What are phantom shares?

Phantom shares are cash-settled awards that mimic share ownership. The employee receives a cash payment equal to the increase in share value on vesting. No actual shares are issued. The payout is taxed as employment income (up to 45%) with employer NIC. Phantom shares (also known as shadow equity, synthetic shares, or cash-settled share awards) are incentive arrangements that mimic the economic benefit of share ownership without actually issuing shares. How they work: (1) Grant — the company grants phantom shares to the employee, specifying a notional number of shares and a base value (the market value at the grant date). (2) Vesting — the phantom shares vest after a specified period (e.g., 3 years) or on specific events (e.g., a company sale, achievement of performance targets). (3) Payout — when the phantom shares vest, the employee receives a cash payment equal to the increase in the share value: (vesting value - base value) × notional number of shares. For example, if 1,000 phantom shares are granted with a base value of £10, and the vesting value is £20, the payout is (£20 - £10) × 1,000 = £10,000. (4) Cash, not shares — the payout is in cash, not shares. The employee does not receive actual shares and does not become a shareholder. (5) No voting rights — phantom shares do not give the employee voting rights, dividend rights, or other shareholder rights. They are purely an economic incentive. Phantom shares are used by companies that cannot or do not want to issue actual shares, providing a share-like incentive without the complexity and dilution of real share schemes. Relevant legislation: ITEPA 2003, Part 2 (employment income — cash-settled awards); ITEPA 2003, Part 7 (employment-related securities — cash-settled alternatives). Example: A company grants 5,000 phantom shares to an employee with a base value of £10 per share. After 3 years, the shares vest when the company's value has increased to £25 per share. The payout is (£25 - £10) × 5,000 = £75,000. The employee receives £75,000 in cash, subject to income tax and NIC. Common mistake: Assuming that phantom shares qualify for CGT or BADR treatment. The payout is cash and is taxed as employment income — there is no CGT and no BADR. The total tax rate can be significantly higher than for EMI/CSOP options.

How are phantom shares taxed?

Phantom shares are taxed as employment income. No tax on grant. On vesting, income tax (up to 45%) and employer NIC (13.8%) are due on the cash payout. The company can deduct the payout as a trading expense. No CGT or BADR. The tax treatment of phantom shares: (1) Grant — no income tax or NIC on grant, as the award is not yet vested and has no ascertainable value. (2) Vesting — when the phantom shares vest and the cash payout is made, income tax and NIC are due on the payout amount. The payout is taxed as employment income at the employee's marginal rate (20%, 40%, or 45%). The payout is subject to PAYE (the company deducts tax and NIC before paying the net amount to the employee). (3) Employer NIC — the company pays employer NIC at 13.8% on the payout. (4) Corporation tax deduction — the company can deduct the payout (and the employer NIC) as a trading expense, reducing corporation tax at 25%. (5) No CGT — the payout is cash, not shares, so CGT does not apply. (6) No BADR — BADR does not apply (BADR is a CGT relief, and there is no CGT on cash payouts). (7) No share ownership — the employee does not own shares, so there is no CGT on disposal. The total tax on phantom shares can be significant — on a £100,000 payout, the employee pays up to £45,000 income tax, and the company pays £13,800 employer NIC (offset by a £28,450 corporation tax deduction). Compare this to EMI, where the same gain would be subject to 10% BADR (£10,000) with no income tax or employer NIC. Relevant legislation: ITEPA 2003, Part 2 (employment income); ITEPA 2003, Part 7, Chapter 4D (cash-settled alternatives); CTA 2009 (corporation tax deduction). Example: An employee receives a phantom share payout of £100,000 on vesting. Income tax at 45% = £45,000. Employee NIC at 2% = £2,000. Net payout to employee: £53,000. Employer NIC at 13.8% = £13,800. Corporation tax saving (25% of £113,800) = £28,450. Net cost to company: £85,350. If the same gain were through EMI options: CGT at 18% BADR = £10,000, no income tax, no employer NIC. The employee would receive £90,000, and the company would have no cost. Common mistake: Not budgeting for the cash payout and employer NIC. Unlike EMI/CSOP (where the employee pays the exercise price), phantom shares require the company to fund the cash payout and the employer NIC. This can create a significant cash flow burden, especially for growing companies.

