Alternative Equity Incentive Schemes to EMI Share Options

Introduction

While the Enterprise Management Incentive (EMI) share option scheme undeniably offers the most attractive tax efficiency, EMI options may not always be possible or the most suitable form of equity incentive schemes. This is often because the qualification criteria for EMI are not met, for example those to be incentivised are not employees.

Alternatives to EMI Schemes

A number of alternatives other than an EMI scheme may be worth considering when exploring the most suitable form for remunerating, retaining and incentivising employees and business contributors by way of equity rewards. Some popular alternatives are unapproved options, Company Share Option Plans, Nil paid shares and growth shares.

Unapproved Options

Characteristic and tax treatment

Unapproved option schemes (i.e. schemes that are not obliged to follow the rules and regulations set by HMRC for EMI and CSOP option schemes) can be highly customised in terms of scheme limit, eligibility criteria, exercise price and vesting conditions, with the following tax implications:

(i) the recipient is typically subject to income tax on the difference between the exercise price and the market value of the shares at the time of exercise, although despite this the company can claim a statutory corporation tax deduction on exercise equal to the difference between the market value of the shares at that time less any amount paid by the employee for the shares;

(ii) both the company and the recipient may be liable to pay national insurance contributions (NIC) on the value of the shares acquired upon exercise of the options; and

(iii) the recipient may be liable to pay Capital Gains Tax (CGT) on disposal on any increase in value from the time of exercise to the time of sale.

Pros and cons

Given the considerable flexibility and discretion in designing the scheme, unapproved options could benefit a broader range of individuals including those who might not qualify for EMI options (e.g. non-employees like advisors, consultants and contractors) with no limit to the overall value or number of recipients, but the flip side is the lack of tax advantages for the option holder.

How can it be used?

Unapproved options are most suitable for small-scale and personalised incentives as there is no requirement for all employees to be granted options and the scheme itself can be set up on a highly selective basis for certain individuals only that each of whom may be subject to different criteria and milestones (e.g. ‘exit-based’ options to incentivise employees to work towards a profitable exit).

Company Share Option Plans (CSOPs)

Characteristic and tax treatment

CSOPs are similar to EMI share option schemes, but not quite as tax efficient. Like EMI, a key benefit is the ability to agree on a valuation with HMRC before granting the options.

CSOPs offer discretionary share options to employees and full-time directors with favourable tax treatment provided certain conditions are met, including:

(i) the company must be either listed on a recognised stock exchange or must be independent and not controlled by another company (other than the corporate trustee of an employee ownership trust);

(ii) the underlying shares must be ordinary shares, non-redeemable and fully paid-up;

(iii) options may only be granted to employees and full-time directors (though no limit to the number of recipients);

(iv) options must be exercised at a price not less than their market value on the grant date (which needed to be agreed with HMRC at the outset);

(v) any individual can only be granted options up to £60,000 (calculated using the said market value on the grant date); and

(vi) options must generally not be exercisable before the third anniversary of grant (except for defined ‘good leaver’ circumstances (i.e. injury, disability, redundancy, retirement or a TUPE transfer) which must be within six months, or within 12 months in the event of death of the option holder).

For the company, it may generally be qualified for a statutory corporation tax deduction equivalent to the amount of gains realised by the recipients on exercising their options, which will be given in the accounting year in which such options are exercised.

For the recipients, the key tax implications are as follows:

(i) there is normally no income tax and NIC liability on the grant of the option if the exercise price is not less than the actual market value on the date of grant;

(ii) there is normally no income tax and NIC liability on exercising options if the date of exercise is at least three years (and no more than ten years) after the date of grant; and

(iii) on a sale of the option shares, CGT may be payable on any gain over the amount paid for the shares (or any gain over the value of the shares at the date of exercise where an income tax charge on exercise applies), but annual exemption and/or other reliefs (e.g. business asset disposal relief) may be available.

If income tax is payable, the recipients will be charged on the difference between the market value of the shares acquired and the option price paid for them. Any such amount will be withheld by the company under PAYE and Class 1 employee and employer NICs will also be due if the shares are readily convertible assets at the time of exercise.

Pros and cons

CSOPs, similar to other option schemes, provide flexibility in the setting up and operation, such as selecting participants and offering different terms to different individuals, as well as imposing performance targets for any grant. Compared to unapproved option schemes, financially CSOPs are highly favourable for employees as there is no upfront cost until exercise and no tax liability will arise when the options are exercised if certain conditions can be satisfied.

Nevertheless, employees can only hold up to £60,000 in options and the company’s value has to be agreed upon at the time of grant. In addition, individuals with a material interest in the company (broadly speaking, over 30% equity interest) are not eligible to receive share options under CSOPs.

How can it be used?

CSOPs are most suitable for smaller companies, particularly for rewarding and retaining part-time employees who are not directors and would not meet the full-time working requirements of an EMI scheme. It can also be used for a multinational company looking to mirror, with suitable adaptation, their parent’s international share plans for their UK employees as there is no requirement that the company must trade in the UK.

