Share shock at e-commerce insolvency,

Companies must oppose government plans to change the national insurance rules, writes Michael Jacobs

Earlier this year the government was shocked to learn that fast growing e-commerce companies faced potential insolvency as the result of a direction from the Accounting Standards Board (ASB).

It required companies to provide in their profit and loss accounts for the National Insurance Contributions (NICs) payable by them on the exercise of unapproved options by their employees.

This resulted from the government's decision to make employers pay NICs at 12.2% on the gain arising on the exercise of unapproved options granted after 5 April 1999.

The outcome has been that the Treasury has this summer changed the law on NICs to permit employers to transfer their NICs liability (but only in this kind of case) to their employees.

The ASB proposal is eight times more serious than the problem created by Gordon Brown last year.

It deserves an immediate and forceful rebuttal by companies.It is vital to growing companies that they can grant options over unissued shares to recruit, retain and motivate key employees.

This basic business precept is under attack from the ASB in the form of a discussion paper on share-based payment published on behalf of the accounting standards boards of the UK, USA, New Zealand, Canada and Australia (G4+1) on 20 July 2000.

Many quoted and unquoted companies, led by the Quoted Companies Alliance (QCA), maintain that the proposals outlined in the discussion paper are fundamentally flawed.

Two of the main recommendations are that there should be a charge made to a company's profit and loss account based on the value of shares or share options granted to employees as motivational incentives and where payment for goods or services is made in shares or share options.

But the proposed changes are misconceived for a number of reasons.

Granting share options over unissued shares is typically done by smaller quoted companies and start-up businesses to give incentives to their employees, so to introduce these proposals would significantly hamper entrepreneurial activity in the UK.

The proposed charge against profits for the value of shares acquired does not reflect an expense of the company.

It would significantly reduce the profits of companies where the true cost has already been borne by the existing shareholders by dilution of their equity.

One of the principal reasons to grant such options is precisely that no cost is incurred by the employer.

It would be folly for companies to agree that the notional cost of such incentives should reduce actual distributable profits, while at the same time shareholders are suffering a real dilution in their equity and a reduction in the capital value of their shares as a result of the company being forced to retain its earnings.

The greater the success of the employees, the larger the cost to the company and the more its distributable profits, and its share price, would be depressed.

Currently there is no tax deduction for such a charge and, accordingly, the cost to companies would be even greater and thus create an unfair playing field between cash rich companies that can create incentives using surplus cash, which attract a tax deduction, and cash poor companies using options over unissued shares, which do not.

A few years ago, the US Financial Accounting Standards Board tried to introduce similar rules.

Its proposal was unsuccessful and, should the ASB be allowed to push through these changes in the UK while the same provisions do not apply to US based companies, it would significantly undermine the UK's competitive position.

The corporate drain from the UK to the US would dwarf the brain drain created by the Treasury's attack on entrepreneurs through IR35.

The effect of these proposals would be to deter companies from using share-based payment as a means to give incentives to their key employees and to drive entrepreneurs to set up their companies abroad.

The ASB would like to see the implementation of the changes outlined in the discussion paper.

Sir David Tweedie, the ASB chairman, commented at the time of its publication: 'Sadly, practice has developed in a manner that assumes that share-based payments are merely paper transactions that aren't an expense of the company.'

While there is much of value in the ASB's paper it does not justify this criticism.

It is, unfortunately, loosely argued and terminologically inexact.

There are several technical arguments which support the ASB's basic proposition, but they are intellectual constructs which bear little relevance to commercial reality.

The drafting group has ignored the competitive pressures faced by growing companies and the need to use share incentives to recruit, retain and motivate key managers, technicians and business generators where no monetary alternative is available or the incentive relates to a capital value beyond the scope of a company's resources.

It would be far better to improve disclosure of share-based payment in company accounts than to make companies treat as an expense an item which is not a cost to the company, but to its shareholders.

The government has gone to great lengths to introduce competitive share option schemes and the ASB proposals would, at a stroke, undo all the progress that has been made.

The ASB's proposal will do nothing to stimulate the UK economy and will be seriously damaging to growing companies.

The ASB intends to develop an accounting standard on share-based payment.

These proposals are wrong both in principle and in their application.

They should be vigorously opposed by all growing companies both for their own benefit and the benefit of their shareholders and their employees.Michael Jacobs is a partner at Nicholson Graham & Jones and chairman of the Quoted Companies Alliance Share Schemes Committee