EOnation: Share Retention by Employees

["Langley, Aidan (UK)" <alangley@deloitte.co.uk>]

     Jacquelyn Yates asked me to comment on whether employees tend to 
     retain their shares at the end of required holding periods.
     
     I am not aware of any recent research on this topic. My experience 
     suggests that employees generally cash in their shares sooner rather 
     than later. They do this either to diversify their portfolios or 
     because they need the cash.
     
     It is difficult to see how government policy can change this, given 
     that government only has the blunt weapon of fiscal incentives. There 
     is very little government can do to encourage someone who has an 
     urgent need for cash to hold onto his shares. Ad as for the employee 
     who wishes to diversify his portfolio, he is doing what conventional 
     wisdom, and any independent financial adviser, would tell him. 
     
     The UK now has what I consider to be the most generous fiscal 
     incentives in the world for employee share ownership, following the 
     2000 legislative changes. But the UK government will not achieve its 
     stated objective with the changes it has made. The stated objective is 
     to double the number of employees who participate in share ownership 
     plans.
     
     There are lots of things to talk about in the new UK legislation, but 
     the two things which are most relevant to this topic of employee share 
     retention are: the new All Employee Share Ownership Plan ("AESOP") and 
     the enhanced taper relief for employee shareholders.
     
     The AESOP is somewhat like the US ESOP, except that it is not designed 
     as a retirement benefits plan, and the tax reliefs are more generous. 
     Employees who hold shares in an AESOP for at least five years can then 
     withdraw them without any tax consequences at all.
     
     The Government is trying to encourage employees to retain their shares 
     in the AESOP following the end of the five-year period. The way it is 
     doing this is by making the "base cost" for capital gains tax the 
     value of the shares on the date of withdrawal from the AESOP. In other 
     words, the employee will only pay capital gains tax in relation to any 
     growth in value of the shares following their removal from the AESOP.
     
     The employee is obliged to remove the shares from the AESOP if he 
     terminates employment, but otherwise he can keep the shares in the 
     AESOP until retirement. In principle, therefore, this makes it more 
     attractive to retain an investment in an AESOP than in almost any 
     other investment vehicle. It is even more attractive than a pension 
     plan - because you will eventually have to pay tax on the pension.
     
     But the attractions are only superficial because very few people 
     actually pay capital gains tax anyway. There are other reliefs 
     available from capital gains tax. These mean that it is a tax paid 
     only by wealthy investors with substantial private investment 
     portfolios.
     
     Therefore this apparently generous relief, although aimed at all 
     employees, is really only going to benefit a few individuals in each 
     company, who are probably already highly compensated.
     
     Similar comments apply to the enhanced taper relief for employee 
     shareholders. This is a general relief available to any employee who 
     acquires shares in his employing company - whether or not through a 
     tax-qualified plan. It operates by reducing the effective top rate of 
     capital gains tax from 40% down to 10% for any employee who holds the 
     shares for four years or more. This should be contrasted with the 
     position of a non-employee investing in the same company. The 
     non-employee can reduce his effective tax rate down to 26%, but to do 
     so he must retain the shares for ten years or more.
     
     Clearly, this does provide a reason for not diversifying your 
     portfolio. But only if you actually pay capital gains tax anyway, and 
     most people do not.
     
     So the effect of the changes will be to encourage highly-compensated 
     individuals with substantial investment portfolios to be "overweight" 
     in shares in their employer. I don't think that will achieve the 
     Government's objectives. But on the other hand, I don't believe those 
     objectives are achievable without a fundamental change in the tax 
     system.
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