INTRODUCTION – WHY SHARE OWNERSHIP SCHEMES?
 Historically there are a number of reasons why companies wish to offer share participation to their employees, but in general terms the motive is always the promotion of business success through workforce incentivisation. The aim is to motivate the employees to take a more personal interest in the company’s success, which in turn will result in their working harder and more productively.
To be an effective tool for employee incentivisation, a strategy needs to offer advantages in three main areas, which can be summarised as Reward, Control and Economy. In order to examine the value of share ownership schemes, it is helpful to compare them with two alternative incentivisation strategies – wage increases and bonuses.
Reward
The first criterion of an effective incentivisation scheme is that the employee should be easily able to identify what he has received as being a direct reward for the company’s success. Any factors that weaken this link will reduce the effectiveness of the scheme.
Wage increases and bonuses offer immediate cash payments to employees. Of these, bonuses have arguably the greater impact as incentives – not only are bonuses more clearly identifiable as being success-based, but the routine, regular nature of wages means that the reasons for a wage increase are soon forgotten. In either case, though, the fact that the sums received merely represent additional items of payroll tends to blunt their effectiveness, and to reduce the degree to which employees perceive them as direct rewards for company success.
The use of share ownership schemes enables the employees to enjoy dividends based on the company’s profitability, and capital appreciation as the underlying value of the company, and therefore of the shares, grows with success. Because of the nature of share ownership, the economic benefits of belonging to a share ownership scheme are more closely, intimately and automatically tied to the success of the company than for any other incentivisation strategy.
Control
An important element of any strategy is control – the ability of the management to target rewards accurately. Ideally this has two elements – ensuring that only individuals who contributed to success receive rewards, and ensuring that rewards are only paid when the company has succeeded.
Wage increases have some quite obvious problems in the area of control. Because they are based on the contract of employment, which is itself protected by rigid legislation, wages must be regular, secure and dependable, which means that the wage increase is not a suitable tool for rewarding success – while it is easy to increase wages in profitable years, it is considerably harder (often almost impossible) to reduce those wages in the lean years. Targeting wage increases to specific individuals may not always be straightforward, especially if there is union involvement and collective bargaining.
Bonuses offer excellent control. Whether it is on a “formula” basis (where the achievement of preset success criteria triggers an award) or on a purely “discretionary” basis (where management take the decision on who gets awards), the bonus can be accurately targeted to ensure that awards are only paid to deserving employees in recognition of genuine company success.
The control element in share ownership schemes falls somewhere between the other two strategies, although it is far closer to bonuses than wage increases. Depending on the scheme chosen, management can choose to control which employees receive shares, and how many shares are received. An additional element of control is obtained by virtue of the fact that any dividend income paid on the shares is essentially at the discretion of the board.
One element of share ownership schemes that often discourages proprietors from adopting them is the fear that they might lose control of the company if too many shares were owned by employees. This fear is easily allayed, since it is not necessary for the shares issued to employees to carry the same voting rights as shares retained by the original proprietors. Separate classes of shares may be created to offer extreme flexibility in how awards are targeted, without the risk of giving away ownership of the business.
Economy
The manner in which success awards are paid will determine how they are taxed, and tax is likely to represent the single most expensive cost of any incentivisation scheme. It is therefore important to look carefully at the tax implications of a chosen strategy, with regard to both tax costs for the employee receiving an award and the tax treatment for the company.
Wages and bonus are, for tax purposes, broadly similar. Both count as earned income in the hands of the employee, taxable at rates of 10%, 22% or 40% depending on income levels. In addition, both are subject to primary Class 1 National Insurance Contributions – these are, since 6 April 2003, charged at a rate of 11% on income between £89 and £595 a week and 1% on income over £595 a week. For the employer, both also carry a charge to secondary Class 1 NI Contributions – at a rate of 12.8% on income in excess of £89 a week.
The major taxation advantage of wages and bonus are that they reduce the company’s profits for corporation tax purposes; the company also obtains corporation tax relief for the cost of secondary Class 1 NIC. Bonuses also have a timing advantage over wages in that the company can obtain corporation tax relief for a bonus even if the bonus is paid late, so long as payment occurs within nine months of the end of the company’s accounting year.
Dividends paid out to holders of employee shares are not treated as earned income, so there is no charge to National Insurance Contributions for either the employee or the company. A dividend is taxed at rates of 10% or 32.5% depending on the shareholder’s income levels, and is treated for tax purposes as though it already suffered a 10% tax withholding. So long as the total income of an employee, including dividends, is below the higher rate threshold (£29,900 of taxable income), there is no additional tax to pay on the dividends. For higher rate employees, there is an additional income tax charge equivalent to 25% of the net dividend.
The disadvantages of dividends are that they are paid out of post-tax profits, and so do not reduce the company’s corporation tax bill. Additionally, they do not count as “pensionable” income (although this is less of a problem than it used to be because of the recent changes to pensions law).
Appendix A shows the cost implications of paying incentivisation awards to employees by the use of dividends or wages/bonus, and illustrates clearly the advantages of share ownership schemes.
Conclusion
For profitable companies, which are able to take advantage of employee incentives to boost business profitability, employee share ownership schemes offer valuable benefits in terms of reward, control and economy.
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