Death of an executive perk

Employee share options could soon come under scrutiny by the Treasury

Employees hoping to receive stock options as a bonus from their grateful employers should beware. Proposed changes to existing legislation could mean that a company's trading profit falls by the same amount as the "fair value" of the options it has granted.

Employees hoping to receive stock options as a bonus from their grateful employers should beware. Proposed changes to existing legislation could mean that a company's trading profit falls by the same amount as the "fair value" of the options it has granted.

The proposals, included in the Accounting Standards Board's (ASB) Share-based Payment paper, will change the way options are charged against company profits. At the moment, when a company hands out stock options to employees it has no obligation to record the transaction as a charge to the profit and loss account.

But the ASB argues that the fair value of the options should be charged against the company's profits at the appropriate time - instead of just being ignored. It's hard to argue against this, with the smart money betting that it will eventually become mandatory.

The ASB paper is concerned only with the accounting treatment of options given to employees, yet the tax consequences of this may be profound. Corporation tax rules do not necessarily have to align with accounting rules but if the ASB's proposals are adopted, the amount of corporation tax payable to the Treasury will be reduced.

This is when the Law of Unintended Consequences may kick in and start to make life uncomfortable for the lucky recipients of those options. The Treasury is unlikely to sit idly by while companies whittle away its corporation tax receipts by giving tax-deductible benefits-in-kind to their employees. Once the fair value of a granted option is explicitly recognised as a tax-deductible cost to a company, the Treasury will surely argue that the recipient of the option must be getting that same fair value as a taxable benefit-in-kind. It will then instruct the Inland Revenue to act accordingly.

To grasp the nasty implications of all this, consider the benign tax environment that exists today. Providing that the exercise price of an option is greater than, or equal to, the market price when granted, the Revenue says that the option has no "intrinsic value" so is not a benefit-in-kind of any value. Hence there is no income tax liability for the recipient. Of course, if and when the option is exercised, there may be an income tax or capital gains tax liability on the excess of the market price over the exercise price.

But if the ASB has its way and the fair value - rather than the intrinsic value - becomes the measure of worth, all this is likely to change. There is no doubt that the fair value of an option even with zero intrinsic value is far from negligible.

There are a number of ways of determining the fair value of an option. Options to buy the shares of a few companies are already traded, so the price is readily available. But most companies don't have traded options, so the fair value has to be calculated. Methods for doing this are well established and in most cases the need to calculate a value would not cause great contention.

For example, if your employer offers you three-year options on 10,000 shares, currently trading at £2.50 per share, with an exercise price of £2.50, the Revenue might well declare this to be a benefit-in-kind worth £4,525 (18 per cent of £25,000), which could lead to a tax demand for 40 per cent, or £1,810. However, if the ASB's main proposals are adopted, you should be able to spread this charge over the three years from grant to exercise. Although most of it will have to be paid, you know whether your options are going to end "in the money".

The ASB's proposal to move from intrinsic value to fair value makes a great deal of sense from a strictly accounting point of view. But the unintended tax consequences are potentially severe; under such a regime many employees offered options would probably decline them, removing the concept of options as a powerful tool for the motivation of senior employees.

At the moment it is all in the discussion stage. But if you are hoping to receive options from your employer, you would be wise to stay on top of the issue.

* The Accounting Standards Board welcomes comments by 31 October. Email: sharepay.dp@asb.org.uk