Phantom Share Schemes

Contributed by Martin Jackson ATT, Lead Tax Writer, Croner-i Ltd

A phantom share scheme is an arrangement where the value of a future cash bonus is dependent upon, and calculated by reference to, the increase in value – usually of a specified number – of company shares but which the employee does not own. It is essentially a hypothetical calculation: if the employee had owned x number of shares, how much would their value have increased over the specified period? This gives the basic amount of the cash bonus potentially payable to the employee. There are many possible variations and conditions; for example, the result could be subject to an additional multiplier, so that the employee benefits from a particular fraction (thus, some or all) of the underlying increase in share value. In almost all cases, payment of the bonus is contingent upon the employee remaining in the employment for a specified period. But the common element of all phantom schemes is that the employee does not actually acquire any shares or securities (hence the term ‘phantom’).

Many companies like the idea of rewarding their employees based on the company’s performance but are either unwilling or unable to give them an equity stake in the company for a variety of reasons. For example, the owners may be keen to ensure that no one other than the controlling individual or family should have shares in a company. In other cases there may be the danger that an employee shareholder could create an imbalance, for example where two individuals hold shares in a company equally. Whilst this could be overcome by issuing ‘non-voting shares’ to the employee, creating a new class of share capital carries its own implications and should not be done lightly.

It is not just private unlisted companies that use phantom schemes; major listed companies may also consider using them, particularly where they have reached institutional limits for employee share schemes. In practice, phantom schemes may be more convenient to operate in listed companies, as the hypothetical share value can be readily identified, whereas in smaller private companies, valuation is more problematic and may require some form of agreed mechanism. If the company is quoted, the employee can also see the increase on a regular basis.

In some situations it may be impossible to give employees shares in their employer – for example, where the company is not limited by share capital (e.g. a company that is limited by guarantee) or in non-corporate cases where there is no equity share capital (e.g. partnerships or public-sector organisations). In these cases, the phantom share scheme represents a sort of ‘halfway house’ solution. One of the reasons larger businesses, such as partnerships, decide to incorporate is that doing so provides the business with the opportunity to incentivise staff more widely through shares.

Employment related securities regime

Phantom share schemes do not normally involve the acquisition by employees of anything classified as a ‘security’ as defined in  ITEPA 2003, s. 420 , which would otherwise bring in the charging provisions of  ITEPA 2003, Pt. 7  (the ‘employment related securities’ regime).

This distinction was the subject of discussion in the recent case of Saunders  [2024] TC 09129 . In that case, an employee (Mr Saunders) was granted ‘Stock Appreciation Rights’ (SARs) by his employer. Under the SARs, Mr Saunders was entitled to receive a future payment, contingent upon various events, one of which was a sale of the company, provided it took place within two years of leaving the employment. The amount of the payment was to be calculated by reference to any increase in the fair market value of the employer’s shares between the date the SARs were granted and the date of the subsequent company sale. Some of the SARs vested immediately while others vested in instalments over a period ending in July 2015, such that when the company was sold in January 2017 all his SARs had vested and, as the sale took place within two years of his leaving, he was entitled to a cash payment. The gross payment amounted to over £1.2m and this was paid via the employer’s payroll, subject to PAYE. Mr Saunders argued in the FTT that the payment was not ‘earnings’ and so income tax should not have applied.

Interestingly, both parties cited Abbott v Philbin (HMIT)  (1960) 39 TC 82  in support of their respective positions. In that case, Mr Abbott had purchased share options from his employer which enabled him to acquire shares for less than their market value and it was determined that the initial grant of those options (as separate assets) gave rise to earnings, with the subsequent exercise and sale of the shares being a separate matter for capital gains tax. The case led to legislative changes, ultimately resulting in the current employment-related securities legislation (  ITEPA 2003, Pt. 7 ), but it was accepted that Abbott v Philbin remained good law other than to the extent it had been expressly reversed by statute.

