Last updated on December 16th, 2019 at 11:17 am
Since its launch in 2000, implementing an Enterprise Management Incentive (“EMI“) option scheme has become by far and away the most popular HMRC tax favoured share incentive plan adopted by companies for UK employees.
Essentially, qualifying companies can set up an EMI scheme whereby options can be granted over shares to qualifying employees worth up to £250k (each employee) without giving rise to an income tax or NIC charge. They also allow the employee to purchase shares in the company for a discounted value. The total value of shares in a company which may be subject to unexercised EMI options at any time is £3 million.
If a company does not meet the qualifying criteria for an EMI share option scheme, then the next best alternative opted for is usually a growth share scheme.
Why set up an EMI share option scheme?
EMI option schemes are intended to help companies retain valued employees and to reward the employees for investing their time and skills in helping the company grow.
Particularly for tech start-ups, share options can be an important part of the package in attracting high calibre employees who can be persuaded to join a company for a lower cash salary when they see the potential for realising a significant capital gain in the future (on an exit event when their options will commonly be exercised).
Share options more closely align the interests of a company’s owners and its employees as both will be more united in wanting to build long-term shareholder value through growing the business in the expectation everyone will eventually benefit from an exit event.
If employees are instead issued shares from the outset of their employment (or at any time during their employment) then this will generally involve employees having to pay for their shares, or suffering a significant tax charge if their shares are gifted or acquired at less than their full value at the time.
Share options are also more straightforward to link to the achievement of performance targets, while an employer does not have to worry about the added complications that arise once employees actually holding shares (e.g. the ability to influence shareholder voting and other rights acquired by way of being a minority shareholder).
As discussed further below, EMI options have two key tax benefits:
1) No income tax is usually charged upon exercise of the option; and
2) Capital gains tax upon eventual sale of shares acquired on exercise is usually charged at a reduced rate of 10%.
The options allow the employee to exercise (i.e. buy the shares) at the market value of the shares (agreed with HMRC) when the options were granted – the intention being that when the options are exercised the market value of the shares is higher, therefore the employee has received the shares at a discount. When the shares are eventually sold by the employee they will be liable to Capital Gains Tax (“CGT”) on any gain over the market value at grant and qualify for Entrepreneurs Relief meaning an effective CGT rate of 10%.
While there is no income tax liability on the grant of an EMI option, there may be an income tax liability on exercise. If the exercise price was less than the market value at grant, then income tax is due on the difference between the exercise price and the market value at grant. This is the reason why companies ensure they agree a valuation with HMRC before granting the options so they can be sure the exercise price will be at least the market value per share at grant and employees won’t suffer any income tax liability on exercise.
Broadly, the National Insurance Contributions (“NICs”) treatment of EMI options follows the income tax treatment in that there will be no NICs if no income tax is due, but there will be such contributions due if income tax is payable and the shares are readily convertible assets. The employer and the employee may enter into arrangements under which the employer NICs liability is transferred to the employee.
Qualifying companies are those which are not subsidiaries of another company, are UK based, have gross assets of no more than £30m, have fewer than 250 employees and must participate in a qualifying trade with a view to realising profits.
Qualifying trades are any that are not investments in land, shares or financial instruments, financial services, leasing assets, licence/royalty fees receipt, legal/accountancy services, property development, farming or forestry. Qualifying employees are those who work full time (defined as at least 25 hours per week or for at least 75% of their paid working time) and do not hold more than 30% of the company’s shares.
There is no advance approval process required from HMRC although there are HMRC notification and reporting requirements (see below).
Setting up a scheme
In order to set up a scheme, the company’s articles of association will need to be checked (and possibly altered) and option scheme rules drafted in the form of an agreement between the company and the employee/director.
A valuation of the company will also be required to establish the market value of the shares. The valuation is then often agreed with HMRC (see further below). The main circumstances in which a valuation is required include on 1) grant of the EMI options (the tax market value of the unquoted shares on grant is required in order to calculate the £250,000 limit applicable to EMI options, to complete the HMRC notification form following grant and to determine whether there will be a tax charge on exercise) and 2) exercise of the EMI options (if an income tax charge arises on exercise the market value of the shares on exercise needs to be agreed with HMRC so as to calculate the tax due).
Share valuations vary depending upon the nature of the business and the company’s stage of development. Factors that may be considered include the assets of the company, the historic trading position, dividend yields, comparable price earnings ratios, any recent investment rounds or offers to acquire the company and comparable selling prices of similar companies in the sector.
