Providing key managers and employees with valuable shares and share option rights can be a very powerful incentive and motivator. The employees, for example, will identify more closely with the company's success and obtain a sense of proprietorship. The employing company can benefit from increased commitment and productivity, while retaining its key employees.
In practice, the provision of shares and options to employees and directors is often complicated (and sometimes hampered!) by the numerous special rules that are designed to tax any 'benefit' enjoyed as taxable employment income. The Enterprise Management Incentives (EMI) scheme, however, avoids many of these tax disadvantages while offering more flexibility than the existing Inland Revenue Approved share schemes.
The tax benefits of an EMI scheme are perhaps best appreciated by looking at the main tax charges that typically arise on unapproved employee shares and share option arrangements. It should be noted, however, that EMI schemes do not offer complete protection from employment income tax charges - for example, a tax charge still arises on the exercise of an option granted to purchase shares at less than their market value at the date the option is granted.Tax on shares and options
The main employment income tax charge arises where an employee/director receives free or cheap shares, whether from a direct share award or on the exercise of a share option. The tax charge is based on the 'benefit' received, broadly calculated by reference to the value of the shares less any consideration paid by the employee. Following the Finance Act 2003 changes, many shareholdings are likely to fall within the 'restricted securities' regime. If the employee pays an amount equivalent to the market value of the shares (reflecting any inherent restrictions in the rights attaching to the shares), there is no immediate tax charge. (A typical restriction would be a requirement that the shares be sold back to the company at less than their full value if the employee subsequently left).
However, if the shares would be worth more ignoring such restrictions, income tax and National Insurance Contributions (NICs) are likely to be payable on a later sale of the shares (or similar 'chargeable event'), unless a special election is made (as outlined later).
The amount of sale proceeds etc, that would be subject to income tax increases according to the difference between the unrestricted value of the shares and their restricted value. For example, assume the value of shares on an unrestricted basis is £1,000 and the employee pays the restricted value of £800; 20% of all future growth in those shares (on a sale etc,) would be subject to income tax/NIC and not capital gains tax (CGT). Consequently, the director/employee could be exposed to a sizeable income tax liability if the shares increase in value significantly.Section 431 election
This income tax/NIC risk can be entirely eliminated by making a so-called s431 election. As a general rule, protective elections are made to put the matter beyond doubt. The election has the effect of basing the initial income tax charge on the unrestricted market value of the shares. Thus, using the above example, if the employee makes the s431 election and suffers income tax on £200 (ie, £1,000 less £800), this removes any future growth in value of the shares from the income tax regime.
The s431 election must be made jointly by the employer and employee within 14 days of the share acquisition. The election is not submitted to the Revenue but must be carefully retained by the employer so it can be produced in the event of a subsequent Revenue enquiry.
Alternatively, employees would have to ensure that they paid the full unrestricted value of the shares, but this is generally less desirable given the need to ensure that the relevant valuations would be accepted by the Revenue.Impact on PAYE and NIC
The employment income tax charges are based on 'unrealised' gains and the employee does not receive any cash to finance the tax liability, which often creates difficulties. If the shares constitute readily convertible assets (RCAs), the tax would be collected under the PAYE system. Shares would constitute RCAs, if they are about to be sold, where there is an arranged 'market' for them, or where they are held in a subsidiary of an unlisted company. The employee must reimburse the PAYE tax within 90 days otherwise they will also be subject to a 'grossed-up' income tax charge on the PAYE amount under s222.
Furthermore, where the shares are RCAs, NICs are also due on the benefit of shares and the exercise of options. This would cost the company an additional 12.8% in employers' NIC and employees' NIC would also be due.
It is possible for the employing company to pass its NIC liability to the employee.Main benefits of EMI options
The EMI scheme provides greater benefits and more flexibility than approved Company Share Option Plans. (CSOPs are subject to a £30,000 limit on the value of shares held under option, although they are available for use by all companies, regardless of size or type of trade.)
In most cases, where employees exercise their EMI options at the market value (on grant), their entire profit on sale will be taxed under the capital gains regime with considerable taper relief advantages. One of the most important benefits of EMI options is that they attract business taper relief from the date the option is granted as opposed to the actual acquisition of the shares (as is the case with all other share options).