When should I use phantom shares instead of EMI?

Use phantom shares when: the company cannot issue real shares (shareholder restrictions, complex structures), the company wants to avoid dilution, employees are overseas, or the company wants a simpler structure. EMI is preferred when the company qualifies, due to the superior tax treatment. Phantom shares are used as an alternative to real share schemes (EMI, CSOP, growth shares) in several scenarios: (1) Cannot issue shares — the company's shareholders may have restrictions on share issuance (e.g., a shareholders' agreement that requires unanimous consent for new shares), or the company's legal structure may not allow for share schemes (e.g., a partnership or a limited liability partnership). (2) No dilution — the existing shareholders may not want to dilute their shareholding. Phantom shares do not issue actual shares, so there is no dilution. (3) Overseas employees — for employees in countries where UK share schemes are not practical (e.g., due to local tax or legal restrictions), phantom shares can provide a share-like incentive without the cross-border complications of real shares. (4) Simpler structure — phantom shares do not require HMRC notifications, share valuations, or a trust. The company simply grants the award and pays the cash on vesting. (5) Retain control — phantom shares do not give the employee voting rights or other shareholder rights. The company retains full control. (6) Short-term incentive — for short-term incentives (1-3 years), phantom shares may be more appropriate than EMI/CSOP options (which are typically held for longer periods to qualify for BADR). However, EMI/CSOP are significantly more tax-efficient (no income tax on exercise, 18% BADR on disposal), so for qualifying companies, they are generally preferred. Phantom shares are the alternative when EMI/CSOP are not available or not practical. Relevant legislation: ITEPA 2003, Part 2 (employment income — phantom shares); Schedule 5 ITEPA 2003 (EMI); Schedule 4 ITEPA 2003 (CSOP). Example: A company with a complex shareholder structure (multiple investors with anti-dilution rights) cannot easily issue new shares for an EMI scheme. It uses phantom shares instead, granting cash-settled awards to key employees. The employees receive a cash payout on vesting based on the increase in share value, without the company needing to issue actual shares. Common mistake: Using phantom shares when the company qualifies for EMI. The tax difference is significant (income tax at up to 45% vs no income tax and 10% BADR for EMI). Companies should check whether EMI is available before defaulting to phantom shares.

What is the difference between phantom shares and real shares?

