It is often claimed that one benefit of EMI is that there is no need to involve HMRC - other than to notify them electronically once the EMI 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 EMI 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.
We have also recently encountered companies who did in-house valuations and took no professional advice. In some cases this has resulted in much higher values being used for setting the option price and the reporting of those values to HMRC. This has resulted in increased buy-in costs for employees and/or tax liabilities on exercise.
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. These are likely to be unwanted distractions as part of any subsequent due diligence process.
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.
Two different share valuations
Two different share valuations 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 EMI 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.
By using the UMV, such options will be granted with an exercise price in excess of that which is required to obtain the tax efficiencies of EMI options and will act to reduce the potential upside to option holders.
On the flip side, some companies mistakenly use AMV for the purposes of calculating whether their EMI grants fall within relevant EMI limits. The result of this can be that options are granted in excess of the individual and/or aggregate EMI limits with a proportion of perceived EMI options being treated as tax inefficient unapproved options.
Notifying HMRC of the grant of EMI options
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 EMI companies over the years who have failed to satisfy this final (but all-important) step of the EMI 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) may well result in the loss of all EMI tax breaks as if the notification had never been made at all.
An added complication since 6 April 2014 is that the process for notifying EMI options 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.
Employee working time agreements
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” EMI requirement.
From that date, employees must provide a written declaration that they meet those requirements. Previously this formed part of the EMI1 form but companies now need a declaration to that effect. This can be a standalone document or form part of the EMI option agreement.
As well as drafting and obtaining the declaration, the EMI company then has to provide a copy of the declaration to the employee within seven days of its signing. The exact consequences of failing to do this are not yet clear. The company can be fined up to £500 but, more seriously, it has not been tested yet whether failing to provide a copy of the declaration within seven days could mean that the option is not a qualifying EMI option.
Details of any restrictions on the shares
The EMI legislation requires that the EMI option agreement must contain details of any restrictions applying to the shares under option which would make them restricted securities from a UK tax perspective (such as restrictions on transfer and compulsory transfer provisions).
In the past it was accepted that this condition would be met by stating within the EMI option agreement that the shares were subject to any restrictions set out in the company’s articles of association (and usually appending that document to the EMI option agreement).
However, HMRC guidance issued in July 2016 indicates that this approach is no longer acceptable and that any restrictions on the shares must be brought to the attention of the option holder by being summarised within the EMI option agreement. If this has not been done HMRC will consider any evidence in determining whether the restrictions have been otherwise brought to the attention of the option holder on or around the date of grant. Failure to state a trivial restriction will not be considered a compliance issue.
Options granted before 28 July 2016 are not impacted by this change in approach but we are still seeing a number of instances of grants after that date failing to provide proper summaries of restrictions.
Varying option terms post-grant
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 HMRC arguing that a new option has been granted.
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) along with further EMI compliance requirements. In addition, the capital gains tax entrepreneurs’ relief clock is likely to be restarted.
If any potential variations are likely post-grant then as an attempt to future-proof the options 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 “disqualifying events” after EMI 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 EMI option, then the EMI option holder will lose the benefit of the 10% rate of capital gains tax via entrepreneurs’ relief.
Potential disqualifying events 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 EMI 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 solution for businesses looking to reward and retain their key employees.