The option scheme rules and agreement can contain good and bad leaver provisions that avoid an employee leaving and taking shares with them. These provide that on an employee leaving a company there is an automatic transfer of shares held by that employee. Employees will be treated as good leavers (typically on death, disability and sometimes, redundancy) or bad leavers (dismissed for other reasons or resigning). Good leavers typically get “fair value” and bad leavers get par value or the price paid on subscription if higher.
The scheme rules also include detail about how and when the options can be exercised and can relate to certain performance targets being met (by the company and/or the employee), the employee having remained employed for a specified period, or upon the sale of the company. The options may also lapse and be forfeited if the employee tries to assign them or grant security over the options.
As the employer has responsibility for making income tax and national insurance payments through PAYE to HMRC the option scheme agreement should contain appropriate indemnities for tax and national insurance contributions and provisions for recovery of such payments from employees.
The shares under option must be part of the ordinary share capital of the qualifying company, fully paid up and not redeemable (as stated at paragraph 35 Schedule 5 ITEPA 2003), while the options must be capable of being exercised within 10 years.
Ordinary share capital
Ordinary Share capital is defined in section 989 Income Tax 2007 as “in relation to a company, means all the company’s issued share capital (however described), other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company’s profits.”
As the HMRC Employee Tax Advantaged Share Scheme Manual states at ETASSUM54010 it does not matter whether the shares in question are called “ordinary”.
In September 2018 the Chartered Institute of Taxation published a table setting out HMRC’s views on a number of different types of share capital that could be considered ordinary share capital, each with differing dividend rights.
We recently advised on an EMI share option scheme where HMRC agreed a valuation relating to options granted in respect of B shares to be issued once the option is exercised. The company’s articles defined the B shares as alphabet shares whereby the board could declare a dividend that was distributed in non pro-rata proportions between A and B shares, while the B shares were non-voting but otherwise had an equal right to any capital distribution made to shareholders. Therefore, because there is no fixed rate to dividends the B shares for the purposes of the EMI share option scheme can be considered ‘ordinary share capital’.
How vesting works
After the share options have been granted, ‘vesting’ commonly refers to the period over which an employee accumulates more of an entitlement to the beneficial interest of a share option in advance of (and subject to) an exercise event. For example, an option granted may vest over a four year period, following which it may be exercised in whole upon the exercise conditions being met (for example, in an exit only scheme, the company being sold). Sometimes the vesting period is preceded by an initial ‘cliff’ period whereby there is no vesting of the option.
The vesting period can be up to 10 years (exercise has to happen within 10 years from grant) and the vesting frequency is usually either monthly, quarterly, or more often annually. For example, a key employee may be granted options that entitle them to up to 5% of the company’s share capital on an exit event, with the option vesting as to 1% of the company for each year over a five year period, following which the option becomes exercisable once there is an exit event.
HMRC EMI clearance / advance assurance
Its not necessary, but as good practice some advisers we know as a matter of course seek advance assurance from HMRC that the EMI option scheme qualifying criteria are met. Such advance assurance and dialogue with HMRC would be particularly useful if there is a question in respect of a company’s situation which the rules do not give a clear answer on (e.g. if the company is not sure it meets either the independence, qualifying subsidiaries or gross assets tests). An advance assurance application is made by preparing and sending a letter to HMRC together with supporting documentation.
Each application should include the company’s registered office address, registered number, corporation tax reference, a copy of the latest available accounts for the company and each of its subsidiaries with a permanent establishment in the UK, a copy of the up-to-date articles of association and details of all trading or other activities carried on by the company and its subsidiaries.
As much detail as possible should be given relating to the company’s specific concerns so as to avoid a delay in the response and also to avoid any later dispute that insufficient or false facts were provided to HMRC.
Although the procedure is not statutory, HMRC is normally bound by any assurance given, provided the information supplied was correct and complete at the time it was given and has not been superseded by subsequent events. It is therefore important that all relevant information is supplied in writing.
Restrictions on shares
The EMI contractual documentation used must contain details of any restrictions (e.g. obligatory buy back rights that the company can exercise if conditions are met) that will apply to the shares that will eventually be issued (or transferred) to option holders on exercise. HMRC guidance published in July 2016 means that it is not sufficient that such restrictions are only set out in a company’s articles (and/or shareholders agreement), but that they are also cross-referenced and summarised in sufficient detail within the body of the EMI option agreement itself.