Phantom shares are cash-settled (no shares issued, taxed as income at up to 45%). Real shares involve actual share issuance (dilution, but EMI/CSOP provide 10% BADR). Phantom shares avoid dilution but have higher tax. Real shares are more tax-efficient but more complex. The key differences between phantom shares and real shares: (1) Nature — phantom shares are cash-settled awards (the employee receives cash, not shares). Real shares involve the issuance of actual shares (the employee becomes a shareholder). (2) Tax — phantom shares: income tax at up to 45% on vesting, no CGT, no BADR. Real shares (EMI/CSOP): no income tax on exercise (if exercise price ≥ market value at grant), CGT at 18% BADR on disposal. The total tax on real shares can be significantly lower. (3) Dilution — phantom shares: no dilution (no shares issued). Real shares: dilution (new shares are issued, reducing the percentage ownership of existing shareholders). (4) Shareholder rights — phantom shares: no voting rights, no dividend rights, no shareholder rights. Real shares: full shareholder rights (voting, dividends, capital distribution). (5) Complexity — phantom shares: simpler (no HMRC notifications, no share valuations, no trust, no share registry). Real shares: more complex (EMI 92-day notifications, annual returns, share valuations, trust or share registry). (6) Cash flow — phantom shares: company must fund the cash payout on vesting. Real shares: no cash payout (the employee pays the exercise price). (7) Employee perception — real shares may be more motivating (actual ownership and shareholder rights), while phantom shares are seen as a cash bonus. (8) Exit — on a company sale, phantom shares vest and pay out in cash. Real shares are sold to the buyer, with the employee receiving the sale proceeds (minus exercise price). For qualifying companies, EMI/CSOP are generally preferred due to the superior tax treatment. Phantom shares are the alternative when real shares are not practical. Relevant legislation: ITEPA 2003, Part 2 (phantom shares — employment income); Schedule 5 ITEPA 2003 (EMI — real shares); Schedule 4 ITEPA 2003 (CSOP — real shares). Example: An employee is granted either phantom shares or EMI options over 10,000 shares (base/exercise price £10). On vesting/exercise, the shares are worth £25. Phantom shares: payout = (£25-£10) × 10,000 = £150,000. Tax at 45% = £67,500. Net: £82,500. EMI: exercise cost = £100,000 (10,000 × £10). Sale proceeds = £250,000 (10,000 × £25). Gain = £150,000. CGT at 18% BADR = £15,000. Net: £135,000. The EMI option is £52,500 more tax-efficient. Common mistake: Assuming that phantom shares provide the same tax advantages as real share schemes. The tax treatment is fundamentally different — phantom shares are taxed as employment income, while EMI/CSOP options are taxed as capital gains (with BADR at 10%).

Can phantom shares be structured tax-efficiently?

Phantom shares are always taxed as employment income (up to 45%). However, they can be structured with vesting conditions, performance targets, and deferral mechanisms to manage the timing and amount of the tax charge. Co-investment structures can also improve the tax efficiency. While phantom shares cannot match the tax efficiency of EMI/CSOP (which provide 10% BADR), they can be structured to manage the tax charge: (1) Phased vesting — structuring the phantom shares to vest in tranches over several years can spread the income tax charge, potentially keeping the employee in a lower tax band in each year. For example, instead of a single £300,000 payout in one year (taxed at 45%), the payout can be split into £100,000 per year over 3 years (potentially taxed at 40% in each year). (2) Performance targets — linking vesting to performance targets can delay the tax charge until the targets are met, and the payout is known. This provides certainty for both the company and the employee. (3) Deferral — allowing the employee to defer the payout to a later date (e.g., a company sale) can align the tax charge with a liquidity event, when the employee has the cash to pay the tax. (4) Co-investment — the employee can co-invest (pay for a portion of the phantom shares upfront), which can reduce the taxable amount on vesting. The co-investment amount is deducted from the payout, reducing the income tax charge. (5) Salary sacrifice — in some cases, the employee can sacrifice salary in exchange for phantom shares, reducing the income tax and NIC. However, the rules are complex, and the sacrifice must be genuine. (6) International structuring — for international employees, the phantom shares can be structured to take advantage of lower tax rates in the employee's country of residence (subject to local tax laws). While these strategies can manage the tax charge, phantom shares will always be taxed as employment income — there is no way to convert the payout to capital gains or obtain BADR. Specialist advice is recommended to structure phantom share arrangements effectively. Relevant legislation: ITEPA 2003, Part 2 (employment income — structuring options); ITEPA 2003, Part 7 (employment-related securities rules); CTA 2009 (corporation tax deduction). Example: An employee is granted phantom shares that would vest with a £300,000 payout. Instead of vesting in one year (tax at 45% = £135,000), the vesting is phased over 3 years (£100,000 per year, tax at 40% = £40,000 per year, total £120,000). The phased vesting saves £15,000 in income tax. If the employee co-invests £50,000 upfront, the taxable payout is reduced by £50,000, saving an additional £20,000 in tax. Common mistake: Structuring phantom shares without considering the tax implications. The structure can significantly affect the tax charge, and specialist advice is needed to optimise the arrangement.

