Remuneration and share plans update

On Friday 23 September 2022, the short-serving Chancellor, Kwasi Kwarteng, announced in the “mini-budget” that the recent wide-ranging changes to the “off payroll worker” rules (commonly referred to as IR35) were going to be reversed from 6 April 2023.  This reversal was subsequently cancelled by Jeremy Hunt on 17 October 2022 which means, in short, that there will be no changes to the way in which the current rules work.

By way of a brief recap, the rules which have been in place since 6 April 2021 require that businesses that meet criteria to be classified as “medium or large” must determine the tax employment status of contractors who provide services through intermediary entities (such as personal service companies).  That determination must be shared with each contractor.

The determination is based on a number of factors such as the degree of control exercised over the activities of the contractor; the extent to which they are integrated within the business; the nature of their remuneration; and whether they can provide a “substitute” to provide the services on their behalf.  This can be a challenging assessment for businesses to make, and the starting point for making this determination is generally the HMRC “check employment status for tax” (or CEST) tool.

Payments made to contractors who are “deemed employees” must be subject to PAYE and employee NIC withholding, as well as employer NIC.

For those businesses that engage contractors and non-employee service providers, we therefore continue to recommend taking the following practical steps:

1. Establish whether the IR35 rules apply to them.
2. Have a comprehensive internal policy covering everything from identification of contractors within a business, to who makes the status assessments, and the process for communication of those assessments to contractors.
3. Ensure payroll is set up to operate PAYE, where required.
4. Ensure engagements with contractors take the IR35 rules into account (e.g. with indemnity provisions for PAYE and employee NIC where payments are being made on a gross basis).

Background

As part of the “mini budget”, delivered on 23 September 2022, the Chancellor announced that the “banker’s bonus cap” will be scrapped. The cap, which was introduced reluctantly by the UK government in 2014 to implement the EU’s 2013 Capital Requirements Directive (CRD), requires a limit on the ratio of fixed to variable remuneration of 1:1 (or 2:1 if shareholder approval is obtained). The CRD remuneration rules were brought in as a response to the 2007-8 financial crisis which was widely seen to be exacerbated by high-risk taking behaviour taken by bankers incentivised by large bonuses.

The cap was never popular with the UK government or with banks who both argued that the measure would do little to reduce renumeration levels for managers and senior staff (referred to as material risk takers or MRTs). Instead, as predicted, banks raised base salaries and many introduced role-based allowances to create a level of non-variable pay to compensate their MRTs for the cap on their bonuses. This in turn led banks to take on higher fixed costs as a result and undermined the flexible renumeration structures that many banks used to reduce wage costs when market conditions were poor.

Implications for banks

Despite the cap being scrapped for banks operating in the UK, it will remain relevant for international banks that operate in EU member states and so continue to be subject to the full requirements of the CRD remuneration rules. For such banks, the application of the cap to MRTs that work across UK and EU jurisdictions will be more complicated.

For UK banks, it will be interesting to see whether the fixed to variable ratio will decrease over time. Shifting remuneration from fixed to variable is not easily done and even banks with role-based allowances would not simply be able to withdraw these from one day to the next – doing so would run the risk of MRTs claiming constructive dismissal.  Rather, banks are likely to have to stagger changes in the makeup of renumeration packages as new MRTs join and existing MRTs’ pay policies are due to be reviewed.

Last but not least from the “mini-Budget” was the news that, from 6 April 2023, the longstanding limit on the value of tax-qualified share options which a qualifying company can offer to its employees under a Company Share Option Plan (CSOP) will double from £30,000 to £60,000 per employee. HM Treasury’s rationale was that “this will encourage employers to offer more shares to their employees, so everyone can share in the success” of the company.

In addition, it was announced that the employee-control and open market shares restrictions attaching to CSOPs will be removed. This will align CSOPs more closely with the rules of the more popular Enterprise Management Incentive (EMI) plans. Currently, if the company using a CSOP has more than one class of ordinary share capital, a majority of shares of the class that is used for the CSOP must be either open market shares (shares held due to reasons other than the shareholders’ status as directors or employees of any company or trustees for such people) or employee-control shares (shares held by current or former directors or employees of the company or of a company it controls which enable those shareholders to control the company). The expectation is that removing this restriction will increase the use of CSOP by private equity houses or other institutions that hold minority interests in investee companies.

