While Enterprise Management Incentive (“EMI”) options are often seen as easy to implement, the company’s and employee’s eligibility at the point of grant of the option is not the end of the story.
Certain post-grant events can have a significant impact upon the tax efficiency of EMI options.
The purpose of this note is to highlight some of the key disqualifying events.
Change of control
When a company whose shares are under EMI option subsequently becomes a subsidiary of or comes under the control of another company a disqualifying event will have occurred. One exception to this rule is when the company comes under the control of a corporate trustee of an employee ownership trust (a particular type of tax favoured share trust).
EMI options may be protected from the negative impact of a disqualifying event if the original EMI options are exchanged for a replacement option in the new parent company. If this occurs then the change of control will not be seen as a disqualifying event and the tax and valuation treatment of the original options can be rolled-into the new options.
In order to qualify for EMI the company must carry out certain trading activities and must not carry on certain specified excluded activities to any substantial extent. If the nature of the business changes after grant such that the company fails to meet these requirements then a disqualifying event will have occurred.
A company may also meet the trading activity requirements when the EMI options are granted if the company was preparing to carry out the qualifying activity. If however the company:
- ceases those preparations; or
- fails to actually carry out such activities within two years of grant
this will constitute a disqualifying event.
Working time requirements
Employees granted EMI options need to meet certain requirements based on the amount of time they spends working for the company/its group. In broad terms, these require the employee to spend 25 hours a week or 75% of his/her overall paid time in working for the company/group.
If the employee fails to meet the working time requirements then this will count as a disqualifying event. Special leave such as an extended unpaid leave or a sabbatical may count as a disqualifying event.
In addition to the above, if, at the end of the tax year, the employee’s average working time for the company/group does not satisfy the above requirements this will also constitute a disqualifying event.
Cessation of employment
A further disqualifying event occurs when an employee holding an EMI option ceases employment with the company or a subsidiary of the EMI company.
The rules that govern EMI do not include any special provisions for employees who leave the company as a result of redundancy, retirement or illness. Death will count as a disqualifying event; however, the tax consequences for such an event are not the same as the other disqualifying events mentioned on this page.
Variation to EMI option terms
If certain changes are made to the terms of an EMI option which increase the market value of the shares or mean that the option does not meet the requirements of the EMI legislation then this will also count as a disqualifying event.
Changes to what HM Revenue & Customs consider to be fundamental terms of the option may also be deemed to constitute the grant of a new option with potentially more significant consequences than a disqualifying event alone.
Variations to share capital
When there is an alteration of the share capital of the company that affects the value of the shares under option then this may (depending upon the detail) give rise to a disqualifying event.
If there is a conversion of the shares under option to a different class then this may result in a disqualifying event.
Grant of HMRC tax favoured CSOP options
The grant of a Company Share Option Plan (“CSOP”) to an employee which causes the EMI individual limit to be breached for a particular employee can also constitute a disqualifying event. The EMI company should therefore be careful if it is operating EMI and CSOP arrangements in tandem.
Impact of a disqualifying event
If one of the above disqualifying events occurs then the tax treatment of the options may alter adversley.
Where EMI options are not exercised within 90 days of a disqualifying event occurring, the option becomes an unapproved option from an income tax perspective from that point onwards.
The result of this is to, in effect, apportion:
- any growth in value of the shares from grant up until the disqualifying event occurs to the lower capital gains tax (“CGT”) regime; and
- any growth in value from the date of the disqualifying event onwards to the higher income tax (and potentially NIC) regime.
Qualifying EMI options can also benefit from the lower CGT rate of 10% which is afforded by CGT Entrepreneurs’ Relief.
- EMI options are not exercised within 90 days of a disqualifying event; or
- a disqualifying event occurs within 12 months of the date of grant of the option (whether or not it is exercised within 90 days of the event)
then CGT Entrepreneurs’ Relief will no longer be available on the option.