What is net settlement?

Net settlement refers to a withholding method undertaken by some companies to satisfy their PAYE income tax and National Insurance withholding obligations when delivering shares to employees. Instead of delivering the full number of shares in settlement of a share award, a company will calculate the amount needed to satisfy PAYE and National Insurance withholding obligations and deduct a number of shares with a value equal to this amount from the number of shares to be delivered to the employee at settlement. The company will then pay the employee's PAYE tax and National Insurance liability to HMRC directly and the employee receives the net number of shares.

HMRC's new guidance

HMRC has recently published new guidance in its Business Income Manual setting out its views on the corporation tax deduction allowable for share-based payment expenses in the context of net settled and cash cancelled share options.

Where share awards are made to employees and the relevant conditions are satisfied, a statutory deduction is available in computing a company's profits for corporation tax purposes. One of these conditions is that the employee must actually acquire the shares. Where shares are not acquired, a statutory deduction is not available.

The amount of relief provided (where shares are issued) is generally equal to the amount on which the employee will be subject to income tax, which will be based on the market value at the time shares are actually acquired less any amount paid by the employee (e.g., exercise price).

The requirement for shares to actually be issued to employees creates a mismatch in the treatment between awards which are fully settled in shares, and those which are partially settled in shares and partly in cash.

In instances where statutory relief is available, there are additional provisions which disallow any associated accounting costs to avoid so called 'double dipping'. Unlike statutory relief, the accounting costs are typically based on the market value of any share/option when it is initially awarded as opposed to when it vests. The accounting cost will then be charged on a proportionate basis over the lifetime of the award (e.g., an award with a three-year vesting period would have a third of the 'cost' charged in each of the three years).

There is, however, an exception to the accounting costs being disallowed where the shares are not acquired by the employee but the employee is subject to income tax (this would typically be the net settled, or cash cancelled portion of an award) and HMRC state, in relation to the net settled portion, that the amount that can be deducted is limited to the amount of the accounting charge. This means that the accounting cost will need to be apportioned between the shares acquired (where the accounting cost will be disallowed) and the net settled portion (where a company may be able to claim a deduction).

Although the accounting cost (in respect of the net settled or cash cancelled portion of an award) is not disallowed, there may be a discrepancy between the amount which is paid and the accounting cost. This will likely be caused because the accounting costs are generally based on the market value of the award at the outset, as opposed to when settled.

Example

To help illustrate this, HMRC provides an example (see here) whereby an employee is granted an option over a 1,000 shares. On exercise, the employee acquires 580 shares, with 420 shares to be net settled. As such, only 42% of any Share Based Payment (SBP) expense, and 42% of any amount charged to income tax should be considered when calculating any deduction.

• In the period the options are exercised, there is a GBP 400 SBP expense charged in the accounts. Per the above, GBP 168 of this (equating to 42%) is in respect of the net settled portion of the award.
• Assuming the shares have a market value of GBP 2 at the time of exercise, and an exercise price of GBP 0.50, there would be a GBP 1,500 option gain which is charged to income tax. GBP 630 of this (equating to 42%) would relate to the net settled portion of the award. 

The allowable deduction for corporation tax purposes is then the lower of these two amounts, so GBP 168 in this instance. 
The guidance suggests that there may be scope to amend prior company tax returns for any previously disallowed accounting costs in this regard, and that prior year accounting costs could not be taken in the current year. Practically it can be difficult to amend prior corporation tax returns, and frustatingly, HMRC has not identified the legislative basis for why excluded accounting costs in prior periods could not be taken in the year the expense is actually incurred. This creates a distinction between those awards that are 100% settled in shares or 100% settled in cash where rolling up costs over the lifetime of the award is allowed.

See the new HMRC guidance here.

Other considerations

Recharge Agreements - Where awards are granted over shares in a parent company, it is relatively common for there to be an intercompany recharge agreement pursuant to which the parent will charge the subsidiary for the provision of the share awards to the subsidiary's employees. This will add another layer of complexity to any analysis of what expenses are deductible and is not dealt with in HMRC's guidance.

Uncertain Tax Treatment (UTT) – Employers looking to take a position in their tax filings that is contradictory to HMRC's position taken in the newly released guidance will need to consider whether it is disclosable to HMRC under the UTT provisions.

Next steps

For those companies operating net withholding, the UK employer may wish to revise the corporation tax deduction (if any) that it is claiming for the net settled portion. This will involve reviewing the accounting treatment and the impact of any recharge agreement. If a company wishes to receive a full statutory corporation tax deduction for UK employees without going against HMRC's stated guidance, they may consider operating a sell to cover withholding mechanism and avoiding net withholding for UK employees.

If you need any assistance with determining what corporation tax deductions are available or other employee share-plan issues, please do not hesitate to contact a member of your Baker McKenzie team.