Nil paid shares

Characteristic and tax treatment

Nil paid shares (i.e. no subscription price is paid at issue at the current market value, subject to an obligation to pay up when called) provide immediate share ownership to employees with the following tax advantages:

(i) generally only CGT would be chargeable on any future growth in the value of the shares realised on sale, rather than being subject to income tax; and

(ii) normally no liability to employee’s NICs would arise on the acquisition of the shares, nor on any subsequent growth in value.

Despite no initial tax charge incurred when the shares are issued, the deferred outstanding subscription price will eventually have to be paid when called, even if that amount payable is above market value because the share price has fallen.

For nil paid shares to be issued, the company’s articles of association may need to be amended by a special resolution before any such plan can be introduced if the following aspects are not included in the provisions:

(i) allowing or otherwise at least not prohibiting the issue of nil paid shares;

(ii) covering the making, payment and enforcement of calls;

(iii) dealing with the dividend entitlements and voting rights attaching to nil paid shares (where typically these are not entitled to receive dividends and are non-voting).

No corporation tax relief will be available to the company on the growth in value of the nil paid shares.

Pros and cons

As the participants will become shareholders from the outset, they can enjoy full shareholder’s rights (including financial stake such as receiving dividends) with other existing shareholders. Their cashflow concern can also be eased as no upfront payment is required for receiving a larger number of shares that he/she would otherwise be able to afford.

Nevertheless, there is a key risk that on a liquidation, they will be called by the liquidator for the amount due to be paid up on the shares. In addition, leaver provisions are usually built in so that employees are required to forfeit his/her shares when they leave the company. For the existing shareholders, the issue of nil paid shares will immediately dilute their shareholdings.

How can it be used?

Nil paid shares may be used for private companies without imminent funding needs. The economic interests can also be aligned immediately among all shareholders so as to foster their incentive and motivation towards a profitable exit.

Growth shares

Characteristic and tax treatment

Growth shares are a type of flexible equity reward for employees and non-employees based on the future capital growth that they help to drive. These are a special class of shares created to allow holders to benefit from the value of a company over and above a pre-determined valuation ‘hurdle’, subject to rights, restrictions and conditions which may be individually set by the company.

In practice, it is common for growth shares to have a low initial or even nominal value on issue unless and until the valuation hurdle is exceeded, whereupon recipients are entitled to share in the employer’s value above the hurdle (usually on an exit-only basis such as a sale or initial public offering).

Employees are not required to pay income tax or NIC when acquiring growth shares provided that they pay the full market value, and there is also no NIC obligation on the employer company. Nevertheless, any increase in value would count as a ‘gain’ when growth shares are sold and hence the employees might have to pay CGT, the liability of which depends on their individual circumstances.

Similar to nil paid shares, no corporation tax relief will be available to the employer company on the increase in value of the growth shares.

Pros and cons

Growth shares allow employees to invest in the company upfront at a more affordable cost while existing shareholders would not be diluted in respect of the ‘built-in value’ thereof. The employer company may impose conditions to commercially and effectively mirror a market-value option arrangement (e.g. conferring no voting or dividend rights, vesting upon hitting performance targets/milestones and forfeiture of shares issued to a ‘bad-leaver’).

Having said that, the company must obtain a formal valuation (and keep accurate records) each time growth shares are awarded to set their market value, although unlike EMI the valuation cannot be pre-agreed with HMRC. Apart from the recurring business valuations (which can be expensive), there is also an inherent uncertainty that HMRC could decide the valuation was less than full market value and the employees holding the relevant growth shares might then be liable to pay more additional income tax and potentially NIC on the discount.

How can it be used?

Growth shares can be used separately, or, if structured carefully, can be operated alongside with EMI option scheme/EIS as a complement due to its flexibility to include employees who do not qualify for those schemes, without the tax liabilities arising from issuing shares. In addition, growth shares are not required to be exercised within a prescribed period of time, and so may offer another option for companies that do not envisage an exit in the foreseeable future.

Checklist when considering the EMI alternatives

Some key issues to consider before selecting the arrangement that is the best fit for your business:

• What type, value and development phase of a business do you have?
• What are your business and financial objectives for implementing an EMI alternative?
• What kind of commercial factors that you need to consider?
• Do you want all employees to participate?

How can we help?

As explained above, there are no hard and fast rules on selecting the most appropriate alternative to an EMI scheme to suit your needs. JLN possesses significant experience in advising on and putting in place different share incentive schemes and we are happy to utilise our skills and expertise to resolve common and uncommon issues that may arise during the process.

If you would like to know more about the details and implications of the various options, please get in touch via wewillhelp@jonathanlea.net to schedule a 20-minute no-cost, no-obligation call as a starting point.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited 2023.