In the 2012 Budget the Chancellor announced two enhancements to the rules relating to the tax-favoured employee share options for small companies, known as “Enterprise Management Incentives”, or “EMI options”.
1. The current individual limit of £120,000 on EMI options is to be increased to £250,000.
This change is subject to EU State Aid approval, and will therefore be made, by statutory instrument, with effect from a date yet to be announced, but “as soon as possible”.
However, no corresponding proportional increase has been made to the overall limit, of £3 million, on the maximum initial unrestricted market value (“UMV”) (as at the time of grant) of shares over which unexercised EMI options may be granted (and which have not been exercised or lapsed) over shares in a qualifying company. It follows that options over shares up to the new maximum limit may be granted to only 12 employees!
Companies must be aware that increasing the shares under EMI options granted to selected employees, to take full advantage of the increased individual limit, may well restrict their ability to grant tax-favoured EMI options to other, or new, employees.
Although not expressly referred to in the Budget announcements, it is expected that – when the increase has effect – the existing 3-year restriction, on the grant of fresh EMI options to an employee who has previously been granted options up to the current statutory limit, will not prevent fresh EMI options being immediately granted in excess of the current £120,000 limit. In any event, if options have only ever been granted to an individual over shares with an UMV of just under the £120,000 limit, this restriction would not apply.
The other requirements for a company to qualify to grant EMI options (principally, the need for “independence”, having less than 250 fte employees, gross assets of less than £30 million, and not carrying on certain disqualifying activities) remain unchanged. However, the Government is to consult on ways to extend entitlement to qualify to be granted EMI share options to academics who are employed – albeit not on an eligible full-time basis – by a company qualifying to grant EMI options.
2. Allowing shares acquired upon the exercise of EMI options to qualify for Entrepreneurs’ Relief from CGT: but only if the shares acquired upon the exercise of an EMI option are held for at least one year.
This change, which is also subject to EU State Aid approval, will be made in the Finance Act 2013. However, it is intended to take effect in relation to shares acquired upon the exercise of EMI options on or after 6 April 2012. Changes will be needed to the CGT rules to ensure that shares acquired by the exercise of EMI options are separately identified for Entrepreneurs’ Relief (“ER”) purposes.
Given that, to qualify for the reduced 10% rate of CGT on gains on the disposal of EMI shares, subject to a lifetime limit of £10million on ER relief, the shares must be held for at least a one year qualifying period, and all other requirements relating to ER relief (other than the need to hold shares representing a 5% interest in the company), it follows that the earliest time at which disposals of EMI option shares may qualify for ER relief, is 6 April 2013 (assuming that the shares were acquired upon the exercise of an EMI option on 6 April 2012).
Unlike the position which held good at the time when “taper relief” from CGT was available, the time during which the option is held unexercised will not count towards the qualifying one-year period.
This will alter significantly the dynamics of the use of EMI options.
Companies with outstanding “exit-only” options should contact us to discuss how best to allow optionholders access to the ER relief – which could represent a significant saving of CGT on disposal of the option shares – see further below.
Holders of EMI share options which are (from 6th April 2012) capable of immediate exercise should consider whether to exercise their options earlier than they might otherwise have chosen to do so, simply to ensure access to the lower 10% rate of CGT by way of ER relief when the shares are sold.
“Exit-only” EMI options
Many companies have granted so-called “exit-only” share options which, as the name suggests, are exercisable only at a time when the shares will be immediately sold, typically upon a sale of the company. In these cases, ER relief will not be available as the shares will not have been held for the qualifying period. The gain on sale will therefore still be charged to CGT at the standard rate of 28%.
HMRC will not permit the terms of an EMI share option, which does not already include a directors’ discretion to advance the time of exercise, to be varied so as to allow the option to be exercised at a time which is estimated to be at least one year in advance of an “exit” event.
