Long-Term Incentive Plans: Structure and Design

1. A Presentation forThe ESOP Centre and STEPat a conference to be held at The Royal Yacht Hotelin Jersey, Channel Islands,on Friday, 11th July, 2008

2. Long-Term Incentive Plans: Structure and Design Reminder of the purpose of an L-TIP • The award of shares or cash on the basis of the achievement of performance targets. • The structure is a deferred right to receive shares at nil or negligible cost. • The reason is for incentive and motivation and retention.

3. Long-Term Incentive Plans: Structure and Design The comparison with share options • The cost of the shares is usually nil. • The benefit is the full value of the shares. Through a discretionary trust (EST) – Why? • The company cannot issue shares at a consideration that is less than nominal value so there is a need to recycle existing shares to deliver 100% share value. • Historically, the company has not been in a position to own its own shares.

4. Long-Term Incentive Plans: Structure and Design Quoted companies • The design is led by the Institutional Investor Guidelines from the Association of British Insurers and the National Association of Pension Funds. • The sanction is that the requirement for shareholder approval provides the opportunity for the institutional investors to vote against an L-TIP that does not comply with the guidelines.

5. Long-Term Incentive Plans: Structure and Design The ABI Guidelines on Policies and Practices For the Quoted Companies Last Release: 3rd December, 2007 • The regular phasing of awards on an annual basis, recognising that phased vesting is not an alternative to phased grants. • The threshold vesting amounts should not be significant by comparison to annual base salary and “cliff-edge” vesting profiles are considered inappropriate, particularly where there may be clustering of performance outcomes around the average. • The vesting of awards with high potential value should be linked to commensurately higher levels of performance. • The performance criteria should be a genuine reflection of the company’s underlying performance, supported by a full reasoning, typically linked to Total Shareholder Return or Earnings Per Share, and with reference to comparator groups, based on measurement over a minimum of three years.

6. Long-Term Incentive Plans: Structure and Design For the Private Companies General Practice • During the natural life of a company, where there is no expected or planned exit date. • Usually operate staggered grants with overlap option periods, mirroring the quoted company phased award model on an annual basis. • Where there is an expected or planned exit date. • May consider large single one-off awards in the first year in order to lock all benefit into a low initial cost with an accumulating right to exercise unravelling on a year-on-year basis.

7. Long-Term Incentive Plans: Structure and Design The tax challenge for the L-TIP: To avoid a tax charge for the employee at the outset • The design advantages of the L-TIP flow from its flexibility but beware of the need for careful tax planning as the L-TIP is a tax-unapproved scheme. • The protective structure is for the award to be an unenforceable promise where the transfer of shares or the interest in shares is dependent on the fulfilment of certain pre-defined performance conditions. • But are there alternative tax structures to superimpose upon the commercial designs?

8. Long-Term Incentive Plans: Structure and Design Alternative 1:Enterprise Management Incentives • The opportunity to avoid income tax at the inception of the scheme. The EMI formula for a L-TIP EMI as a nil cost 100% discount option + Employee share trust = Long-term incentive plan

9. Long-Term Incentive Plans: Structure and Design The tax implications of EMI • At the inception of the scheme, • no income or NICs at the inception. • At the maturity of the scheme, • income tax and NICs only on any discount that was given at the inception. • At the sale of the shares, • capital gains tax on the growth since inception.

10. Long-Term Incentive Plans: Structure and Design The summary of using EMI as an L-TIP • The scheme operates through a compact body of bespoke legislation that is purposely designed to deliver tax advantages. • The company can secure the statutory corporation tax deduction on the gain realised by the employee at exercise. • The company does need to qualify for EMI, including its gross assets not in excess of £30million at the inception of the scheme.

11. Long-Term Incentive Plans: Structure and Design Alternative 2: Restricted Securities • The opportunity to avoid income tax at the inception of the scheme. • The Special Rule under Finance Act 2003 • No income tax or NICs at the time the restricted securities are acquired provided the restriction is a forfeiture or compulsory transfer restriction that ceases within 5 years following the acquisition of the shares.

12. Long-Term Incentive Plans: Structure and Design The use of the restricted securities tax elections Four Scenarios • Scenario A: • The Special Rule restriction and no election made to be subject to income tax and NICs on acquisition on unrestricted value. • The Consequence: • No income tax and NICs on acquisition at all! on neither restricted nor unrestricted value. • Future gain subject to income tax and NICs.

13. Long-Term Incentive Plans: Structure and Design The use of the restricted securities elections Four Scenarios • Scenario B: • The Special Rule restriction and an election is made to be subject to income tax and NICs on acquisition on unrestricted value. (A Section 425 Tax Election) • The Consequence: • Income tax and NICs on acquisition on the unrestricted value less amount paid. • All future gain subject to capital gains tax.

14. Long-Term Incentive Plans: Structure and Design The use of the restricted securities elections Four Scenarios • Scenario C: • The Non-Special Rule restriction and no election made to be subject to income tax and NICs on acquisition on unrestricted value. • The Consequence: • Income tax and NICs on acquisition on the restricted value less amount paid. • Further income tax and NICs when the restrictions are lifted, or there is a variation or removal of restrictions or the shares are sold.