Employee working time agreements
Since 6 April 2014 employees need to provide a written declaration that they meet the 25 hours a week / 75% of paid time “working time” EMI requirement. This declaration can be a standalone document or be integrated within the employee’s EMI option agreement. The company granting the options also needs to ensure that the employee is provided with a fully executed copy of this declaration within seven days of it being signed.
From a tax perspective, the scheme must be registered with HMRC within 92 days of establishment and there is an identical timeframe for notifying HMRC of any options being granted. There is an annual return (known as an EMI40) that must be filed by 6th July following the end of the tax year. The scheme registration, option notification and EMI40 filing must take place online (since 6 April 2014) via HMRC’s ERS service and failure to notify/file can lead to the scheme being cancelled and the tax advantages being lost.
Its important to note that the registration period is strictly enforced by HMRC with only very limited reasonable excuses permitted.
There are a number of steps to the online registration process and companies are advised to start the process as soon as possible in order to ensure that they can comply in time.
While its true that you don’t have to involve HMRC in agreeing a valuation for the purpose of your EMI option scheme, in our experience it is very much recommended and we strongly advise that all companies make use of HMRC’s share valuation advance approval service. Obtaining such agreement from HMRC at the outset provides certainty on the tax treatment of the options and also that any grant of options are within HMRC’s EMI limits.
We often come across companies who have made various EMI valuation mistakes. Some don’t get a valuation agreed with HMRC at the time the options are granted, while others will obtain agreement from HMRC on their valuation but then grant the options outside the typical 60 day HMRC approval window. We have seen a few startups do their own valuation that is based on a recent investment round they’ve carried out. This results in an unnecessarily high value being used for setting the option price and reporting those values to HMRC. Regardless of what value they raised money at, the same companies could have agreed a lower valuation with HMRC and therefore significantly lowered the buy in costs for employees and/or tax liabilities on exercise.
Without an agreed HMRC valuation, a company is likely to have its historic market values questioned meaning there will be a risk that the options were granted at a discount or that the EMI limits were exceeded at grant. This uncertainty is likely to be raised as an issue by any experienced investors or any buyer of the company when they are undertaking due diligence. We have also seen key employees put off from joining a company because they do not have confidence in the robustness of the EMI options they are being offered.
As a result, as well as disgruntled employees being taxed at up to 47% (rather than at 10% or less) on a proportion of the gain made on the option shares, an investor or buyer may require certain indemnities and/or retention amounts to cover any possible PAYE/NIC exposure.
It’s important to note that there are two different valuations relevant to EMI share options. These are:
a) the unrestricted market value (UMV) which excludes restrictions on shares (such as leaver provisions) from having any negative impact on value; and
b) the actual market value (AMV) which takes account of any restrictions and will therefore usually be a significantly lower value than UMV.
A common mistake companies make is to set the exercise price of an EMI option at not less than UMV when it should be the lower AMV that is relevant for these purposes. By using UMV, options will be granted with an unnecessarily high exercise price that will reduce the upside of the EMI scheme to option holders.
In order to produce a valuation report that can be agreed with HMRC we usually require the following information:
- full financials for the last five years;
- articles of association;
- shareholders agreement(s);
- share subscriptions and fund raising;
- details of any dividends
- details of any shares changing hands;
- details of any options or free shares granted in the past;
- details of any registered IP;
- details of significant assets held by the business;
- details of any long term sales contracts;
- the number of options you intend to grant and the size of the option pool;
- a brief description of the company;
- directors CVs or LinkedIn profiles;
- details of any proposed fundraising or sales of shares; and
- any other details you think will be relevant.
The EMI option tax breaks can be lost on the happening of certain “disqualifying events” after EMI options have been granted. Failure to exercise an EMI option within 90 days of the happening of such an event can cause some of the option gain to be taxed at higher income tax/NIC rates. In addition, if a disqualifying event occurs within the first twelve months of the grant of an EMI option, then the option holder will lose the benefit of the 10% rate of capital gains tax via entrepreneurs’ relief.
Potential disqualifying events include:
a) the loss of independence of the EMI company, i.e the company comes under the control of another company whereby it is a 51% + subsidiary; and
b) an option holder ceasing to be employed and/or ceasing to provide 25 hours a week (or 75% of their paid time to the business).