CSOP options generally provide tax favourable treatment for both employees (no income tax and employee National Insurance contributions (NIC) and employers (no employer NIC), but their popularity has declined since the introduction of the EMI plan, another discretionary tax-qualified option plan, in 2000. Prior to the introduction of EMI plans, CSOPs were the only discretionary tax advantaged scheme available in the UK.

One of the reasons for the relative popularity of EMI plans when compared to CSOPs is the more generous individual limit of £250,000, which is significantly higher than the existing CSOP limit of £30,000. In addition, EMI plans are generally more flexible and offer additional tax advantages. The decline of CSOPs is illustrated by the fact that there were 5,170 live CSOP schemes in 2000/01 compared to just 1,910 in 2009/10, according to HMRC figures.

Despite the declining use of CSOPs following the introduction of EMI plans, CSOPs have retained a somewhat steady use by companies that either do not qualify for EMI but nevertheless wish to implement a tax-favourable discretionary option plan, or by companies that have outgrown the qualifying company limit set by the EMI rules but wish to continue to grant tax efficient options as part of their overall reward and remuneration strategy (typically for middle managers rather than senior executives). It will be interesting to see whether a doubling of the limit to £60,000 will result in renewed popularity for CSOPs for companies other than those that have outgrown their EMI plans.

Andrew Ninian, Director of Stewardship and Corporate Governance at the IA, notes in a letter to Remuneration Committee Chairs that the current inflationary impact is disproportionally affecting lower-paid workers. Accordingly, inflationary salary increases in respect of executive directors may not be appropriate in the current circumstances.

In normal circumstances, the IA would consider executive salary increases acceptable where these are in line with inflation or at the levels provided to all employees. However, the IA notes that in the current climate, Remuneration Committees should consider whether to exercise restraint in respect of executive salary increase and look more widely at the overall quantum paid to executives when compared to the pay levels and conditions across the entire workforce. In particular, absent special circumstances, it would not be appropriate for Remuneration Committees to seek to increase executive salaries at a level greater than inflation or the increase awarded to the wider workforce.

The IA first addressed the issue of windfall gains in their 2020 guidance paper, noting that there are potential scenarios in which windfall gains could arise if the level of share grants expressed as a multiple of salary were maintained after a substantial share price fall which was of course particularly relevant during the pandemic. They concluded at the time that Remuneration Committees of companies that had suffered a share price reduction related to the pandemic should monitor the wider market and any share price recovery over the relevant LTIP performance periods to ensure that adjustment to vestings could be made to guard against windfall gains relating to market movements unrelated to performance.

In light of those vesting decisions likely being made by Remuneration Committees in 2023, the IA have reiterated this approach. To ensure that participants in 2020 grants do not benefit from those larger share grants, the IA recommend that Remuneration Committees consider if vesting outcomes need to be reduced. In the spirit of wider shareholder disclosure, this process should be clearly articulated to all shareholders and must set out why these vesting outcomes have either been reduced or maintained.

Where companies recruit a new executive and decide to pay them less than the previous incumbent, the company should clearly set out its intended salary path, including the timeframe within which it might increase the new executive’s salary.

Reflecting the marked increase in the number of the FTSE100 companies that have incorporated an ESG metric into their variable remuneration (see our separate article later in this Update), the Principles state that any ESG target is material to the business, quantifiable, suitably stretching and clearly linked to the implementation of the company’s strategy. However, companies should not reward executives for “business as usual” activity nor should they be used as a means to increase overall quantum.

The IA recognises that Non-Executive Directors’ (NEDs) fees have not always reflected the increased complexity and time commitment expected of their role. They recommend that, given the important oversight role NEDs play, they should receive fees that better reflect the time-commitment, scope and complexity of their role with the caveat that any such increases must be properly explained.

The IA’s corporate governance research service, entitled the Institution Voting Information Service (IVIS), will now designate Remuneration Reports and Policies of any company whose executive pensions are not aligned with those of the wider workforce from 2023 with a “red top”. This is the IVIS’ strongest level of concern and is used to highlight serious breaches in IA guidance.