Companies are increasingly turning to share awards or share options to attract, incentivise and retain their key employees.

This applies to all companies, from new or struggling companies compensating for a lack of cash availability, to family-controlled businesses facing the dilemma that the present generation may be unable to provide the necessary management skills, to established companies seeking to reward staff in anticipation of a disposal of the company.

There are a number of ways to share the equity. The starting point in every case is to identify the company’s objectives and to then consider, of the choices and schemes available, which one best meets those objectives. Tax efficiency is always important but this still needs to be balanced against the company’s other commercial objectives. However, often the clear share option scheme of choice is the Enterprise Management Incentive (EMI) scheme.

EMI offers something that no other share option scheme currently does—the triple benefit of significant tax advantages, flexibility of structure and terms, and being cost-effective to set up and administer. From 6 April 2013, these benefits take a further quantum leap forward as the rules on entrepreneurs’ relief (ER) and EMI have been significantly extended.

This article:

  1. provides a summary of the key aspects and qualification requirements for EMI, for those who would like a recap;
  2. outlines the key changes to the ER rules and their impact on EMI; and
  3. uses a simple example to illustrate why every company should at least consider EMI as part of its overall package of employee incentives.

An overview of EMI

Essentially, EMI enables employers to give their employees the option of acquiring shares in the future at an exercise price set at the date of grant.

Like any other tax approved scheme, there are qualification requirements that must be met. However, EMI schemes are widely accepted as being one of the most flexible schemes available. For instance, the exercise price can be less than market value (although this will affect the tax treatment—see below), the options can be offered to selected employees and to each such employee on different terms, and there are very few limits on the types of exercise or performance conditions that can be attached.

Consequently, when structured correctly, EMI can help attract and retain employees, can assist employees to identify more closely with the future objectives of the employing group and can be an effective way of focusing management’s efforts.

Assuming no disqualifying events take place for EMI, EMI options are taxed as follows (using the tax rates for 2013/14):

  • No income tax (IT) or national insurance contributions (NICs) are payable when EMI options are granted.
  • No IT or NICs are payable when EMI options are exercised, provided the exercise price at least equals the actual market value of the shares at grant.
  • The exercise price of EMI options can be set at less than the actual market value of the shares at grant (and can be nil, if option shares are not newly issued). However, in this case IT (or PAYE and NICs if the shares are readily convertible assets) will essentially be payable on the discount at the employee’s marginal rate of IT, the top rate of IT currently being 45%.
  • When the shares are eventually sold, the employee will be liable for capital gains tax (CGT) at a flat rate of 28% or 18% (depending on whether the employee is a higher-rate taxpayer or not) or a flat rate of just 10% (if ER applies). In addition, the employee can also use any unused annual exemption to reduce the taxable gain (currently £10,900).
  • For the employer, the costs of setting up and administering an EMI scheme will be a deductible expense for corporation tax. In addition, the employer can obtain a corporation tax deduction equivalent to the gains made by employees exercising EMI options against its own profits chargeable to corporation tax. This can provide significant tax relief for the employer with no equivalent cash outlay.

In light of the commercial and tax benefits, most companies considering a share scheme will go for EMI. Fortunately, most of these companies will qualify for EMI, but some don’t. Here’s a summary of the key EMI requirements and limits:

  • The company must be independent of other companies and not under the control of another company (whether on its own or together with other persons), i.e. the shares must be in the parent company even if that is a non-UK company.
  • The company may only have qualifying subsidiaries, i.e. it must own more than 50% of the share capital of each subsidiary it controls (or 90% of subsidiaries with a business which wholly or mainly holds or manages land).
  • The company/group’s gross assets must not exceed £30 million.
  • The company must be a trading company, or the parent company of a trading group, with a qualifying trade. Excluded trades include, for example, banking or other financial activities and property development.
  • The company/group must have a UK permanent establishment, such as a place of management, a branch, an office, a factory or a workshop.
  • The company/group must have fewer than the equivalent of 250 full-time employees.
  • Participating employees (including executive directors) must be subject to UK tax and must work at least 25 hours per week or, if less, 75% of their working time for the company/group. Non-executive directors are not eligible to participate.
  • Participating employees (including executive directors) must not have a “material interest” in the company either alone or together with their associates. For this purpose, a “material interest” means beneficial ownership or control of more than 30% of the shares or entitlement to more than 30% of the assets on a winding up or other distribution.
  • An employee can only be granted EMI options over shares with an unrestricted market value at the time of grant that does not exceed £250,000. The company is also subject to a £3 million overall limit on the unexercised EMI options it may have in place, again based on the unrestricted market value at the time of grant.
  • The shares must be non-redeemable, fully paid-up ordinary shares but otherwise can be subject to special rights and restrictions.
  • In addition, the EMI options must take the form of a written agreement between the grantor and the employee, be capable of being exercised within 10 years from the grant date and prohibit the transfer of the employee”s rights under them.

The key changes to EMI and ER

Until 6 April 2013, ER reduced both the 28% and 18% CGT rates down to a flat 10% CGT rate on the first £10 million (the current lifetime limit) provided that throughout the period of one year ending on the date of disposal (i) the company was a trading company or the holding company of a trading group, (ii) the individual owned at least 5% of the company’s ordinary share capital and could exercise at least 5% of the voting rights and (iii) the individual was an officer or employee (full or part time) of the company or another company within the trading group.

These strict requirements were problematic for many EMI option holders because frequently EMI options are over shareholdings of less than 5% and/or can only be exercised immediately before a company sale or other exit event. This meant they were often liable for 28% CGT on any resulting gain, rather than the more attractive 10% CGT with ER.

However, from 6 April 2013 two major restrictions on the availability of ER have been removed specifically for EMI, meaning the typical EMI option holders described above would now qualify for ER and the 10% CGT rate:

  • the 5% requirement has been removed so an individual holding less than 5% of the shares or 5% of the voting rights can now qualify; and
  • the 12-month clock will start ticking from the date the option is granted and not the date the option is exercised, so provided the individual holds the option for at least 12 months even shares held for a moment before a sale can now qualify.

Illustrating the benefits of EMI

Taking all this together, here is an example:

You have an employee subject to 45% IT. You grant them an EMI option over 2% of the shares with an exercise price set at the actual market value at the time of grant. A year later you sell the company, enabling them to exercise their option immediately prior to sale and receive a gain (over and above the exercise price) of £100,000. The company has traded and the employee has been an employee for the previous 12 months. Using the 2013/14 tax rates:

  • There is no IT or NICs to pay by the employee or the employer.
  • The only tax to pay is CGT on the gain. Assuming the employee hasn’t used their annual exemption, the gain will be reduced by £10,900 to £89,100. In light of the new ER rules, ER will now be available. Consequently, the effective rate of CGT will be 10% on the gain of £89,100 equating to £8,910, meaning the employee will be entitled to keep the net sum of £91,090.

If instead of this you had simply paid that employee a cash bonus of £100,000, then using the 2013/14 tax rates the employee would be liable for £45,000 under PAYE and there would be employees’ and employers’ NICs to pay on the gain too. Consequently, this employee will be entitled to keep £55,000 less employees’ NICs, meaning he will be over £36,000 worse off. In addition, the employer will have to pay 13.8% employers’ NICs on the cash bonus.

Given the significant benefits of EMI and the fact that the valuable tax benefits are now even better in light of the ER changes, every company should consider adopting EMI as part of its package of employee incentives. It is important to remember that EMI may not always be available or other types of scheme may be more appropriate. Consequently, the starting point in every case is to identify the company’s objectives and to design the scheme around that.

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This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.