Under share incentive schemes employees are given shares or the right to buy shares.

In the case of share option schemes the employing company grants the employee an option to buy shares in the company at some date in the future at a price based on the current share price.

Hopefully the share price will increase during the intervening period, so that when the option is exercised a profit is made. However, if the reverse happens nothing is lost, as the option does not have to be exercised.

If the scheme is one permitted by the Inland Revenue, no income tax (or National Insurance contributions) are payable by the employee, except on any dividends paid on option shares after the option is exercised.

Capital gains tax is payable only if and when the shares are subsequently sold (not when an option is exercised) and the more favourable taper relief applies (see Chapter 10).

Shares arising from the first three types of scheme shown below can be transferred to an ISA within 90 days of exercising the option (without counting against the current year's limits), thus ensuring longer tax free ownership.

If your employer has a scheme that is approved by the Inland Revenue you should consider joining, as the tax free benefits are significant.

The following schemes are approved by the Inland Revenue:

Savings related schemes

These are linked to a save as you earn contract (SAYE) and the total option value is limited to the maximum SAYE contract value, i.e. up to £250 a month plus the bonus after three years equal to 2 times the monthly contributions, or 6.2 times after five years.

The scheme must be open to all employees, with a qualifying period of service not exceeding five years.

The way it works is that at the commencement of the contract the employee starts an SAYE scheme with a bank or building society chosen by the employer and at the same time is offered an option to buy shares in three or five years' time, at a price which can be up to 20 % below the current market price.

Clearly if the shares go up in value over the period a profit is made. If the value of the shares goes down, all is not lost as the option does not have to be exercised and the SAYE savings scheme bonuses are worthwhile in themselves.

The bonus received at the end of the SAYE contract is tax free. Contributions then cease (although you can start again) but in the case of a five year contract, if the money is left in for a further two years instead of being used to buy options or withdrawn, a further bonus equal to 5.7 times the monthly contributions is received.

The bonuses are equivalent to 3.67% per annum after three years, 3.99% after five years and 4.07% after seven, tax free. In the case of SAYE contracts terminated before the expiry of the contracted period, no bonus is paid but interest of 3% a year is paid instead.

CGT is calculated on the gain over the option price but taper relief starts from when the option is exercised.

All employee share plans (AES0Ps)

This new type of scheme began in the year 2000. As the name implies, AES0Ps must be open to all employees, although a qualifying period of up to 18 months is allowed and the allocation amounts can be tied to length of service and/or hours worked. Allocations can also be based on performance.

There are three sections:

• free shares: employees can be given up to £3,000 of shares free of tax and NICs;
• partnership shares: employees can be allowed to buy shares out of pre tax income up to an annual maximum of £1,500;
• matching shares: employers can match partnership shares by giving employees up to two free shares for each one bought.

Free and matching shares must remain in the scheme for at least three years; partnership shares can be taken out at any time. Income tax and NICs are payable on the initial value of the shares if they are taken out after three years but this is avoided if the shares are left in the scheme for five years.

Capital gains tax will be payable only on the increase in value after the shares are taken out. If left in the scheme till sold, no CGT will be payable.

Up to £1,500 a year of dividends paid on the shares will be tax free if used to buy more shares in the company.

Profit sharing schemes

Companies can allocate a proportion of profits to the acquisition of shares in the company for the benefit of eligible employees. The maximum value per employee in any tax year is £3,000 or 10% of salary, whichever is the greater, subject to a maximum of £8,000.

The shares must be held by trustees for at least two years. Once they are transferred to employees they can be sold but income tax and National Insurance contributions are payable on the initial market value if the shares are sold within four years of the original allocation, the rate reducing to 75% of the applicable income tax rate if sold between four and five years. Thereafter they are only subject to capital gains tax.

Dividends are taxed in the normal way, whether the shares are held by the trustees or the employee.

Schemes must be open to all employees but a qualifying period of service up to five years is permitted.

Schemes must be merged into an all employee scheme after April 2002.

Company share option plans (formerly executive schemes)

Unlike the other schemes, company plans may be selective in membership.

There is an upper limit to the market value of shares when options are taken up, of £30,000 and a three year minimum period before options can be exercised. There may also be a requirement for minimum productivity improvement before options can be exercised.

Discounts are not permitted in this case options must be offered at the full current market price.

Cash will be required to buy the shares when the option is exercised and usually there is an arrangement with a stockbroker for immediate sale of some at least of the shares, to raise all or part of the cash, with a temporary loan to cover the period between sale and receipt of proceeds.

The usual tax reliefs apply.

Enterprise management incentives

This further new scheme also began in the year 2000. It is for key people in smaller companies, i.e. independent trading companies with gross assets not exceeding £15 million.

Any number of employees can each be granted options within a total for the company of up to £3 million in value of shares.

The usual tax reliefs apply.

Unapproved share option schemes

Although there are no tax reliefs on unapproved schemes (apart from the more favourable capital gains tax taper relief because the shares are in the employing company), it can still be worthwhile joining in, as the potential gain from an increase in value over the option period, even after paying additional income tax and National Insurance contributions, may well be worth having.

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