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Phantom Shares & Cash-Settled Awards

Phantom shares provide cash bonuses linked to share value without issuing actual shares. Understand how they work, the tax treatment, and when to use them instead of real share schemes.

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Phantom shares (also known as shadow equity or synthetic shares) are cash-settled awards that mimic the economic benefit of share ownership without actually issuing shares. When the award vests, the employee receives a cash payment equal to the increase in the share value (or a portion of it). Phantom shares are used by companies that cannot or do not want to issue actual shares — for example, companies with complex shareholder structures, companies in jurisdictions where share schemes are not practical, or companies that want to avoid diluting existing shareholders. Understanding how phantom shares work and their tax treatment is essential for companies considering this alternative to traditional share schemes.

How Phantom Shares Work

Phantom shares are cash-settled awards that track the value of the company's shares. The process: (1) Grant — the company grants phantom shares to the employee, with a notional number of shares and a base value (the market value at grant). (2) Vesting — the phantom shares vest after a specified period (e.g., 3 years) or on specific events (e.g., a company sale). (3) Payout — when the phantom shares vest, the employee receives a cash payment equal to the increase in the share value (vesting value minus base value) multiplied by the notional number of shares. The payout is in cash, not shares.

Tax Treatment

Phantom shares are taxed as employment income: (1) Grant — no tax on grant (the award is not yet vested). (2) Vesting — income tax and NIC are due on the cash payout at the employee's marginal rate (up to 45%). The payout is subject to PAYE. (3) Employer NIC — the company pays employer NIC (13.8%) on the payout. (4) Corporation tax deduction — the company can deduct the payout (and the employer NIC) as a trading expense, reducing corporation tax. There is no CGT (the payout is cash, not shares) and no BADR.

When to Use Phantom Shares

Phantom shares are used when: (1) The company cannot issue real shares (e.g., due to shareholder restrictions, complex structures, or legal requirements in certain jurisdictions). (2) The company wants to avoid diluting existing shareholders. (3) The employees are in a different country where real share schemes are impractical. (4) The company wants a simpler structure (no share valuations, no HMRC notifications, no trust). (5) The company wants to retain control (phantom shares do not give voting rights or dividend rights).

Phantom Shares vs Real Shares

Phantom shares vs EMI/CSOP: (1) Tax — phantom shares: income tax at up to 45% on vesting, no CGT, no BADR. EMI/CSOP: no income tax on exercise, 18% BADR on disposal. EMI/CSOP are significantly more tax-efficient. (2) Dilution — phantom shares: no dilution (no shares issued). EMI/CSOP: dilution (shares issued on exercise). (3) Complexity — phantom shares: simpler (no HMRC notifications, no share valuations, no trust). EMI/CSOP: more complex (92-day notifications, annual returns, valuations, HMRC compliance). (4) Employee perception — real shares may be more motivating (actual ownership), while phantom shares are seen as a cash bonus. (5) Cash flow — phantom shares require a cash payout on vesting (the company must fund the payout). EMI/CSOP do not require a cash payout (the employee pays the exercise price). For qualifying companies, EMI/CSOP are generally preferred due to the superior tax treatment. Phantom shares are the alternative when real shares are not practical.

Key Points

What You Need to Know

Phantom shares are cash-settled awards that track share value without issuing actual shares
Taxed as employment income: income tax (up to 45%) and employer NIC (13.8%) on vesting
No CGT or BADR (the payout is cash, not shares)
No dilution of existing shareholders (no shares issued)
Used when companies cannot or do not want to issue real shares

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EMI Eligibility & Qualifying Companies EMI Tax Advantages Company Share Option Plan (CSOP)Growth Shares Business Asset Disposal Relief (BADR)Share Schemes on Exit Save As You Earn (SAYE / Sharesave)Unapproved Options & RSUs Share Incentive Plan (SIP)Employee Ownership Trusts (EOTs)Share Valuation for EMI & CSOP HMRC EMI Notification & Reporting Phantom Shares & Cash-Settled Awards Share Schemes on IPO

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