Tax Implications of Vesting and Reverse Vesting

Amy Thomson

Following on from Mark Stevens’ article on employment law guidance for the tech sector, Amy Thomson, a Solictor in VWV’s tax team, explores the tax implications of vesting and reverse vesting.

The terms ‘vesting’ and ‘reverse vesting’ are often used in the context of early-stage technology companies, but what are the tax implications of these types of conditions?

The first point to note is if a company issues shares to its employees or directors, the value of the shares will be subject to income tax and NICs in the same way that salary received is taxed. There is also the employment-related securities legislation to navigate if the shares are subject to restrictions, including a requirement to transfer shares when leaving.

Vesting

Vesting schedules can be based on time, performance or some other milestone, or a combination of the three.

As we have seen, vesting provisions are often used to incentivise employees by way of share options.

Whereas there are various tax-efficient option schemes available, the ‘go-to’ scheme for most early-stage technology companies is the Enterprise Management Incentive (EMI) scheme. The EMI scheme offers generous tax advantages. For example, if the options are granted with an exercise price equal to the market value at grant, there is no income tax or NICs payable on the exercise of the option, any uplift in value is subject to capital gains tax when the shares are sold.

Including vesting conditions does not affect the tax advantages, however, a company can decide whether vested options can be retained if the employee leaves.

If it’s not possible to grant EMI options (or another tax advantages scheme) or if the company opts not to, it may grant options that are not tax-advantaged. There are no specific legal or participation requirements for non-tax advantaged options and vesting schedules can be included in the same way. Similar to EMI options, there is no tax charge on the grant of an unapproved option but income tax (and possibly NICs) will be due on exercise.

Reverse Vesting

Reverse vesting enables an individual to have equity immediately upon joining, but the company retains control over those shares by requiring them to be forfeited if certain conditions are not met. An example of this is where there is a provision in the company’s articles requiring employees to transfer their shares if they leave the company.

Investors and founders often insist on reverse vesting as a way to give protection against key members leaving by providing an incentive for them to stay for a minimum period. During the forfeiture period, the individual will be treated like any other owner holding shares of that type.

Shares subject to forfeiture restrictions may also be subject to other restrictions, however, such shares can benefit from tax advantages if the forfeiture period is five years or less. Shares meeting this criteria can be awarded for no consideration and no income tax will arise until the risk of forfeiture has passed.

It may be appropriate for the employee to be taxed upfront in which case elections under section 425 and section 431 (1) and (2) of ITEPA should be considered.

Incentives and Share Schemes

Retaining key employees is critical to the success of most businesses, particularly early-stage technology companies, and there are a broad variety of incentives available which retain and motivate employees whilst being financially viable for your business.

Amy Thomson is a Solicitor in the Tax team at national law firm VWV. Contact Amy on 07973842388 or athomson@vwv.co.uk.