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Markel Tax

05 Nov 2019

A Guide to Enterprise Management Incentives (‘EMI’) Schemes

For several decades, the Government have recognised the value of employee sharing ownership, and hence they have attempted to encourage companies to reward employees with share incentives. Research has shown that sharing ownership can have a positive effect on productivity, performance, employee retention and morale and, indirectly, the value of the company. With this in mind, the Government have introduced several statutory share schemes that benefit from preferential tax treatment in order to encourage companies to provide equity incentives.
The Enterprise Management Incentives (‘EMI’) scheme is arguably the most successful and attractive of the existing statutory schemes. First introduced in 2000, EMI has proven to be popular with start-up and SME companies. However, setting up a scheme correctly can be a minefield and expert advice should always be sought. This guide is intended to explore the benefits of the scheme, the main criteria that need to be met and the considerations that a company and its owners need to think about before implementation.

Tax Treatment

As EMI is a statutory scheme, designed by the government, the tax treatment is significantly more favourable than an unapproved scheme for both the recipients and the grantors.

Recipients

The basic principles of the tax treatment of the exercise and sale of shares attained via an exercise of an EMI option is illustrated below:

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No tax charges arise when the options are granted, regardless of the terms of the option.

On Exercise

Assuming that the exercise price stated in the option agreement is greater than or equal to the UMV of the shares at the date of grant, there is no tax liability on exercise.
If the exercise price is less than the UMV of the shares at the date of grant, the difference will be subject to Income Tax and potentially, National Insurance.

On Disposal

Any further uplift in value following exercise will be subject to Capital Gains Tax (‘CGT’) treatment. Additionally, as long as more than two years have passed since the date of grant at disposal, the employee should qualify for Entrepreneurs’ Relief (‘ER’), effectively reducing the CGT rate from 20% to 10%. 

Granting Company

When an EMI option is exercised, the company is entitled to claim corporation tax relief on the difference between the exercise price and the market value at the date of exercise.

Qualifying Companies

Both quoted and unquoted companies can utilise an EMI scheme provided that they meet the ‘Qualifying Company’ conditions (although it is more common for an unquoted company to operate an EMI scheme). A company looking to grant EMI options must satisfy five tests, which are explained below:

Independence Test

To qualifying for EMI, a company must not be a 51% subsidiary of another company, meaning that less than 50% of its ordinary share capital must not be either owned or controlled by another company, or by another company and persons connected with that company. Additionally, arrangements must not exist which could result in the company becoming a 51% subsidiary or otherwise being controlled (an example of this might be another company having the option to purchase the entire share capital of the company).
Control in this context means the power to ensure that the affairs of another company whose shares are subject to EMI option are conducted in accordance with that company’s wishes. This may be through share ownership, voting power, or because of any powers conferred by Articles of Association or other document.

Qualifying Subsidiaries Test

A company that owns subsidiaries does not qualify for EMI unless each subsidiary is a qualifying subsidiary. For the purpose of this test, a subsidiary is a company which the company controls, either on its own or together with any person connected with it, including dormant companies.
A subsidiary is only a qualifying subsidiary if the company whose shares are subject to EMI options holds, directly or indirectly, more than 50% of the share capital of the subsidiary.
No other person must be able to control the subsidiary, with control having the same meaning as it had for the independence requirement. Similarly, there must be no arrangements in existence by virtue of which any person could obtain control of it. There are further tests regarding subsidiaries that engage in property management.

Gross Assets Test

The value of the company’s gross assets must not exceed £30 million at the date the EMI option is granted. If the company is a member of a group of companies, the limits are applied to the gross assets of the group as a whole by combining the gross assets stated in each of the constituent companies’ balance sheets and excluding any intra-group items (such as book value holdings of subsidiary shares and intercompany loans).

Number of Employees Test

A qualifying company must have fewer than 250 full-time equivalent employees at the date on which a qualifying EMI option is granted. This requirement applies to employees of the company and all its qualifying subsidiaries, regardless of whether the employees are based in the UK. A full-time employee is someone whose standard working week (excluding lunch breaks and overtime) is at least 35 hours. Any employee who worked longer than those hours would still only count as one full-time employee.
Where there are part-time employees their full-time equivalence can be calculated on a pro-rata basis, for example, someone working 21 hours a week would be expected to count as 60% of a full-time employee.
Students on vocational training, and employees on maternity or paternity leave at the time an option is granted are not counted as part of the test. Apprentices are also excluded from the definition of employees for this test, if in accordance with general legislation on employment law they are not regarded as employees.

Qualifying Trade Test

For a company to be a qualifying company for EMI purposes, the company or a qualifying subsidiary must have a permanent establishment in the UK, which is defined as either having:
  • it has a fixed place of business there through which the company’s business is wholly or partly carried on; or
  • an agent acting on behalf of the company has and habitually exercises their authority to enter into contracts on behalf of the company.
A company must also carry on a qualifying trade on a commercial, profit making basis, which does not, to any substantial extent, include certain excluded trading activities. As a matter of practice, HMRC define a “substantial extent” as being 20% of company’s or group’s activity. There is no fixed method in calculating the extent of an activity, but either a method looking at the number of employees engaged in the excluded activity or the level of turnover created by the excluded activity.
Generally, the ‘excluded activities’ are trades that do not carry significant risk to capital, including (but not limited to) legal and accountancy services, property development and farming. The excluded activities are detailed further in HMRC’s guidance

Eligible Employees

In addition to the tests that the granting company are required to meet, the employees must meet certain tests to be eligible to receive EMI options.

Employment Requirement

Intuitively, an individual must be an employee of the granting company or a qualifying subsidiary to be eligible for a grant of EMI options. Directors are included for the purposes of this test.

