Questions hanging over ‘owner-employee’ contractsAdd To My Clippings Alt Text

What are we to make of George Osborne’s headline-grabbing proposal to introduce a new type of employment contract for “owner-employees”? Under such contracts, employees would give up employment rights such as unfair dismissal and statutory redundancy pay and, in return, receive between £2,000 and £50,000 of shares in their employer which would be exempt from capital gains tax.

The Government hopes that owner-employee contracts will prove popular with businesses and employees alike, but in practice employees may have little choice but to agree to the arrangement. Employers will be free to make offers of employment conditional upon accepting owner-employee status.

Moreover, the Chancellor confirmed that employers will also be able to apply the arrangement to existing employment relationships. The position here is likely to be more complex than for prospective employees, as in many cases employees will be selling off rights they have already obtained. Will employees need to sign something like a compromise/settlement agreement to give up their existing rights? Will the change only be valid if they have received independent legal advice? Will employers need to consult with affected employees about the changes?

One likely scenario for the new type of contract will be where an employee is about to complete the two-year qualifying period for unfair dismissal. Although the Chancellor has said that the new “owner-employee” status will be optional for existing employees, the employer could force the issue by terminating the initial contract and offering reinstatement conditional on the employee agreeing to continue as an owner-employee.

The proposal is mainly aimed at fast-growing small and medium-sized companies that “want to create a flexible workforce”. Yet businesses of all sizes are likely to welcome the opportunity to buy off basic employment protections for a one-off share issue of as little as £2,000 of shares. To prevent abuse, one possibility might be a requirement to issue a minimum amount of shares - up to £50,000 - depending on the employer’s size, determined for example by headcount or revenue. Or perhaps the amount of shares required to be issued should depend on employees’ length of service.

There are further questions about how the proposal would work in practice. For instance, the Government says that a company buying back an employee’s shares on termination must be for a “reasonable price”. It is not yet clear how this will be calculated, who will pay for the valuation and what will happen if the company declines, or is unable (for example if it does not have the distributable profits) to pay. What does “reasonable price” mean? “Fair value” is just one basis of valuation. Would employees be left with shares that for practical purposes they cannot sell, because there is no open market? Will the legislation contain “bad leaver” provisions, whereby employees forfeit the shares if they are fired for gross misconduct and so on, or will these terms be subject to negotiation?

For group companies, will the shares be in the employing entity or the parent company, and what if that entity is based overseas? What about employees who are employed by a service company, where the shares may have no value, or by an employer with no share capital, such as a company limited by guarantee or a limited liability partnership (LLP)? How will such employers be able to use owner-employee contracts, if at all?

A major unanswered question at this stage is whether there will be any restrictions on eligibility. For example, other tax-advantaged enterprise schemes set a shareholder’s maximum entitlement at 30% of the company’s share capital. Or perhaps directors will simply not be eligible at all? Otherwise, where start-ups are concerned, founder director-shareholders will effectively be given a large tax advantage for giving up rights that would likely never be needed in any event. This would create a huge incentive to choosing a company as the vehicle for a start-up over other forms of business structure, such as an LLP.

Will the “owner-employee” shares have to have the same rights as the existing shares, or can they be non-voting shares with limited dividend and capital rights? The company and the other shareholders will want to have drag along rights under which, in the event of a third party wishing to buy the company, the owner-employees will be forced to sell their shares to that third party along with the other shareholders.

Currently, where employees are given shares in their employer, they are liable to income tax to the extent that they pay less than the market value of those shares. Will this also be the case for owner-employee shares and, if so, then how would one value the rights given up in exchange for the shares? Such a tax charge would potentially favour higher-paid employees (who could be given more shares tax-free by virtue of surrendering more valuable rights than lower-paid colleagues), but the alternative of a blanket exemption from tax when owner-employee shares are issued seems an obvious target for abuse.

The devil, as they say, will be in the detail. The Government is planning to consult on “some details” of the proposal later this month and introduce legislation later in the year so that employers will be able to use owner-employee contracts from April 2013. Until the proposal is fleshed out, it is difficult to predict what its impact could be. But potentially many employers will want to consider switching to the new model, justifying the label of “radical change” Mr Osborne has given it.

 

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