Phantom options

Outline

Phantom options are designed to mirror traditional share options but with the gain to the employee being paid in cash.  The intention behind a phantom option is similar to a share option in that the option holder is motivated to grow the value of the underlying shares that are subject to the phantom option.

Under a phantom option, an employee is awarded (or “granted”) an option over a notional number of shares at an option price which is often (but does not have to be) the market value of a share at the initial grant of the option.  The employee may then “exercise” the option and become entitled to receive payment on meeting certain specified conditions. 

At the time of exercise the employer company pays a cash bonus equal to the “spread” or growth in value of the underlying shares (subject to the deduction of income tax and National Insurance contributions).

Benefits

As phantom options do not use real shares, they are a useful tool where a company does not want to introduce employee shareholders – for example, where dilution to existing shareholders is not acceptable or possible.

Phantom options are “liquid” as they are paid out in cash. With a phantom option, the employer does not therefore need to consider how and when value can be realised from the employee’s interest in the same way as it will have to for actual shares/share options.

Phantom options are also relatively simple to implement and operate and give rise to no concerns regarding minority shareholdings in the company. 

Disadvantages

Phantom options have a direct cash cost to the company and the cost of satisfying the gain on them needs to be calculated and managed.

Unlike certain types of tax approved share options (i.e. EMIs and CSOPs), phantom options confer no particular tax breaks.

As a result, the sums paid out on exercise of a phantom option will be taxed in the same way as a cash bonus; with potentially up to 47% income tax and employees’ National Insurance contributions (“NIC”) being deducted from the payment. The employer will also incur an employer’s NIC liability at 13.8% of the amount paid out on the shares but with the benefit of corporation tax relief on the payment and employer’s NIC it incurs.

As a cash-based arrangement which pays out on exercise, phantom options confer less of a feeling of ownership than an actual share or share option plan. Participants in phantom option arrangements are therefore incentivised to grow share value up to exercise but not beyond that date.

Share valuations are likely to be required at grant and at exercise (if not on a corporate transaction) in order to calculate the spread.

How we can help

We design, draft and implement phantom option plans for our clients, covering all tax and legal issues and liaising with share valuers to value the relevant shares under option.