Aimed to help small entrepreneurial companies recruit and retain

• Up to £100,000 options tax free for each of 15 key employees

• No approval procedure

EMI options

BUT company must:

• have gross assets of less than £15m (~$23m)

• be independent

• be trading in the UK

EMI options

Changes announced this November

• remove limit of 15 employees

• increase value limit to £2.5m

CGT taper relief

• Capital gains tax decreases the longer shares are held

• 2000 Budget - taper relief for all employee shareholders

• Effective CGT is 10% on gain if shares held for 4 years!

4 Overview of developments in Europe

• France

• Holland

• Germany

• Italy

• Spain

• Holland• Germany

• France

• Spain • Italy

Country Taxableevent

Maximum socialsecurity payableby employer

Maximum socialsecurity payable byemployee

Top rate ofincome taxpayable

Top rate of capitalgains tax payable

Total

Exercise 20.9% 17.2% 50% 88.1%Austria

Sale within

24 months50%

Exercise 6.5% 1.5% 60% 68%Finland

Sale 28%

Grant 26.6% 7.8% 55.3% 89.7%Norway

Exercise 28%

Exercise 23.75% 11% 40% 74.75%Portugal

Sale 10%

Exercise 12.2% 10% 40% 62.2%UK

Sale 40%

Belgium Grant 16.7% 55% 71.7%

Denmark Exercise 9% 32% 41%

Holland Vesting 18.89% 8% 60% 86.89

Luxembourg Exercise 15.7% 11% 47.15% 73.85

Sale 47.15%

Spain Exercise 32.6% 6.4 48% 87%

Tax on Options - Europe

5 London Stock Exchange

• Demutualised and listed to become London Stock Exchange plc

• To avoid conflict, regulatory work now under Financial Services Authority

• Admission to listing and trading now separate

London Stock Exchange

Merger story

• Talks with Frankfurt Deutsche Börse exchange to form iX-international

• OM Group announces hostile bid

• LSE withdraws from iX talks

• LSE publishes defence to OM bid

• OM bid fails

• What next? Link with NASDAQ?

6 Impact of new e-conomy

• More flexible/shorter vesting

• No performance conditions

• Challenges to corporate governance guidelines

Impact of new e-conomy

War for talent

• Global battleground

• Changing views of institutions?

Impact of new e-conomy

dot.corps

• New incentive design challenges

• Technical challenges

• Institutional investor relations

So, in 2000…..

• Good news - new plans, help on NI costs

• Keep an eye out for future options lobbying

• Bad news - accounting for options

…….. what about 2001?

Thank you