An EMI schemes allow companies to grant options (rights to acquire shares in the future) to qualifying employees on a highly tax efficient basis. Enterprise Management Incentive Options can be used by both private and smaller listed companies alike whether they are in the UK or not and either for targeted grants to specific key employees or on a wider or even all-employee basis.
An 'EMI' scheme can form a tax efficient part of a company’s succession planning (bringing selected key managers through to have a stake in the business) or be used as a pure incentive arrangement to reward employees/directors.
What are the benefits?
The scheme offers significant flexibility and can be designed to meet a company’s commercial objectives. As an option based arrangement, it is risk-free for employees and has no nuisance impact on shareholders/the business.
It also confers real tax benefits on both employers and employees which can result in:
For the employer:
- No employer’s National Insurance Contributions (“NIC”) on either the grant or exercise of the options (provided certain conditions are met); and
- Corporation tax relief on the difference between the market value of the shares at exercise of the options and the exercise price paid by the employee.
For the employee:
- No income tax and no employees’ NIC on either the grant or exercise of the options (provided certain conditions are met); and
- EMI options capital gains tax (“CGT”) only should apply to the growth in value of the shares – resulting in a tax/NIC saving of the employee of up to 47%. Importantly, EMI options start to accrue the 12 month holding period for CGT entrepreneurs’ relief (“ER”) from the date of grant.
This should result in a 10% (as opposed to 18% or 28%) rate of tax on any growth in value of the option shares. As another specific concession that applies to the scheme, there is also no need for a 5% holding in order to qualify for ER - so even small minority holdings under EMI options can potentially qualify for the 10% rate of CGT.
Who can use the scheme?
Certain requirements must be met by both the company and the employee in order for options to qualify. These requirements include:-
For the company:
- The company’s gross assets must not exceed £30 million on the date of grant of the options;
- One company in the group must carry on a trade and have a permanent establishment in the UK or be the holding company of such a trading group;
- The company must not be involved to a substantial extent in certain types of trade/activity. These “excluded activities” cover a number of activities including financial, property development and asset exploitation;
- The company must be independent (i.e. not under the control of another company);
- If the company controls any other company then that other company must be a 51% subsidiary of the company – a higher percentage applies to property holding subsidiaries; and
- The company must not have 250 or more full-time equivalent employees at the date of grant of the option.
For the employee:
- Employees must work for the business for at least 25 hours a week or (if less) 75% of their total paid time; and
- Employees must also not have a 30% or more interest (direct or indirect) in the company.
What are the limits?
Each employee can hold EMI options worth over £250,000 of shares (valued at the date of grant). Due to HMRC’s favourable approach to valuing these option shares, this could give in the region of up to £1 million worth of shares per individual!
Companies may grant Enterprise Management Incentive Options worth up to £3 million (again valued at grant).
Enterprise Management Incentive Options can be designed to meet a business’ own objectives. We can help to design options to meet these goals, covering such things as:
- Individual option award levels;
- The aggregate option pool available to employees;
- Managing dilution to existing shareholders;
- Determining when options become exercisable and how value is realised from the resulting EMI shares;
- Whether any performance conditions should apply to the EMI options to add in their motivational effect; and
- The effect of a leaver holding EMI options.
HM Revenue & Customs backed Enterprise Management Incentive options are widely acknowledged as a real success story; both as far as the Government and growth businesses are concerned. Since their launch in 2000, they have grown to be easily the most widely implemented HMRC backed incentive arrangement with significant tax breaks and flexibility on offer.
One of the additional benefits is their perceived simplicity and it is true to say that the scheme has helped to demystify employee share schemes.
This apparent simplicity does however hide a number of traps for the unwary. While the process for implementation of an EMI option offers significant flexibility and relative ease, businesses should have regard to a number of potential pitfalls which can have some quite substantial repercussions.
It is often claimed that one benefit is that there is no need to involve HMRC - other than to notify them once the share options have been granted. While this may be strictly true, we would advise all companies to make use of HMRC‘s facility for advance approval to share valuations. Obtaining agreement from HMRC provides much greater certainty on the likely tax treatment of the options and also that any grants are within HMRC’s limits.
Over the years (often as part of a due diligence exercise for potential buyers or investors) we have encountered a number of companies who have fallen into EMI valuation traps.
Firstly there are those who do not get an HMRC agreed valuation at the time the options are granted; perhaps because they simply took a view on valuation themselves at the time. Similar issues are faced by the second category of at risk companies; those who, despite having obtained HMRC agreement to a valuation, grant their options outside the typical 60 day HMRC approval window.
Failure to be able to point to an agreed valuation from HMRC inevitably leads to questions as to historic market values and the risk that the options may have been granted at a discount or that the EMI limits have been exceeded at grant.