This means that the maximum 75% taper reduction would be available against the employee's gains after just two years from the date of grant. This is particularly advantageous for so-called 'exit' based EMI schemes, where employees can only exercise their EMI options on a sale of the company.Corporate tax deduction
For accounting periods starting after 31 December 2002, companies can obtain corporate tax relief on shares provided to employees, broadly based on the amount subject to income tax relief in their hands (Sch 23, FA 2003). It can often be overlooked that shares provided under an EMI scheme also enjoy corporate tax relief. Thus, a company can deduct the market value of the shares when the EMI options are exercised, based on the difference between the market value of the shares at the time of exercise and the amount paid by the employees (even though the legislation exempts the shares from an income tax charge where the exercise price represent the shares' market value when the option is granted). The value of this tax relief can be highly significant where EMI options are exercised on a sale. (See example in the panel).Grant of EMI options
Options under the EMI scheme will normally be granted by the employing company or its parent company, but existing individual or employee trust shareholders may also offer their shares. No tax charge arises on the grant of the option. The EMI legislation contains a specific 'commercial purpose' test stating that an option only qualifies if it is granted' … to recruit or retain a key employee in a company' and not for tax avoidance.
The value of share options awarded to each employee must not exceed £100,000 for each individual employee (the value of any existing CSOP options are taken into account for this purpose) but each employee can be awarded a different amount.
EMI options must be over (fully paid and irredeemable) ordinary share capital giving right to a share of profits and are non-assignable. Considerable flexibility exists over the basis on which EMI options can be exercised.
It is possible to grant conditional options (such as options only exercisable on a sale of the company) or options based on specified performance requirements.
Restrictions can be placed over the actual shares enabling owner managers to provide limited voting rights to protect their position. The employer company is completely free to set its own exercise period but the options must be exercised (and any relevant conditions must be satisfied) within ten years to obtain the tax benefits. (EMI options are, therefore, more flexible than CSOP options which have a three-year 'waiting period').
For EMI options granted after 11 May 2001, the maximum value of 'unexercised options' over the company's shares must not exceed £3m. The employees must also meet certain conditions.
Broadly, the employees' 'committed time' (ie, spent on the employment) must be at least 25 hours per week, or if less, 75% of their available working time including self employment. EMI options cannot be granted to employees if they have (together with associates) at least a 30% equity interest in the company, including unexercised options other than EMI options.Exercise price
EMI options will frequently be granted to acquire shares at their market value at the date of the grant. In such cases, there is no income tax (or NIC) charge when the option is exercised. However, the exercise price can be set at any level (although it is illegal to issue shares for less than their nominal value) without affecting the qualifying status and tax advantages of the scheme.
For shares acquired after 18 June 2004, the legislation deems that a s431 election (see above) has been made. For earlier exercises, it was necessary to make an actual election.
The basic thrust of the EMI regime is to tax the growth in value of the shares from the grant date as a capital gain. If the option has been granted at a discount to the initial value of the shares, this is taxed as employment income. However, the income tax charge on discounted EMI options is based on the excess of the initial grant value (or, if lower, current value) over the exercise price. If the shares are RCAs, the PAYE and NIC rules outlined above will apply. (This treatment contrasts with unapproved share options where the tax charge is based on the market value at the exercise date).Qualifying company
A company will only be a qualifying 'EMI company' if it satisfies certain conditions designed to ensure that only small independent 'higher risk' companies qualify. A company is 'independent' for this purpose provided it is not controlled by another company within s840 ICTA 1988. It is not therefore possible to grant EMI options over shares in a 51% subsidiary.
Similarly, a company that is more than 50% owned by a venture capitalist does not qualify. For a singleton company, the gross asset value shown in its balance sheet (according to UK GAAP) must not exceed £30m (£15m for options granted before 1 January 2002).
The company must also carry on a 'qualifying trade'. The definition is framed so as to prevent 'low-risk' activities from qualifying, in a similar way as for Enterprise Investment Scheme and Venture Capital Trust companies.
The company's trade(s) must be carried on wholly or mainly in the UK on a commercial basis. The trade must not consist substantially (ie, more than 20%) in the carrying on of excluded activities such as dealing in land or shares, banking, leasing, receiving licence fees or royalties, legal and accountancy services, property development, farming, and operating and managing hotels and nursing homes. High tech companies are assisted by the special 'let-out' rule that enables a company to be an EMI company where it receives royalties and licence fees from the exploitation of 'internally created' intellectual property.
