Company share schemes twist the knife in the wounds of investors

As if the stock market turmoil hadn't done enough damage to people's wealth, some employees who have taken up the offer of cheap stakes in their firms could find they are liable for tax even if their holdings have plunged in value. Kate Hughes reports

Our pension pots and investments have hit the rocks over the past few turbulent months, and our savings may have come under threat, but now another consequence of the stock market travails has emerged: thousands of us could end up paying taxes for investments that have actually dropped in value.

For decades, many employers have rewarded staff by offering them shares in their companies at a discount on the market price. Share save schemes have traditionally been a favourite among growing companies, but they are also used by large firms including banks, supermarkets and airlines.

There are four government-approved share schemes, each offering certain tax advantages. By far the most common is save as you earn (SAYE), under which staff can put up to £250 a month in their employer's scheme for a set number of years, and then use the money to buy shares. There is no income tax to pay on the difference between the price paid for the shares and their market value.

Share incentive plans (SIP) are also open to all staff but are more complex and have a variety of structures, including offering free shares or matching the number of shares bought by the employee with free ones. As long as the shares aren't sold for five years, there will be no liability for income or capital gains tax.

An employer can also choose to offer certain employees the opportunity to buy shares worth up to £30,000 under a company share option plan (CSOP), with no income tax liability when they are purchased.

Under an enterprise management incentive (EMI), a company with assets of up to £30m can offer its choice of employees an option to buy shares worth up to £120,000. The staff won't have to pay income tax or national insurance contributions (NICs) when they buy them.

There were 10,840 companies operating approved schemes in the UK at the end of 2006-07, up from 9,600 a year earlier, according to HM Revenue & Customs.

"But if your employer doesn't want the hassle of arranging an approved share scheme, they may offer you an unapproved one," says Roy Maugham, tax partner at accountancy firm UHY Hacker Young. "These are similar to CSOPs and are less restrictive than approved schemes, but an unapproved scheme means the employee is liable for income tax."

So if, for example, your firm offered you shares for £3 each, and the market value when you decided to buy them was £5, you would be charged income tax on the difference at that time, £2, for each share you bought. This would either be at 20 per cent if you're a basic-rate taxpayer, or 40 per

cent if you're in the higher band

This is where the trouble starts and the tax bill adds up, even if the value of your shares subsequently drops and you find you are sitting on a loss.

UHY Hacker Young says unapproved share schemes are regularly used by firms listing on the Alternative Investment Market – the exchange for smaller, growing companies. With the credit crunch taking hold, the AIM All Share index has fallen by 60 per cent in the past year, from 1,137 points last November to its current value of around 450 points. But you will still face an income tax bill based on the share price when you bought them, regardless of when that was.

"The tax treatment of these schemes and the current financial crisis have made them far less attractive to employees, at a time when growing companies may need to offer their most valuable staff a strong incentive to stay on board, instead of joining a more established business," Mr Maugham explains. He believes the Government should waive income tax on unapproved schemes in the current economic climate.

Many independent financial advisers warn against investing in unapproved schemes, but if you still want to press ahead, the advice is to buy the shares at the offer price and sell them immediately. That way you are only paying income tax on a return you can actually enjoy.

But whether it is an unapproved or approved scheme, Adrian Kidd, an independent financial adviser (IFA) for Unleash Financial Partnership, says buying a holding in a single company is too risky for most people, particularly in a volatile market. "Investing in share schemes is like any other investment decision: you need to have a view and a time horizon and see if that marries up with your attitude to loss and gain. Just because you get a discount doesn't make them a good deal."

But Ben Yearsley of Hargreaves Lansdown believes that SAYE schemes, in particular, have their place. "The risk only comes when you have exercised your option to buy with SAYE. At that point you could sell the shares immediately and hopefully bank a profit.

"You shouldn't put all your eggs in one basket, but if the price is higher at the end of the saving period then you should exercise the option and buy the shares. If it is lower, opt for the cash back with the interest," he adds. "Basically, it is a no-risk way of saving up to £250 a month in the company you work for. Invest now in cash – diversify later when you actually get the shares."