After what looked like a huge bureaucratic clanger dropped by the UK government had left the future of the UK’s Enterprise Management Incentives (“EMI”) share scheme in doubt, the European Commission (“EC”) has announced the renewal of the UK’s EMI ‘licence’, confirming that the scheme can continue at least until the UK has formally left the EU. Prior to the EC’s announcement, the scheme was left in limbo after the expiration of the UK’s previous licence on 6 April 2018.
On 4 April, just two days before the expiration of the EMI licence, HMRC announced the news through the release of an ERS Bulletin, stating that any options granted after the expiration of the previous licence on 6 April 2018 were at risk of falling outside of the EMI scheme. The late notice left hopeful EMI users with the choice of either delaying the grant of options until such time as the future of the EMI scheme was certain, or continuing with their plans and taking a chance that the licence would be renewed and, if so, backdated to 6 April. HMRC are yet to release a statement on the EC’s announcement and so it is possible that the government will use the opportunity to make changes to the existing scheme rules. Whatever the government decides to do, it appears likely that the scheme will be treated as having continued uninterrupted from 6 April.
The EMI scheme is the UK’s most tax-efficient employee share scheme and so many SME businesses will be relieved to hear that it remains available as a useful tool for attracting, retaining and rewarding key employees. Here, we assess the nuts and bolts of the EMI scheme and the benefits it can provide to all parties.
PURPOSE OF THE SCHEME
The key word attributable to EMI is ‘incentivise’ – the scheme is built to reward successful target-driven company growth achieved through the efforts of key employees, however the directors wish to measure it. From the outset, those employees to whom options are granted are given bespoke, achievable targets relating to their roles, focusing and incentivising them to achieve the growth that will benefit the company’s shareholder and ultimately unlock their own piece of the pie.
It could be argued that there is only potential upside for the employer in offering EMI options. After all, any employees who fail to achieve targets or cease to be employed before exercising options leave with nothing: the unexercised options lapse and with them any future rights to purchasing shares.
HOW IT WORKS
The mechanics of the scheme are pretty simple: an employer selects which qualifying employees they would like to include, decides how much of the company they would be willing to give up in return for the employee(s) successfully meeting targets, and then agrees those all-important targets.
Once the parameters have all been set and the employee agrees to the principle of the scheme, the employer then grants an option to the employee. It’s important to note that an option does not constitute the issue or allotment of shares to the employee, or the creation of a ‘share pool’ set aside for the employee(s). In its simplest terms, an option is a right to acquire (i.e. buy, not be gifted) shares at some point in the future (known as ‘exercising’ the option), and in the case of EMI said right is dependent on the employee successfully meeting pre-agreed targets.
For all intents and purposes, this is no different to most other forms of company share scheme. What’s different about the EMI scheme is how the eventual exercise of options by the employee is taxed and the benefits that can bring to all parties.
EMPLOYEE TAX IMPLICATIONS
With the EMI scheme there are no tax implications on granting options and it’s only when the options are exercised and shares are purchased that a tax charge could arise. However, unlike most company share option schemes, the taxation of EMI options is based on the market value of the shares at the date the option was granted, not their market value when the option is exercised. This provides a fantastic opportunity for the option-holding employee to generate huge growth value that could be free of income tax at the time the option was exercised.
This is best illustrated with an example:
Sally, Sales Director at Company X, is granted an option over 100 shares in the company, equivalent to 10% of the total issued share capital. The option is exercisable only if Sally increases sales by 15% in each of the next three years. At the date of grant, the company’s shares have a market value of £15 per share.
After three years have passed, Sally has successfully achieved her targets and exercises her option. At the date of exercise, the company’s shares have a market value of £100 per share. Provided Sally pays at least the market value at the date of grant for her shares (£15 per share), no tax liability should arise and the growth in share value is tax-free.
Where an employee pays less than the market value of the shares at the date of grant, income tax and, in certain circumstances, national insurance can be due.
Shares are chargeable assets for capital gains tax and so an eventual disposal by the employee will incur a tax charge. Without any special provisions, this could prove costly to the employee, but the EMI scheme continues to give generously.
The normal rules for Entrepreneurs’ Relief are relaxed for EMI shares and there is no minimum shareholding requirement (normally 5%) and the qualifying holding period of 12 months is calculated with reference to when the option was granted, not when the shares were eventually acquired. In theory this should lead to most successful EMI schemes producing shares that qualify for the 10% Entrepreneurs’ Relief rate when they are eventually disposed of by the employee.
COMPANY TAX IMPLICATIONS
A successful EMI scheme also rewards the employing company, which is afforded a corporation tax deduction in the year in which options are exercised, equivalent to the difference between the price paid and the market value at the date of exercise.
RULES OF THE SCHEME
Given the tax advantages afforded to the scheme, it’s heavily regulated and any failure to comply can result in a loss of tax-advantaged status. There are rules dictating qualifying companies; employees; and option agreements, some of which are summarised below:
The company must:
- be an independent, trading company with only qualifying, trading subsidiaries (if any);
- have gross assets of less than £30m and fewer than 250 full-time employees; and
- have a permanent establishment in the UK.
- be an employee of the company whose shares the options are being granted over;
- be a ‘full-time’ employee, meaning one who works at least 25 hours a week for the company or at least 75% of their working time; and
- not already hold a material interest (>30%) in the company at the time the option is granted.
- be granted over the company’s ordinary, fully-paid up share capital;
- be capable of being exercised within 10 years from date of grant; and
- be agreed in writing.
So, with the Enterprise Management Incentives scheme set to be in place until at least Brexit has been achieved, it remains a truly tax-efficient tool for SME companies to use in growth planning. At Walpole Dunn we have experience of managing an Enterprise Management Incentives scheme from start to finish, including assessing a company’s suitability, setting up a scheme from scratch (including liaising with HMRC on share values), and advising all interested parties on how the scheme will affect them and their tax implications at each stage.
If you’re interested in discussing the scheme for your existing employees, or have the opportunity to attract new employees with Enterprise Management Incentives options, contact us today for an initial free of charge meeting.