If a company grows to exceed the £30m EMI gross assets limit or the 250 full-time equivalent employees limit, then this will not be deemed a disqualifying event, albeit the company would be prohibited from granting any future EMI options.
How much does it cost to set up an EMI share option scheme?
We advise on and produce appropriate EMI share option schemes on a fixed fee basis, usually for £3,000 plus VAT (for the full service as listed below). To-date all the schemes we have worked on have been put together without the need for face-to-face meetings, although we would be happy to meet you if you happen to be based near our Sussex office. The aforementioned fixed fee includes the following assistance provided from us:
Full EMI option scheme service
- Putting together an EMI option agreement or separate EMI option scheme rules and an option certificate (together with a notice to exercise) for each employee, the later more apt if the company intends for several employees to join the EMI option scheme. Such contractual documentation can provide that the grant of EMI options are exercisable either based on time vesting, performance measures or on an exit/sale of the company and will include good and bad leaver provisions to protect the company in the event the employee leaves.
- A review of your articles and making any change(s) required to implement the EMI scheme.
- HMRC share valuation application consisting of carrying out the valuation (to determine the exercise price of the share options), writing a letter to HMRC requesting agreement to the proposed share valuation, compiling supporting documentation and any dialogue or negotiation with HMRC if required.
- Detailed guideline documents for both the client as employer and also the employee, describing the process of granting and exercising the options, explaining the key terms and clearly outlining the tax implications.
- Shareholder resolutions and board minutes approving the terms and implementation of the EMI option scheme and the grant of EMI options.
- Formal notice of the grant of the EMI options to HMRC.
- Advance assurance application, if necessary (rarely), to HMRC (for clearance that the company is eligible for EMI purposes) including preparing and sending the letter to HMRC requesting advance assurance, and the supporting documentation. £500 plus VAT
- Annual return to HMRC for your EMI scheme. £100 plus VAT for a ‘nil’ return or £150 plus VAT if changes need to be reported
- HMRC share valuation application only – consisting of the letter to HMRC requesting agreement to the proposed share valuation, compiling supporting documentation and then any dialogue or negotiation with HMRC if required. £1250 – £1750 plus VAT depending on the complexity
- All legal work as per the fixed fee list above, but with no HMRC Share Valuation Application. £1,500 plus VAT
- Unapproved share option scheme – where share options are granted to a non-employee, such as a non-exec director or consultant and fall outside of the EMI share options scheme HMRC legislation. £700 plus VAT
Please see our free downloadable EMI Option Scheme Checklist And Questionnaire which will help you get started on setting up an appropriate EMI share option scheme for your company.
1) Unapproved options tax impact: Ant is granted an unapproved option to acquire a 4% shareholding in his employer for its market value of £15,000. Five years later, he exercises the option at a time when the shares are worth £150,000, and two years after that he sells them for £200,000 when the company is acquired.
Ant pays no tax when the option is granted, but on exercise he is treated as having received taxable earnings of £135,000 (£150,000 share value less the £15,000 that he acquired them for). He pays income tax at the higher rate of 40%, a tax of £54,000, even though at this stage he has received no cash.
On sale of the shares, Ant pays capital gains tax on the £50,000 growth in value since he acquired the shares. Irrespective of any reliefs that may be available to him, capital gains tax is charged at 20% on this, meaning a tax hit of £10,000.
So although Ant has been fortunate in being able to acquire shares for £15,000 that are eventually sold for £200,000, he has had to pay tax in aggregate of £64,000, most of which is payable well before he has received any money for the shares (and which in any event might be lost altogether if the shares once acquired then collapse in value).
2) EMI scheme tax impact: Dec is granted an EMI option to acquire a 4% shareholding in his employer for its market value of £15,000. As in the previous example, five years later he exercises the option when the shares are worth £150,000, and eventually sells them for £200,000 when the company is sold.
Dec pays no tax when the option is granted, and nor does he pay any tax when the option exercised.
On sale of the shares, Dec pays capital gains tax on the gain of £185,000 (£200,000 sale proceeds less £15,000 option exercise price). Ignoring any reliefs he may have available, capital gains tax is charged at the reduced rate of 10%, a tax of £18,500.
Therefore Dec has saved tax of £45,500 compared to Ant, and paid no tax at all until after receiving his proceeds from the sale of the shares. The EMI tax treatment has therefore been very beneficial.