Working Time Requirement

To be an eligible employee for EMI purposes, the grantee is required to spend:
  • at least 25 hours each week on average; or
  • if less, 75% of their working time on average,
working as an employee for the company whose shares are subject to the EMI option or for a qualifying subsidiary.

No Material Interest Requirement

An individual will not be an eligible employee if they and/or their associates hold a material interest in the company, which is defined as either:
  • having a beneficial ownership of, or the ability to control directly or indirectly, more than 30% of the ordinary share capital of the company; or
  • where the company is a close company, possession of or entitlement to acquire rights that would give 30% of the assets, if the company were to be wound up, and make them available for distribution among the participators.
Broadly, an associate is a relative or partner of the employee or a trustee of a settlement holding shares in which the employee has a beneficial interest.

Share Requirements

Qualifying EMI option can only be granted over shares that are: It should also be noted that it must be possible for the options to be exercised within ten years of the date of grant.

Share Valuation

Unlike with non-statutory schemes, the Unrestricted and Actual Market Values (‘UMV’ and ‘AMV’) of the shares to be placed under option can be agreed in advance with HMRC. This means that the granting company and the recipients can be confident of the value of the shares under option, which will determine the tax liabilities on exercise of the option and eventual disposal. It should be noted that the legislation does not require the UMV and AMV to be agreed with HMRC prior to the date of grant, but it is highly recommended.

Frequently Asked Questions

Are there any limits to the quantity of options that a company grant?

The total UMV of unexercised EMI options granted by the company cannot exceed £3 million at any time.

Are there any limits to the quantity of options that a recipient can be granted?

An employee may be granted qualifying options over shares with a total value of £250,000.
The shares under option include all EMI options granted by the employing company and any companies that are members of the same group of companies. The value of the shares under option for this purpose is the value of the shares at the time the option was granted.

Can EMI options be granted over growth shares?

Yes, and this is becoming a more frequently used method, as growth shares are usually set with a ‘threshold amount’ (the value of an exit that must be exceed before the growth shares will participate in a distribution) greater than the current value of the company. This should result in a low or nominal initial value, while also securing ER without meeting the normal tests (except for the two-year holding period).  

What happens if a company has granted EMI options ceases to meet all the ‘Qualifying Company’ tests or an EMI option-holder ceases to meet the ‘Eligible Employee’ criteria?

This would be considered to be a ‘disqualifying event’, and the employees have 90 days from the date of the event to exercise any options they have obtained as part of the EMI scheme to retain the EMI tax treatment. What happens if the options remain unexercised after ninety days is dependent on the drafting of the scheme rules, but usually the options will either lapse or continue to exist as unapproved options.

Can the exercise price be higher than the UMV?

Yes, the exercise price can be anything equal to or greater than the nominal value of the shares under option.

Can a company set targets that must be met prior to the option being exercisable?

Yes, the company can draft a clause that requires certain amount of time to pass, targets to be met before the options can be exercised or a combination of the two. It is also to prudent to draft he rules with an overriding board discretion in the event that the targets not be met but the directors wish to allow some or all the options to be exercised anyway.  

What reporting obligations does the company have following the grant of EMI options?

When a company grants EMI options, it must notify HMRC using the online ERS service via the company’s government gateway account within 92 days of the date of grant.
Companies are also required to submit an annual return for each year beginning with the tax year when the first qualifying option is granted and ending with the tax year in which there are no longer any unexercised options outstanding. A company must therefore make a return (a ‘nil return’) for a tax year even if no EMI options were granted or exercised in the year.

We are unsure whether a company qualifies for EMI. Can we request assurance from HMRC?

Yes, a company can approach HMRC for advance assurance that they are a qualifying company, and they will state on the basis of the information supplied, whether they agree or not that the company will be a qualifying company once the options are granted.

Is it worth the effort in comparison to giving an exit based bonus?

Setting up EMI scheme does incur some time and effort as well as requiring a company’s leadership team to decide the terms of the scheme upfront. However, to give £1.00 worth of benefit to an employee will cost the granting company £0.92, which is far more efficient than granting an exit-based bonus, which would cost £1.78 to deliver £1.00 worth of benefit to the employee. See below for the calculation.

Assumptions

  • Nil-cost options
  • AMV at grant was £1,000
  • Additional rate taxpayer
  • Ignores CGT losses and annual exemption
  • Disposal at least two years following grant
    Cash Bonus EMI Option
       
Gross value received by the employee A            500,000            500,000
Taxable employment income on exit B            500,000                 1,000
Income tax and Employee NI (B x (45% + 2%)) C            235,000                    470
Value subject to CGT (A - B) D                        -              499,000
CGT at Entrepreneurs' Relief rate (D x 10%) E                        -                49,900
Total tax payable by employee (C + E) F            235,000              50,370
Net value to employee (A - F) G            265,000            449,630
Employer NIC (B x 13.8%) H              69,000                    138
Employer CT Relief ((A + H) x 17%) I              96,730*              85,023
Total cost to employer (A + H - I) J            472,270            415,115
Cost to the employer of providing £1 of benefit (J/G) K                   1.78                   0.92
*HMRC have been known to argue that exit bonuses are not CT deductible

It should be noted that this guide does not provide any professional advice and is based upon our understanding of UK law and HMRC practices as at the date of writing. Any advice provided within this guide is subject to the provision of legislation as at the date the advice is provided and will not be amended for subsequent changes in the law.

We can help with the design and implementation of an EMI scheme, including the preparation of legal documentation, agreeing a share valuation with HMRC and the process to granting the options. For further information on this matter please contact Thomas Dalby, James Lindon or Liam Hawkins on 0845 4900 509 or email us on taxdeskuk@markel.com.





 
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