For post-16 March 2004 option grants, where the company is a parent company of a group, it must hold at least 51% of the ordinary share capital of its subsidiaries, although any property management subsidiary has to be at least 90% owned. For options granted earlier, all subsidiaries had to be 75% beneficially owned. The £30m gross asset limit is based on the consolidated balance sheet value of the group's assets (ie, ignoring shares in group companies). Furthermore, the group's business, taken as a whole, must not substantially consist of non-qualifying activities and at least one member of the group must satisfy the qualifying trade test in its own right (paras 8-14, Sch 5).Valuation and notification procedure
The (unquoted) owner-managed company will clearly need to value the relevant shares at the date of grant to determine whether the £100,000 limit has been met and whether any discount element is subsequently liable to income tax on exercise. The share value must be agreed with the Revenue's Shares Valuation team, which will normally give such cases priority for agreement.
The EMI option is subject to a 'self-assessment' style notification and declaration process. A notice must be submitted within 92 days of the grant for each employee together with the option agreement (which must cover the terms of the option, any relevant conditions affecting the employee's entitlement and any restrictions attaching to the shares) (paras 37 and 44, Sch 5). It is still advisable to prepare a standard set of scheme rules governing its operation to demonstrate a level playing field between employees. A declaration is required to be given by a director or secretary of the employing company that the EMI rules are satisfied and the employee must 'sign off' on the 'working time' commitment condition. The Revenue is entitled to make an enquiry into the notice within 12 months of the end of the 92-day notice period.Impact of disqualifying events
If one of the relevant EMI conditions is broken (referred to as a 'disqualifying event') during the life of the option, the employee must exercise it within 40 days to retain the EMI benefits (ie, no tax charge on the increase over grant value). A disqualifying event will be triggered, for example, if the company ceases to be independent or meet the 'qualifying trade' test or the employee ceases to work for the company. Failing to exercise the option within the 40-day period will render the employee liable to an (additional) income tax charge on the growth in value of the shares between the disqualifying event and option exercise.Sale of EMI shares
Employees are only likely to exercise their options if the value of their company has increased and they can enjoy the full benefits of share ownership by merely paying the exercise price. Employees of owner-managed companies clearly hope to realise substantial value on a future sale. Other available exit routes would be a sale to another shareholder, employee trust, or sale back to the company, but would normally be at discounted minority values.
In this article, all statutory references are to the Income Tax (Earnings and Pensions) Act 2003, unless stated otherwise
Peter Rayney FCA FTII TEP is a tax partner with BDO Stoy Hayward's Midlands Tax Consultancy Group, based in Birmingham. He is author of The Practical Corporate Tax Manual, published by CCH
Brian is the financial director of Wilson Ltd, which draws up accounts to 30 June each year. On 1 November 2002 he is granted an option to acquire 1,000 £1 ordinary shares in the company at £1.80 per share exercisable at any time within 10 years. The agreed value of the shareholding at that time is £3 per share.
In January 2005, the sale of the entire share capital of Wilson Ltd is agreed, which triggers the exercise of Brian's EMI option. The company is sold with Brian receiving £200,000 for his shares.Exercise of option
Brian will have an income tax charge when he exercises his EMI option in January 2005 as he acquired the shares at a discount on their grant value, as follows:
|Market value at date of grant (1,000 x £3) -||3,000|
|Less: Exercise price (1,000 x £1.80) -||(1,800)|
|Employment income -||1,200|
As the company is to be sold, PAYE and NIC would be payable on the £1,200.Sale of shares
Brian's capital gain arising on the sale in January 2005 is calculated as follows:
|Sale proceeds -||200,000|
|Less: Exercise price||(1,800)|
|Discount charged to income tax -||(1,200)|
|Chargeable gain -||197,000|
|Business taper relief (2 years from grant) (75%) -||(147,750)|
|Taxable gain (ignoring annual exemption) -||49,250|
|CGT @ 40% -||19,700|
Notes 1. If Brian had been granted an unapproved option, there would have been PAYE and NIC on the current value of his shares at the time of exercise, likely to be virtually all the £200,000 sale value (less £1,800).
2. Wilson Ltd would obtain corporate tax relief of £198,200 (@ 30%, worth around £60,000) in the year ended 30 June 2005 (being the amount subject to income tax (£1,200) and the 'income-tax' free exercise profit of £197,000).