It follows that many companies with outstanding “exit-only” options, and who are still some way off any thoughts of a sale, might now consider inviting optionholders to release existing EMI options and re-grant fresh EMI options on terms which allow for early exercise. That said, the following should be borne in mind:
a) There is a statutory rule which restricts an employee from being granted fresh EMI options within 3-years after he or she first held options over shares up to the existing individual limit of £120,000. (It is for this reason that EMI options should only ever be granted over shares with a maximum unrestricted market value of just under the statutory limit.)
Once the new limit, of £250,000 comes into effect, such a company could, instead of cancelling and re-granting, allow the existing options to remain in place and grant fresh options over shares with an unrestricted market value of up to another £130,000, but on terms that (i) they may be exercised at any time for so long as the individual remains an employee, and (ii) insofar as the optionholder chooses to exercise the fresh options early, the “exit-only” options will lapse over a corresponding number of shares. By this means, the existing shareholders avoid granting a benefit which is greater than originally intended, whilst allowing the possibility of access to the ER relief when the EMI option shares are sold on “exit”.
b) One of the advantages of an “exit-only” option is that, as the optionholder will not become a shareholder until immediately before the company is to be sold, it is not always necessary to go to the additional trouble and expense of amending the Articles of Association, and or creating a form of shareholders’ agreement, so as to include protections for existing proprietors such as “good/bad leaver” provisions and “drag along rights”. If, now, optionholders are expected to become actual shareholders in advance of a sale of the company, such protections will be essential. The fact that optionholders will become shareholders may also alter the balance of power as between the existing members of the company, and therefore thought should be given as to whether the shares to be put under option should be of a new class of non-voting shares.
c) There is now a greater tension between (i) the fact that the employer company will normally expect (if all relevant requirements are met) to claim relief from corporation for the gain on exercise realised upon the exercise of an EMI share option – which, if the company will increase in value over time, implies that the option should remain unexercised for as long as possible (so as to maximise the CT relief and therefore also the “exit value” of the company to the advantage of all shareholders), and (ii) the desire of the option holders to access the ER relief upon a disposal of the option shares – which requires the option to be exercised at least one year in advance of such a disposal at a time when the amount available for relief from corporation tax may be significantly less than it would be immediately before an “exit” event. Companies, and their shareholders, will need to determine where the balance of advantage lies. That said (whatever the actual numbers involved), the benefit to employees of accessing valuable reliefs from personal taxes is normally considered to outweigh any benefit to the company, and all its shareholders, from securing (additional) CT relief.
Further planning points
Substituting EMI options for up-front share acquisitions to access ER
If it is intended that an employee become, from the outset, the holder of a number of shares which is below the 5% threshold level required under the general rules governing ER, then – if the company qualifies to grant EMI share options – consideration should be given to having the employee instead be granted, and immediately exercise, an EMI share option so as to access the ER relief one year thereafter (notwithstanding that he or she holds less than 5%).
In the context of this idea, it should be remembered that one advantage of acquiring restricted shares by the grant and exercise of EMI options is the fact that any amount of difference between (i) the actual market value of the option shares (“AMV”), and their initial unrestricted market value (“UMV”), will fall out of charge to income tax. If the shares were simply acquired by direct subscription or purchase, it would be necessary (to protect against future charges to income tax) to make a s 431 tax election which has the effect of bringing into charge to tax, at the time of acquisition, any amount of difference between AMV and UMV for which the employee has not paid full consideration.
A point for acquiring companies (whether or not they qualify to grant EMI options)
If your company, whether or not it is too big for EMI options itself, acquires a company whose key employees hold EMI options, you should consider offering the opportunity for such optionholders to be allowed to “roll-over” their options into options to acquire shares in your company. The shares so acquired on exercise of the new options could then be held for the one year period needed to qualify for the ER relief (always assuming that your shares are considered by such key employees to be a good investment….!).
Increase in HMRC resources to deal with EMI options
It was also announced that HMRC will develop the guidance and resources that it makes available to start-up companies wishing to grant EMI options. New resources are to be made available by the end of 2012. It is unclear if these resources will be in the HMRC Small Companies Enterprise Centre, which is responsible for matters relating to EMI options, or also in their Shares and Assets Valuation Office which agrees actual and unrestricted market values of shares for EMI purposes (both of which are in Nottingham).