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Enterprise Management Incentive (‘EMI’) share option schemes have been good news for employees for a number of years. Given that the shares under option can be eligible to a reduced 10% tax rate under Business Asset Disposal Relief, this reduces the effective rate of tax on lifetime gains of up to £1,000,000 to 10%, so there is no better time to look at introducing an EMI option scheme to incentivise, recruit and retain members of staff.
What is an EMI share option?
An EMI share option is, in many ways, the same as any other share option. Usually the company grants an employee a right to acquire shares in it for a given price at a given time, and quite often if certain criteria are met, such as sale proceeds exceeding £x or based on company performance.
Companies can structure the timing of the exercise of an option dependent upon the preferred approach. Often this will only allow an exercise of an option on an exit (i.e. when the business is sold). This has the advantages of not having numerous minority shareholders. It also avoids problems with having to buy shares back from the employee when, and if, they leave, as options can be structured so that they lapse when an option holder leaves the business.
The rules in relation to an EMI option scheme can be quite fluid in terms of exercise conditions and price. Companies should therefore view this type of arrangement as one that will not in any way adversely affect the day-to-day running of the board or shareholders unless it wants it to.
What is the process for setting up an EMI option scheme?
The first step in setting up an EMI scheme is to ascertain whether the company is able to issue share options under its articles of association. If it is not, the articles will require amendment. Also, if there are outside investors, it is probable that the company would need to seek their approval before granting options. This is quite often dealt with by way of a letter of consent.
The second step is to evaluate if the company and potential option holders meet all of the requirements to qualify for an EMI option. The tests are many, (see below for a brief summary of the company and individual criteria), but for most companies the end result, possibly with the help of professional advice, is clear one way or the other. If there is any doubt over whether the company qualifies for issuing EMI options, it is possible to apply for advance assurance to HMRC. In this situation, we would recommend that professional advice be sought, as in the advance assurance application it is necessary to move systematically through each part of the relevant legislation stating why each area is met (or not).
Assuming that the company qualifies and/or has received advance assurance, the next step is to agree a valuation with HMRC for the shares over which options would be granted. In most cases, HMRC will look at the total value of the company and will be willing to accept a discount to that value for EMI options that represent a small minority in illiquid shares of a private limited company. This discount ranges from 50% up to possibly even up to 90%, albeit dependent on circumstances. The valuation does not necessarily need to be a professional one, but this is recommended and independent valuations can be helpful in the event of dispute with HMRC or to help satisfy a buyer undertaking a due diligence exercise in future.
If there has been a recent transaction in shares, in most cases this will form the basis of the valuation agreed with HMRC. The valuation, once agreed, is normally effective for 90 days.
Once the valuation is agreed, the legal documents are drafted. These will typically consist of a set of scheme rules, an option agreement for each option holder, an employment-related securities election under section 431 Income Tax (Earning & Pensions) Act 2003 and board minutes approving the scheme and the grant of the options.
Once the options are granted, the share scheme and the grant of the options need to be notified to HMRC within 92 days of the date of grant. Failure to do so causes the option to be treated as an “unapproved option” and as a result, the EMI tax breaks will be lost. Note that EMI options granted from 6 April 2024 onwards need only be notified to HMRC by 6 July following the tax year of grant, which is a considerably longer window for attending to this step.
What tax breaks do EMI options provide?
There is no income tax or national insurance payable on the grant of an EMI option.
If the exercise price is at least equal to the actual market value of the shares at the date of grant as agreed with HMRC, there is no income or national insurance payable on exercise of the EMI option. (If the exercise price is less than this, there will be a charge to income tax based on this ‘discount’.)
Provided that the employee has held the option and/or the shares arising from the option for greater than 24 months, and the company qualifies, BADR is available on the disposal of the option shares. This reduces the effective rate of tax on any gain (the difference between the price paid on exercise and the sum received on sale) to 10% on the first £1,000,000 of gains (a lifetime cap). Thereafter, the capital gains tax rate is 20%.
The employee may also be able to use their annual capital gains tax exemption to set against the gain if not used already elsewhere (note that this is reducing to £3,000 from 6 April 2024). Please note that the tax provisions in this paragraph are correct at the time of writing, but subject to change.
For the company, the cost of setting up and administering the scheme is a deductible expense for corporation tax purposes. Furthermore, a corporation tax deduction is available on the difference between the exercise price and the market value at the date of exercise of the EMI options.
Which companies can issue EMI options?
To issue EMI options a company must broadly:
- Be a trading company or a holding company of a trading group.
- Not have gross assets in excess of £30m.
- Not have more than 250 full-time equivalent employees.
- Be independent i.e. not be a subsidiary.
- Not have EMI options in issue with a value on date of grant of more than £3m.
- Have as a minimum a permanent establishment in the UK (it is possible though to issue EMI options in foreign companies for UK employees).
- All subsidiaries must be qualifying subsidiaries (for example, involvement in a joint venture may result in this test being failed).
- Not carry out an ‘excluded trade’. There is a list of excluded trades, but the main ones that are caught are property companies, financial companies and leasing companies.
Which employees qualify to participate in an EMI option scheme?
The employee must:
- Work for the company (or a company subsidiary) for at least 25 hours per week or for at least 75% of their paid working time; and
- Not have a material interest in the company i.e. they must own less than 30% of the company. There are detailed rules around who and what is included in calculating the 30%.
The above is just a broad list of the major conditions. Sitting behind most of these conditions are sub-conditions that will need to be worked through before the options are finally granted.
Any other restrictions?
The maximum EMI options that an employee can hold amount to £250,000 in any three-year period.
The options must be capable of exercise within ten years of grant.
The option must be over ordinary fully paid-up shares, although they can be different class of share i.e. non-voting or growth shares. Redeemable or preference shares cannot be used.
Worked example of tax position
Spring Limited grants options to Mr Lamb over 1000 shares with an exercise price of £1 per share. The actual market value of the shares on grant of the option was £1. Mr Lamb holds the option for more than 24 months before exercise. The shares are sold for £50 per share. Mr Lamb has no other capital gains
| Sale Proceeds | 50,000 |
| Less cost | (1,000) |
| Gain | 49,000 |
| Annual Exemption 2023/24 | (6,000) |
| Taxable Gain | 43,000 |
| Tax at 10% | 4,300 |
| Total cash retained by the employee | £45,700 |
| Spring Limited gets a corporation tax deduction of | 49,000 |
| Relief at 25% (assuming augmented profits over £250,000) | 12,250 |
Does a company have to use EMI options to issue shares to employees?
There are other types of share option scheme that could be used such as: CSOPs, SAYE schemes, growth share schemes and non-tax advantaged (unapproved) options, but for many companies, unless they fail to meet the criteria, the EMI share option route provides the best all-round solution.
If you would like to discuss any of the issues raised in this article, or would like to learn more about share options, share schemes or employee incentives generally then please contact Anthony Reeves or Cathy Bryant.
This article is for information purposes only and is not a substitute for legal advice, and should not be relied upon as such. Please contact our specialist lawyers to discuss any issues you are facing.
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