15. Long-Term Incentive Plans: Structure and Design The use of the restricted securities elections Four Scenarios • Scenario D: • The Non-Special Rule restriction and an election is made to be subject to income tax and NICs on acquisition on unrestricted value. (A Section 431 Tax Election) • The Consequence: • Income tax and NICs on acquisition on the unrestricted value less amount paid. • All future gain subject to capital gains tax.

16. Long-Term Incentive Plans: Structure and Design The use of the restricted securities elections Planning Principles • The Special Rule asks for the decision between the following:- • No income tax and NICs on acquisition but income tax on future gain, • OR • Income tax and NICs on acquisition on unrestricted value but capital gains tax on future gain.

17. Long-Term Incentive Plans: Structure and Design The use of the restricted securities elections Planning Principles (Continued) • The Non-Special Rule asks for the decision between the following:- • Income tax and NICs on acquisition on restricted value and income tax and NICs on future gain, • OR • Income tax and NICs on acquisition on unrestricted value but capital gains tax on future gain.

18. Long-Term Incentive Plans: Structure and Design The use of the restricted securities elections Planning Principles (Continued) • For private companies, there may be freedom on what restrictions to impose. • For quoted companies, restrictions will typically be a form of agreed lock-up. • For private equity/buyouts, restrictions will typically be on voting rights or sell-back obligations.

19. Long-Term Incentive Plans: Structure and Design The use of the restricted securities elections Planning Principles (Continued) • As a general principle, the employee would elect to pay income tax and NICs at the outset if the share price is currently relatively low and/or there is confidence that the share price will grow. • Always do the calculations on whether or not to make the election; do not make an automatic decision to elect. • Note: the election must be made jointly between the employee and the company within a period of 14 days after acquisition or the chargeable event as appropriate.

20. Long-Term Incentive Plans: Structure and Design 3. Share Loan Schemes • The opportunity to avoid income tax at the inception of the scheme through providing funds for an employee purchase at market value. • The abolition, from 1st October, 2007 through Companies Act 2006, of the general prohibition on loans to directors in favour of a shareholder approval allowing loans, quasi-loans and guarantees to directors and connected persons. • The technique is to have a circular flow of cash • The advance of a loan from the company to the employee. • The subscription for new shares by the employee to the company. • For bad leaver, the sale is at the lower of cost and market value. • On exit, the purchase price is deducted from the sale proceeds and the loan is paid off (the “tail-swallowing” technique).

21. Long-Term Incentive Plans: Structure and Design The appropriateness of the share loan scheme • Where executive share purchase requirements. • Loan funding to facilitate the investment. • Enables actual shareholding from the outset. • No upfront cost required from the employee. • Risk of exposure if the share price falls.

22. Long-Term Incentive Plans: Structure and Design The tax implications for the share loan scheme • No income tax or NICs on purchase by the employee. • Growth captured by the capital gains tax regime. • Benefit-in-kind on the loan interest. • The usual exemptions from the notional interest. • No income tax relief where there is a capital loss. • Any loan write-off is taxed as remuneration. • No corporation tax deduction is available. • Be careful to avoid the 25% tax charge on loans to participators in a close company.

23. Long-Term Incentive Plans: Structure and Design 4. Share Purchase Scheme The use of early share purchase arrangements Two Versions Version A: The Immediate Purchase Scheme For the quoted or the private company. • Purchase of shares by the employee through the net amount of a bonus award, enabling purchase at market value. • Income tax and NICs for the employee on the bonus award through treatment as emoluments but • For the company, an early corporation tax deduction. • For the employee, capital gains tax for future growth. • The key: The benefit of the early corporation tax deduction should be evaluated using discounted cash flow analysis.

24. Long-Term Incentive Plans: Structure and Design The use of early share purchase arrangements Two Versions Version B: The Growth Shares Model Typically for the private company. • Option granted to the employee over newly-created low value growth shares from a separate class or, alternatively, low value shares issued to the employee at the outset of the arrangement. • For the company, low cost funding to the employee share trust for the purchase of the shares. • For the employee, capital gains tax for future growth if linked to Enterprise Management Incentives or, alternatively, if purchased at the outset of the scheme.

25. Long-Term Incentive Plans: Structure and Design And finally, always remember:- • The arrangement must always be constructed as a bona fide employee share scheme as protection against the financial assistance and financial services regimes. • The choice of scheme should be determined by the extent to which it assists in achieving the corporate objectives of the company; so determine the commercial structure and then apply the tax rules to maximise the tax efficiencies!

26. Long-Term Incentive Plans: Structure and Design Best Wishes for your ESOP initiative from:- David Craddock, Consultant, Lecturer, Author and Specialist in Employee Share Schemes, David Craddock Consultancy Services, Telephone: 01782 519925. Mobile: 07831 572615. E-mail: d.craddock@virgin.net Website: www.davidcraddock.com