Granting share options or awarding day-1 equity to employees and non-employees alike, is an established part of remunerating and incentivising staff.  Indeed in many respects it is the conventional approach for aligning the interests of staff with those of shareholders. Another (perhaps less common) approach is to offer some form of shadow equity.

What is shadow equity?

Phantom equity, synthetic equity, shadow equity, etc., all operate to give participants the right to receive a cash payment calculated by reference to the value of a real company share. 

Crucially they do not give an employee a real equity interest or shareholding.

How is shadow equity usually taxed?

Shadow equity is not taxed in the same way as a share option or a real share.

Shadow equity is usually taxed in the same way as a cash bonus and forms part of the employee’s general employment earnings.

When an employee receives payment calculated by reference to their shadow equity interest, that payment is usually subject to income tax, NICs and potentially the Health and Social Care Levy.

Asking employees to pay for the benefit of shadow equity?

Understandably, because shadow equity is a proxy for real equity, employers often want to replicate all of the characteristics of real equity through their shadow equity scheme. 

Sometimes, in order to ensure that employees have genuine ‘skin in the game’ in the form of a proper financial commitment, companies want people to pay for their shadow equity.

Often this payment requirement betrays a lack of understanding about how shadow equity works. 

Because shadow equity is only a close and not an exact approximation to real equity, making participants pay for their shadow equity can throw up different tax problems. 

For example, where an individual is granted an option over real shares, money paid for the grant of that option is usually deductible from the tax calculation relevant for calculating any profit in the option on exercise.

By contrast, making a payment into the shadow equity scheme cannot, as a general rule, be deducted in the same way as if the payment was for real equity. Deductions from an employee’s general earnings can only be made in very specific circumstances set out in statute. A situation could therefore arise where an employee has paid for their shadow equity but the payment is not deductible against any pay-out they may finally receive under the scheme.

Should employees even be asked to pay for shadow equity?

Following on from the above there is then an interesting commercial / design debate about whether an employee should even be asked to pay for their shadow equity in the first place.

If shadow equity is in reality a cash bonus, is it even right that an employee should be asked to pay for what is essentially a right to receive a cash bonus? How, if at all, should that payment be structured? Should the payment be characterised as a real or notional deposit? 

And if payment implies some sort of detriment or sacrifice incurred by the payer, are there other ways to structure that detriment?

If you are considering alternative remuneration strategies it is always good to be mindful of the different taxing principles that apply to the structures you put in place. Prevention is always better than cure!

Should you like further information regarding the content of this article please do not hesitate to contact Nigel Watson (Nigel.Watson@burges-salmon.com) or Rebecca Arthur (Rebecca.Arthur@burges-salmon.com).