Understanding Employee/ Share Ownership Plan (ESOPS) in Kenya
What is an ESOP?
An ESOP stands for employee stock/ share ownership plan. An ESOP grants company stock to employees, often based on the cadre and duration of their employment. Typically, it is part of a compensation package, where shares will vest over a period of time. ESOPs are designed so that employees’ motivations and interests are aligned with those of the company’s shareholders.
How do ESOPs work?
Companies set up a trust fund for employees and contribute either cash to buy company stock, contribute shares directly to the plan, or have the plan borrow money to buy shares. If the plan borrows money, the company makes contributions to the plan to enable it to repay the loan. Contributions to the plan are tax-deductible. Employees pay no tax on the contributions until they receive the stock when they leave or retire. They then either sell it on the market or back to the company.
Types of ESOPs
- Profit sharing schemes – this is a scheme by which employees share in the profits of a business through share ownership. It may be tailored so that the trustees receive payments from the company and apply these payments in acquiring the ESOP shares. These shares are then ‘appropriated’ by the trustees to eligible employees in accordance with the trust deed and rules of the scheme.
- Savings-related share option schemes – under this type of ESOP, employees enter into a save-as-you-earn contract to save a fixed amount each month over a specified number of years. An option is granted at the outset over the maximum number of shares which may be acquired with the total savings and the bonus which is payable at the maturity of the savings contract. The option usually gives the employee the opportunity to purchase the shares at a significantly discounted price compared to the market value at the time of the grant.
- Share option schemes – this is a scheme under which an employee is granted a right (known as an ‘option’) to buy a fixed number of shares at a fixed price at a set point in time. The subscription price, which is usually less than the market value of the shares, is fixed at the date of grant of the option and there may be provisions requiring exercise of the option within strict time limits.
- Phantom share schemes – this is a type of ESOP which gives selected employees, often senior management, many of the benefits of owning shares in the company without actually transferring any shares to them. It simulates share ownership without actually providing it. The employees are granted ‘units’ which correspond to a fixed number of ESOP shares in the company.
How do you register an ESOP in Kenya?
An ESOP scheme can be registered by making an application to the Capital Markets Authority (CMA). Regulation 109 of the CIS Regulations provides:
- A listed company may set up an employee share ownership plan … to enable its employees own shares of the listed company subject to approval of the Authority
With approval from the CMA as a CIS, it is then registered with the Commissioner of the Kenya Revenue Authority (KRA).
The Legal Framework Governing ESOPs
The Capital Markets (Collective Investment Schemes) Regulations prescribe some reporting requirements for an ESOP established by a listed company. The listed company is required to disclose any options granted to its employees under the ESOP. Listed companies must seek approval from the Capital Markets Authority before establishing ESOPs and they must upon formation, be registered with the Capital Markets Authority.
The Companies Act permits both the Company’s issuance of shares and the transfer of Company shares. For the ESOP to purchase shares for the benefit of the employees, one of these options—or both—must be exercised.
The board is given the authority to issue shares in the event of a share issue, subject to the rules of applicable law. When the Company is listed, it cannot offer shares without adhering to the Capital Markets (Securities) (Public Offers, Listing and Disclosures) Regulations, 2002’s disclosure requirements. Additionally, if all of the Company’s shares are issued, the shareholders will have to be engaged to create the new shares before they can be issued.
In addition the Trustees Act, cap 167, in regulating the trust relationship created by the ESOP between the company and the employees as shareholders, makes provision for the trust and sets out the powers and the duties of trustees. The provisions of the Act also guides the preparation of the ESOP Trust Deed and Scheme Rules.
For ESOPs of unlisted companies, an application ought to be made to the Principal Registrar under the Registration of Documents Act for recognition.
Kenyan courts generally recognize and give effect to governing law and jurisdiction provisions in a contract such as those contained in an ESOPs trust deed and rules.
What are the relevant transaction documents when establishing an ESOP?
The Trust Deed and the Rules are the constitutive documents in all the management aspects of an ESOP. The eligibility of employees, procedure of participating in the scheme, rules of exit, allotment, meetings and other rights and obligations of the parties are usually prescribed in the trust deed and the rules. A clause on the conditions of the vesting of the benefits must be provided for in the trust deed and the rules. It must be clear and notified to the participating employees.
An ESOP will need to make provision in its rules for the market value and price of its shares, including rules as to the price at which the ESOP shall allot the shares to the employees and the price at which the trustees shall re-purchase units.
An ESOP will also make a provision in its rules for the transfer of rights arising from the ownership of shares depending on the type of scheme in use.
Taxation of ESOPs
Pre Vesting Stage (Grant Stage)
At the Grant Stage, an option is given to an eligible employee to exercise in the future i.e. upon vesting. As such, during this stage no taxes are triggered on the eligible employees.
Vesting Stage
At the vesting Stage, the employee makes a decision as to whether to exercise the option granted or not. As per the provisions of the Income Tax Act if the employee opts to exercise the option, this creates a benefit, similar to any other employment benefit.
The taxing of this benefit at the point of vesting is generally governed by Section 5(5) and (6) of the Income Tax Act (ITA). Section 5 provides for the benefit whilst Sub-Section 6 provides for valuation. As per Section 5(5) of the ITA the value of the benefit will be the difference between the market price per share and the offer price per share at the date an option is granted.
Section 5(6) on the other hand provides that for the benefit to be chargeable to tax, the ESOP has to be registered with the Commissioner General of the Kenya Revenue Authority (KRA) as a Collective Investment Scheme (CIS).
Recent developments have however emerged where the Finance Act 2022 has amended Section 5(5)(a) and Section 5(6)(a) of the Income Tax Act which provides for taxation of benefits accruing to an employee from a registered Employee Share Ownership Scheme(ESOP). Currently, Section 5(5)(a) of the Income Tax Act provides that the value of the benefit accruing to an employee from an ESOP registered with KRA shall be the difference between the market value, per share, and the offer price, per share, at the date the option is granted by the employer. The bill proposes to determine the value of a benefit accruing from an ESOP as the difference between the offer price per share at the date the option is granted by the employer, and the market value per share on the date the employee exercises the option.
Further, the Bill proposes to amend Section 5(6)(a) of the Income Tax Act which currently provides that the benefits chargeable to tax under a registered ESOP shall be deemed to have accrued to the employee at the end of the vesting period. The Bill amends this to provide that the benefits chargeable shall be deemed to have accrued on the date the employee exercises the option.
Post Vesting Stage
Post vesting of the shares, the employee would become an investor in the company like any other shareholder. Any distributions made on account of the units in the trust constitute dividends from the shares of the company are taxed at 5% (withholding tax).
CONCLUSION
ESOPs are generally a win-win for employers and employees, encouraging greater effort and commitment in exchange for bigger financial rewards. However, they are not always straightforward and can be frustrating if the participant does not fully understand the terms of their particular plan. The cost of setting up an ESOP is substantial and so are the factors that ought to be taken into consideration. Given the potential economic and social benefits of ESOPs, companies may will it in their best interests to consider entrenching an ESOP culture.
How can we assist you?
At Netsheria International, we have an experienced team of lawyers who can offer you legal assistance in drafting the Employee Stock/Share Ownership Plan Trust Deeds and Scheme Rules for your business. Please contact us for our services at info@netsheria.com or visit our website at https://netsheria.com/ for more information on our services.