As well as disgruntled employees being taxed at up to 47% (rather than at 10% or less) on a proportion of the gain on the option shares, specific indemnities, price chips and retentions could also be requested by a buyer/investor to cover potential PAYE/NIC exposures.
There are, in short, two different share valuations that are relevant to EMI options. The unrestricted market value (or UMV) which ignores the negative impact on value of certain restrictions on shares, for instance, leaver provisions. The actual market value (or AMV) on the other hand takes account of any such restrictions and will usually therefore be a lower value than UMV.
While not an issue in terms of compliance, a common misunderstanding is that the exercise price of an option must be set at not less than UMV in order for EMI options to secure their full tax efficiencies - when in fact it is the lower AMV that is relevant for these purposes. In effect such options will be granted with an exercise price in excess of that which is required to obtain the tax efficiencies of EMI options.
On the flip side, some companies mistakenly use AMV for the purposes of calculating whether their EMI grants fall within relevant limits. The result of this can be that options are granted in excess of the individual and/or aggregate limits with a proportion of perceived EMI options being treated as tax inefficient unapproved options.
EMI options notification - a key procedural step towards an option’s qualification for EMI benefits is ensuring that its existence is properly notified to HMRC within 92 days of grant.
We have encountered a number of companies over the years who have failed to satisfy this final (but all-important) step of the process.
It is important to note that this period is strictly enforced by HMRC with only very limited reasonable excuses.
Late notifications, (even by one day) result in the loss of all EMI tax breaks as if the notification had never been made at all. Similarly, a notification to HMRC which does not fully provide the required information will also be treated as a tax inefficient unapproved option.
An added complication since 6 April 2014 is that the process for notifying has moved away from the familiar EMI1 paper form with an online registration and notification process via HMRC’s ERS service replacing the old postal notifications. It is worth flagging that there are a number of steps to this online process and companies (particularly those using an agent or who are not registered for ERS online filings) would be advised to start the process as soon as possible in order to ensure that they can comply in time.
Another change which had effect from 6 April 2014 and which also represents a compliance risk is the form and process for employees to certify that they meet the 25 hours a week/75% of paid time “working time” requirement.
From that date, employees will need to provide a written declaration that they meet those requirements. Previously this formed part of the EMI1 form but companies will now need a declaration agreement to that effect. This can be a standalone document or forming part of the option agreement.
As well as drafting and obtaining the declaration, the company then has to provide a copy of the declaration to the employee within seven days of its signing. Failure to do so brings with it the loss of tax breaks.
It is not uncommon for a business to look to vary the terms of an existing EMI option after it has been granted. This might be to enable an option to become exercisable earlier than the prescribed exercise period or to extend the period for exercise after the usual long stop date.
Any variations to existing option terms need to be looked at carefully as, depending upon the nature of the variations, they can lead to a new option being deemed to be granted by HMRC.
This can have the effect of re-basing the EMI option with the requirement for a new exercise price to be set (at a potentially higher market value than when the original option was granted) in order to retain the tax breaks.
If any potential variations are likely post-grant then as an attempt to future-proof the options then it is advisable for the EMI documentation to provide sufficient “wriggle room”. Significantly, where an inherent and existing provision which is already contained within the terms of an option agreement is used to vary an option’s terms, any such changes should not result in the variation constituting the grant of a new option.
Once an EMI option is granted with an exercise price of not less than AMV, it is often assumed that the employer and employee are “home and dry” as far as the tax breaks are concerned.
This is often the case in practice but companies and employees should be aware that the tax breaks afforded to EMI options can be lost on the happening of certain “EMI option disqualifying events” after the options have been granted. Failure to exercise an EMI option within 90 days of the happening of such an event can cause part of the option gain to be taxed at higher income tax/NIC rates. In addition, if a disqualifying event occurs within the first 12 months of the grant of an option, then the options holder will lose the benefit of the potential lower 10% rate of capital gains tax via entrepreneurs’ relief that might otherwise have been available when he or she sells the underlying option shares.
Typical disqualifying events might include the loss of independence of the EMI company, the employee ceasing to be employed and/or ceasing to provide 25 hours a week (or 75% of his or her paid time to the business), certain changes to the shares that are subject to the EMI option and/or to the option terms itself.
Importantly, a company which grows to exceed the £30m gross assets limit or the 250 full-time equivalent employees limit will not be deemed to be subject to a disqualifying event, although any such company would be prohibited from granting any future EMI’s from then onwards.
With one eye on the pitfalls in terms of grant process and post-grant actions, EMI options can still deliver a simple and highly tax efficient equity solution for businesses looking to reward and retain their key employees.
How can we help?
The beauty of an EMI scheme is the flexibility that can be in-built to meet a business’ objectives.
We have significant experience in implementing Enterprise Management Incentive Options for different sizes of businesses and in a diverse range of sectors to meet their differing commercial objectives.