A Tax Efficient and Flexible Incentive to Attract and Retain the Best Employees
Enterprise Management Incentive (“EMI”) schemes offer tax advantages to employees of smaller companies with growth potential that qualify and can therefore help to attract and retain the best employees. First of all let’s look at the qualifying criteria:
- The company must carry on a “qualifying trade” (see below), or be preparing to do so, and must have a permanent UK establishment. If the EMI options are granted to employees within a group, then at least one company in the group must satisfy these requirements;
- The shares over which the EMU options are granted must be an independent company. That means, in the case of a group, the shares must be options over the parent company;
- The company (or group) must not have gross assets exceeding £30 million at the time the EMI option is granted;
- The company must have fewer than 250 full-time (one who works 35 hours a week) equivalent employees at the time the EMI option is granted.
For a smaller business, the above criteria are usually easily met.
References in this article to companies, also refer to the group of companies where applicable.
The shares used for EMI options can be subject to restrictions, but they must be ordinary shares that are “fully paid up” (for company law purposes) and not redeemable or convertible.
Since EMI options are discretionary, a company is able to choose which eligible employees receive options and how many options each employee gets.
Which companies are EMI schemes suitable for?
EMI schemes can be used by all small companies, but different types of options will be more suitable depending on the owners’ future plans. An owner-managed business where the owners have no intention to sell or list their business will most likely have a different type of scheme to one where the owners have an exit strategy. In the case of a company sale or listing on a stock exchange the advantages of the scheme are gained by giving employees the opportunity to participate in the sale or listing on a recognised stock exchange. An exit-only EMI option plan will mean that employees do not become shareholders until there is an exit opportunity for all the shareholders. The employees would exercise their options and immediately sell them to a buyer, or they would be listed in the case of a company public sale on a stock exchange. Where there is no exit strategy a time-based scheme will be more appropriate. We’ll have a look at these options, and also hybrid schemes, later.
What is a “qualifying trade”?
Again this is not a difficult requirement to meet, as broadly speaking it is a trade that is carried out with the intention of making a profit. There are however some non-qualifying trades such as dealing in land, financial trading, leasing, and property development. It is possible to apply in advance to HMRC for an opinion as to whether a company meets the EMI requirements.
Which employees can participate?
To participate employees must spend 25 hours per week, or, if less, 75% of their working time, on the business of the company. Employees must give written declarations confirming they meet this working time requirement, and these declarations must be retained. Employees that have a “material interest” (essentially 30% interest or more) in the company either on their own or with one or more associates are excluded.
How many options can be granted?
There is a limit of £3m on the total value of shares (as of the grant date) which may be available under EMI options at any given time. There is also an individual limit of which any one employee can hold £250,000.
What are the advantages?
- There is no income tax or National Insurance Contributions (“NIC”s)payable on the grant of the EMI option;
- Normally no income tax or NICs will be payable when an employee exercises the EMI option unless the exercise price is less than the market value of the shares on the grant. If that were the case the difference between the grant market value of the shares (or the current market value, if lower) and the exercise price will be chargeable to income tax and possibly NICs;
- Capital gains tax (“CGT”) is payable on the sale of the EMI options;
- Business asset disposal relief (“BADR”) will potentially be available on the disposal of shares acquired via an EMI option if the shares are sold more than 24 months after the grant of the option.
- If the share option is exercised more than 90 days after a “disqualifying event”, income tax (and possibly NICs) is payable on the increase in value of the shares between the date of the disqualifying event and the date of exercise.
Disqualifying events include the company ceasing to carrying out a qualifying trade, the option holder ceasing to be a qualifying employee, the company being taken over, and certain alterations to the company’s share capital.
The reduction in the CGT tax-free allowances scheduled for 2023-24 and 2024-25 will erode the tax benefit, but if BADR applies the sale of shares acquired via an EMI option will still be subject to an extremely low rate of tax.
Business Asset Disposal Relief
The availability of BADR is an important benefit for EMI option holders. Option holders must have been given the options at least 2 years before selling them.CGT is charged at a low rate of 10%. There is a lifetime limit of gains which is currently £1m. Normally BADR is only available where the company is “your personal company”, but EMI option holders can qualify. The individual must have been an employee or officer of the company throughout the two-year period ending with the disposal.
Time-Based, Exit Only, and Hybrid Schemes
First of all a bit of terminology: options are “vested” when the share can be bought.
A time-based scheme is where options vest over a certain period of time, which incentivises employees to stay with the company. Alternatively, where no sale is anticipated, the shares can provide dividend income for shareholders. It would make sense for employees to buy their shares prior to any sort of exit as they may well be getting dividends if the company is profitable and generating cash. Alphabet shares are often used in this case (different classes of ordinary shares, often “A” shares, “B” shares, and so on for different classes) and these shares can have buy-back options, enabling the company to buy back shares that have been purchased by employees who then leave the company. These shares can be non-voting and even non-dividend. There is therefore flexibility over how shares are issued and how employees are incentivised.
Exit-only schemes are more popular. Such schemes incentive employees to work towards a planned exit event, with everyone focused on the end game. As mentioned above employees exercise their options and sell their shares on the day the company is sold.
A hybrid scheme might, for example, allow for options to vest over a period of years, with a certain percentage of the options vesting each year. If an exit occurs before 100% of the options have vested then the employee can only exercise those options that have vested by the exit date. It is possible to allow for any remaining options to vest on the exit date. For an employee that leaves the business before an exit, they can be classed as a “good leaver” and they may be allowed to exercise any options that had vested prior to leaving, unless they depart in the first 12 months, in which case all options are lost. The opposite of a good leaver is a “bad leaver”, who could be anyone who leaves to join a competitor or is dismissed for gross misconduct.
Employees must be able to exercise EMI share options within 10 years and the EMI option terms must be set out in a written agreement and must detail any restrictions on the shares. Each EMI option must be notified to HMRC within 92 days after its grant and the company must deliver an annual return to HMRC.
As noted above the market value of the shares must be established at the time of the option grant. A valuation can be formally agreed upon with HMRC and it is highly recommended that this is done. Any valuation not previously agreed would otherwise be open to HMRC challenge, which could have adverse consequences for option holders.