View from City Road: Brown exercised over wrong target

Gordon Brown, the shadow chancellor, is barking up the wrong tree over executive share options. Yesterday he labelled them a tax fiddle ripe for action under a Labour government. But they haven't been anything of the sort since the Tories harmonised capital gains tax with the top income tax rate, at 40 per cent. The tax benefits are nowadays minimal, as Brian Friedman, a partner at Arthur Andersen, confirms.

The most obvious effect of an Inland Revenue-approved share option scheme is to classify the tax payable on the eventual profits as capital gains rather than income and defer it until the shares are sold. In practice, the shares are almost always sold as soon as options are exercised.

There is of course a capital gains tax allowance, but at pounds 5,800 a year most senior executives are likely to use that up with their ordinary investments. It is an unlikely reason to join a share option scheme.

Indeed, so muted are the tax benefits that an increasing number of companies are looking at unapproved schemes, where the gain on exercising an option is immediately taxed as income (with any further growth classified as capital gain).

As it happens, there are probably more ways of ducking income tax - pension contributions, investment in enterprise zones - than there are for CGT. If Labour abolishes approved schemes, it probably won't make much difference.

Of course, give an inch and people take a mile, and option schemes (rather than their tax treatment) have been wide open to abuse. Just look at the new millionaires at some of the privatised utilities. It is wrong to use options to give free gifts to top people, but right to use them to reward good performance by linking remuneration to the share price.

One drawback is that they may reward managers for a general rise in the markets rather than their own company's performance, and they also carry no direct penalty for poor performance.

Reuters recently pioneered a move away from executive options towards restricted share plans, in which bonuses are paid in shares. But options are still overwhelmingly the norm in FT-SE companies.

One common way round the defects is to tie the exercising of the option to company performance - indeed, there has been a long and tedious debate about whether earnings per share or some other benchmark of shareholder value is the best to use.

But what Mr Brown really overlooks is that of all the abuses of executive remuneration, this is the one where City institutions are keenest to have a go - for the simple reason that over-generous handouts of executive options dilute their own holdings. This is policing he could leave to the markets.

Since abolition of approved option schemes may just prompt a switch to unapproved schemes anyway, the only way Mr Brown could stop the whole exercise would be to tax the notional profits on options before they are exercised. He may have been hinting at this when he pointed out that executives do not pay income tax on the grant of the option, or on any increase in the market value of the shares before the option is exercised.

Mr Brown would have to find a way to value and tax unexercised options. But what happens if they are never exercised because of a future fall in the shares or an executive's failure to meet personal targets? Such a tax on notional gains would be a nightmare to administer. But it would also be foolish to kill off a way of paying people that - when structured as an incentive rather than a gift - really can reward good performance.