First published in Practical Audit and Accounting, May 2015.
Available for download here as a pdf document.
Enterprise Management Incentive share options
Enterprise Management Incentive share options are one of the most effective ways to incentivise employees in smaller companies. They allow key employees to benefit from the growth in value of the company to which they contribute on a highly tax-advantaged basis.
Tax benefits of EMI options
The government backed Enterprise Management Incentive scheme option is a right to acquire shares. Individual employees may be granted EMI options over shares with a market value at the date of grant of up to £250,000; companies may grant EMI options over shares with a total initial value of £3 million.
The central advantage of Enterprise Management Incentive options is the fact that the growth in value of option shares above the market value of a share at the date of grant is taxed as capital gain rather than income tax.
If the exercise price is set at less than the market value of a share as at the date of grant – not that of exercise – income tax charges will arise when the option is exercised, on the discount as at the time of grant. If the exercise price is at least the initial market value of a share, however, there will be no tax charges at the time of exercise, only when the shares are sold.
Further, if the employee sells their shares at least 12 months after the option is granted, they will be entitled to claim Entrepreneur’s Relief on any gain in market value at the date of grant – a reduced 10% rate of Capital Gains Tax (up to a lifetime cap of £10 million in gains).
Finally, the company may be able to claim a corporation tax deduction on the entirety of the option gain between grant and exercise, whether subject to income tax or Capital Gains Tax.
Note that the limits apply to the “unrestricted” market value of the shares – i.e., ignoring the depreciatory effect of any restrictions attaching to the option shares, such as the possibility of forfeiture if the employee leaves or fails to meet performance conditions. The tax treatment is however calculated on the “actual” market value taking account of any restrictions.
An extra advantage of Enterprise Management Incentives is that HMRC will agree the market value of the underlying shares before the grant has taken place. This provides certainty for companies and employees that the limits on the grant of EMI options have not been exceeded.
Commercial context and different types of plan
A benefit of Enterprise Management Incentive options beyond the tax treatment is their flexibility, which makes them a useful tool to align employees’ interests with those of shareholders.
Exercise of an option can be made conditional on an exit event occurring, employees’ achievement of performance targets – whether relating to the performance of the company as a whole, or of the individual employee – or simply on an employee staying with the company for a defined period. In each case, the Enterprise Management Incentive option provides an incentive for the employee to stay with the company and work towards its goals.
There is also the choice as to whether to grant EMI options for market value, at a discount or at a premium. EMI options granted at a discount incorporate a “bonus” element, while EMI options granted with an exercise price above market value provide a built-in performance target which employees must exceed in order to benefit.
For shareholders, the flexibility of EMI options will also allow protection of their interests. Exit-only EMI options mean that employees only become shareholders at the point when a sale or other exit event takes place, so that there is no need to involve employees in shareholders’ decisions in the meantime, or to place restrictions on the company’s shares to prevent employees selling the shares externally when options are exercised. (Equally, there is nothing to prevent shareholders using EMI options as a mechanism to place shares in the hands of key employees who may become more involved in the company’s decision-making.)
Further, Enterprise Management Incentive options can be granted over different classes of share in a company, offering existing shareholders the chance to determine what benefits EMI optionholders should receive. Where employees are expected to hold shares in the long term, for example, companies may wish to create separate classes of shares which define what (if any) voting rights employees may exercise, or require employees who leave the company to sell their shares to prevent shareholdings from ending up in the hands of individuals who no longer have a connection with the company.
Which companies qualify?
Enterprise Management Incentive options may only be granted by an independent trading company, or by the holding company of a trading group, with gross assets of less than £30 million and fewer than 250 full-time equivalent employees as at the date of grant. The company must also have a permanent establishment in the UK.
“Independent,” in this context, means that the company must be neither a 51% subsidiary of another company nor under the control of another company. Each of the company’s subsidiaries must also be at least a 51% subsidiary of the company and must not be controlled by any person other than the company. If the company has a subsidiary of which the trade consists mainly of holding or managing land, it must be at least a 90% subsidiary. This independence test often means that private equity backed companies do not qualify.
There are also requirements concerning the activities of the company. The company, or at least one company within its group, must carry out (or be preparing to carry out) a “qualifying trade”. This is any trade other than an “excluded activity”, such as dealing in investments, legal or accountancy services, various trades where the holding of property is a significant element, financial activities such as banking or money-lending, and other activities specified by legislation.
If any substantial part of the company’s business consists of non-qualifying activities, or if any substantial part of the company’s activities are non-trading, it will be unable to grant EMI options. HMRC will normally consider “substantial” to mean “more than 20%,” considered in the overall context of the business.
Who can participate?
An Enterprise Management Incentive option may be granted only to an individual who:
- is an employee of the company or of a subsidiary;
- works for the company at least 25 hours a week, or, if less, at least 75% of his or her working time; and
- does not have a “material interest” in the company (of more than 30%).
Risks and pitfalls
EMI options are among the most straightforward share plans to set up and administer.
However, the simplicity of EMI options can conceal a number of pitfalls. In order to achieve the tax benefits of EMI, each option grant must be registered with HMRC within 92 days – this is a simple administrative requirement, but failure to comply can mean that none of the tax benefits will be achieved.
It is also important to consider carefully the terms of an option at the outset, as any substantive changes are likely to be treated as the grant of a new option for tax purposes – meaning any growth accrued to date is charged to income tax and not Capital Gains Tax. This can be a problem if, for example, it becomes desirable to allow the exercise of options in circumstances not foreseen on grant.
There are also other circumstances where the tax benefits can be restricted or lost. For example, if the company ceases to carry on a “qualifying trade” or loses its independence, any gain in the value of its shares from that point onwards will be subject to income tax in the hands of optionholders – and any gain in value of its shares which has already arisen may lose the benefits of Entrepreneur’s Relief if options are not exercised beforehand.
Similarly, if EMI options are granted over “restricted” or “convertible” shares, their gain in value may be charged at least in part to income tax rather than Capital Gains Tax. It is important to take clear advice at the outset to avoid these and other pitfalls.
Finally, it is important to think about the circumstances in which employees can realise their value. This may be straightforward where “exit-only” EMI options are granted, but in other cases, companies should consider from the outset whether, and to whom, employees may eventually be able to sell their option shares – if employees have no opportunity to realise the value of their options, their value as an incentive tends to be limited.
Our checklist for auditors also demonstrates some of the issues which will require consideration in share scheme accounting and audit terms.
What does the future hold?
Despite the considerable tax benefits, there is no indication of an intention on the government’s part to restrict Enterprise Management Incentive schemes.
Designed as a means to help smaller, higher-risk companies recruit and retain employees, EMI options are generally considered to operate in line with the government’s intentions, and to tie in with its wider goals of promoting employee share ownership. In fact, the tax advantages attached to EMI options have only increased in the past few years, as the limits on the grant of EMI options have been raised and the conditions for achieving Entrepreneur’s Relief on the growth in value of shares made easier to achieve.