How to manage both EMI and unapproved share options on a company sale/exit
When your company goes under the due diligence spotlight, an aspect that will be under intense scrutiny will be any form of share options/awards scheme. It is imperative that your company has met the HMRC standards in relation to these schemes, so as not to delay or adversely impact the sale of the company. This is because if a problem has been found then the time taken to correct the error with HMRC will likely be greater than the time span of the sale and with the added detriment that there is unlikely to be a tax-efficient solution and you can find that your buyer wants to escrow sale proceeds or obtain specific indemnities to protect against any uncertain tax costs for the company.
This article summarises some of the key aspects relating to Enterprise Management Incentive (EMI) option schemes that the sellers ought to address as early as possible to avoid problems in a future sale of the company.
1. Share valuations
The first thing that the buyer would like to see during the due diligence process is that the share value has been agreed with HMRC. As part of this process they will need to see all the information that was submitted to HMRC to agree the valuation.
If no valuation was agreed (or if the information submitted was incomplete or misleading), then the value at the date of the grant will need to be determined in retrospect. In this situation, the buyer may be concerned if a very low value has been set for the shares under option. This is because there is the possibility that HMRC would have set a higher value for those shares if they had had all of the information at the relevant time. The most common occasion upon which this issue can arise is if the values are being determined at a time when there is a potential sale of the company.
Although it is not compulsory to agree on the share value with HMRC when an EMI option is granted, we recommend this is still done and that in doing so all details (including any possible sales, fundraisings and transfers between shareholders) are disclosed to HMRC.
2. Notifications made to HMRC
A company will need to notify HMRC within 92 days of granting an option. Additionally, if there are any changes to the nature of the option granted, for example if the employee departs or the company is the option is bought out, then HMRC will also need to be notified. A failure to adhere to the HMRC deadlines will mean the related options will not qualify as EMI options, and so will become non-tax advantaged (or unapproved share options).
If you fail to meet the deadline it may be possible to argue that a “reasonable excuse” exists, but these types of situations are very limited in application.
Be aware that the initial filings made to HMRC on establishing an EMI scheme are part of a two-stage process; the first is to receive the unique scheme reference number and the second is to make the actual notification.
If you made the notification within the deadline, but an error has been made on the form, the buyer will usually want confirmation from HMRC that the options are qualifying despite the clerical error, which again will add time, costs and complexity to deal with.
Further to this, a company with an existing EMI scheme must file an annual return to HMRC detailing specific information about the EMI options. Failure to make the annual filings may impose to pay a fine and remedy the situation, so therefore it is recommended that this is not left to a time when it may hold up the sale of the company.
3. Record keeping and accuracy of information
Companies need to keep a record of what has been granted to who and safely store the signed documents so that when the buyer is requesting this information during the due diligence process, the information is easily accessible.
Please note that this information cannot be obtained from HMRC and so it is vital for the company to keep correct and complete records. The risk inherent in failing to do so is that the buyer may treat the options as having not been correctly granted and therefore not qualifying for EMI tax advantages (such that if the shares are issued they are taxed as unapproved options – which may have a painful tax outcome, with the option holder being taxed under PAYE and NIC as though they had simply received a bonus).
Another aspect that sellers should pay attention too is the accuracy of the information contained in the contracts. You should make sure that the EMI options are granted over the right number and the right class of shares, and that any provisions around when the option can be exercised, vesting and performance targets are carefully drafted to reflect the commercial intention. A clerical error such as attributing the share to the wrong class or in the wrong amount could result in the EMI option becoming unapproved.
4. Monitoring EMI qualifying conditions to avoid disqualifying events
It is vitally important that all EMI qualifying conditions are checked at grant and monitored throughout the life of the option to ensure that no disqualifying events occurred which would render a once qualified EMI option as a non-qualified option. These events include, inter alia:
a) a change in the status of an employee, for example, they become an independent contractor.
b) a change that contravenes the working time regulations i.e. they work for the company for less than 25 hours per week (or if less, 75% of their working time).
c) a change in the company’s trade to a non-qualifying area, such as financial activities, leasing, legal, farming and property development.
Common pitfalls in this category include companies with no subsidiaries which carry on any investment activities – these will not qualify unless the investment activities are incidental. The test here is different and much harsher than the ‘substantial 20% threshold’ which applies to EMI companies with subsidiaries.
For example, any letting of property or holding of shares not amounting to a subsidiary will be a disqualifying event in a single company whereas it would typically only be a problem if it amounted to more than 20% of the group’s activities where there is a group of companies.
d) if the company is licensing IP, where the value in the IP has not been created by the EMI company.
e) if 50% of the company’s share capital has been bought then by virtue the company is no longer an independent entity and will not qualify for an EMI grant.
This is a very wide test (very similar to the EIS test) and will take into account the aggregate interests of any persons connected with the potentially controlling company, including the “arrangements” by virtue of which the company could (as opposed to “will”) come under the control of another company.
It is recommended to grant options as far as possible in advance of a sale and before a particular buyer has been identified as HMRC takes a strict approach to the interpretation of the ‘50% test’. For example, HMRC suggested that a unilateral reorganisation in anticipation of a company sale may be sufficient to qualify as ‘arrangements’ for this purpose. As result, it is very important to check the compliance with the ‘50% test’ and seek advice to understand what the risks when a company exit is in prospect at the time the options are granted as the buyer will look very closely at this during the due diligence process.
5. Tax aspects
The underlying assumption of EMI options, that they have been structured in accordance with EMI rules, will also be stringently reviewed. A failure to structure them in line with the relevant legislation could result in them becoming unapproved and if the sale proceeds, income tax will be due via PAYE along with employer and employee NICs.
A potential buyer will often seek tax warranties or indemnities in relation to the prospective company, thus it is in the seller’s interest to ensure that the correct income tax and NICs have been paid to HMRC. This is prevalent if the company has unwittingly allowed the EMI options to become non-qualifying so the options lose their tax advantage status and incur tax and/or NICs liability. If the sale proceeds on the premise that the options are EMI when in fact they are unapproved, the seller could be in breach of a warranty or an indemnity.
Another potential issue that can arise is when an employee leaves but keeps their options and exercises on exit. In this situation, the income tax and NICs due on exercise will be paid on any increase in the market value of the shares from the date that employment ceased. As precaution companies should carry out valuations when employees leave and keep their options, otherwise, the company runs the risk of their being no record of the value of the shares upon the ceasing of employment. As mentioned above, in order to avoid the EMI option becoming unapproved, it is good practice to monitor each EMI option throughout its lifespan.
How can we help?
If you would like advice and assistance on the legal and tax issues relating to share options and share schemes so that such incentives are optimised and issued correctly please do get in touch and we will provide you with an attractive quote.