Mr Saunders contended that although not ‘securities’ and thus outside of the employment related securities regime, the SARs were nevertheless separate rights, independent of the subsequent payment which resulted. As separate rights, he contended that they were only earnings when granted (though their value was considerably less than the ultimate payment, because at that time there had been no increase in the underlying value of the shares). It was, he argued, analogous to being given a lottery ticket by the employer – taxable when received (on its value at that time), but if it was a winning ticket, the payout would arise from the lottery, not from the employment.

HMRC argued that the SARs were not separate and distinct assets, but simply a contingent right to a future payment and the FTT agreed, dismissing the appeal. It was held that the grant and vesting of the SARs and the conditions which had to be met did not break the causal relationship with Mr Saunders’ former employment. The entitlement and subsequent payment arose from his employment and was a reward for his services.

Formulating a scheme

A scheme might operate similarly to those using real shares, by offering employees ‘notional shares’ in their employing company. These will be valued at the commencement of the arrangement. After the agreed period, typically one to three years, the notional shares will be revalued and any profit on them (or the agreed proportion) is paid to the employees as a cash amount. If the ‘shares’ have gone down in value, no payment is made, but it would be extremely unlikely (and contractually complex) for an employer to seek to recover a ‘loss’ from its employees.

If the company is operating successfully and is increasing in value, the employee receives a cash bonus based on a performance measure that is akin to the value of the company’s shares.

Another approach would be to structure the scheme to produce a cash bonus payable only on an exit, as a proportion of the sale proceeds (or net sale proceeds) by reference to a notional equity interest. Employees being offered the opportunity to participate in such a scheme would normally want to be assured that the company is genuinely working towards an exit, at least in the medium term so that there is a reasonable prospect that they will still be around to benefit.

Payroll

From an income tax and National Insurance contributions point of view, a phantom share scheme – provided appropriately structured – is nothing more or less than a cash-based bonus scheme. This means that any income received by the employee will be earnings under  ITEPA 2003, s. 62  and thus subject to both income tax and Class 1 NICs through the PAYE system in the normal way.

Although there are no tax incentives to be derived from operating a phantom share scheme, they are still, from the employee’s perspective, potentially motivational.

Corporation tax deduction

The employer can legitimately claim a corporation tax deduction on the cash payments it makes as these simply represent ‘remuneration’ for the employee. This is true even though, in a group of companies, the amount may have been calculated by reference to a rise in the value of shares in the parent company.

CGT and IHT

A potential advantage to the phantom scheme over schemes which seek to get pass real shares into the hands of employees, relates to capital gains tax and (particularly in the case of close companies) inheritance tax. A transfer of existing shares to employees, or the issue of new shares to them, may give rise to CGT and/or IHT aspects for shareholders, which would not apply in the case of a simple ‘cash bonus’ phantom scheme (because the employee would not own any real assets).

Conclusion

Phantom schemes can act as a genuine incentive, particularly to key members of staff, and can achieve the same objectives as other share-based schemes, but without using real shares. Consistent with the original philosophy behind the ‘share schemes’ incentive, they will help employees to identify their own performance and success with that of the company.

To obtain the maximum benefit from arrangements of this type, it is advisable for the employer to apply the same degree of formality as if it were implementing a fully-fledged share-based arrangement. There should be appropriate scheme documentation and contractual paperwork which is legally binding and which all parties sign up to. This paperwork should of course set out the basis on which the phantom shares will be valued so that there can be no question of an employee feeling that they have been short-changed when a final bonus is paid out.

Finally, considerable care is needed in putting a scheme in place. Apart from the formula for ascertaining the quantum of any pay-out, an important consideration will be what happens if the employee leaves employment (and whether in ‘good leaver’ or ‘bad leaver’ circumstances) part way through the life of the scheme. Any employment law implications of adding a bonus entitlement (whether contingent or not) into the employee’s overall financial package will also need to be considered.

Links to commentary, legislation and further resources concerning employee share schemes can be accessed via this Quick Link.