This is a guest post by Philippa Sturt, Managing Partner at Joelson. Having become a partner at Joelson in 2012, Philippa specialises in advising on all types of corporate and commercial transactional matters and, in particular, Philippa regularly helps founders/entrepreneurs and their companies with investments and fundraisings as well as shareholder arrangements.
All businesses will wish to look after their employees and provide incentives to keep them motivated and invested in the company so that they continue to perform and support the business’s growth. A common solution is to issue bonus payments to the employee, but the problem is that cash payments are subject to income tax and national insurance contributions for the employee and the money will also eat into the profits of the company. For smaller businesses that need to reinvest their profits to continue to grow, this may not be feasible and is undoubtedly expensive in both the short and long term.
An alternative to a cash bonus is to issue options over shares in the company, where employees are given the ‘option’ to buy a number of shares in the company at a certain, usually at a significantly discounted price. There are several option schemes that can be of benefit to companies. Specifically, the most beneficial for smaller and medium-sized enterprises are Enterprise Management Incentives (EMI) options.
What are EMI Options?
These are share option schemes that provide income tax benefits for the employee and potential corporation tax benefits for the company. The idea is that these options are utilised to recruit or retain employees so that the business does not lose the talent that is helping the company grow.
What Criteria Must be Met by the Company to Issue EMI Options?
- The company needs to be independent; this means it cannot be under the control of another company.
- Any subsidiary of the company must be a qualifying subsidiary; this means that any subsidiary must be at least 51% owned by the company and there cannot be any other arrangement in place whereby this control is diminished.
- The gross assets of the company must be less than £30 million at the time that the EMI options are granted. Where the company has subsidiaries, this test is applied across the group.
- The company must have fewer than 250 full-time employees at the date of issue. HMRC interprets a full-time employee as someone who works 35 hours or more a week, so someone working 17.5 hours a week would be considered 50% of a full-time employee. For these purposes, non-executive directors count as employees.
- The company must undertake a qualifying trade. A qualifying trade is one which is undertaken on a commercial basis with a view to making profits, and does not, to a substantial extent (being 20% or more of turnover) consist of certain excluded activities (such as property investment, shipbuilding, legal services, amongst others).
- The company must have a permanent UK establishment. If the company itself does not have a UK establishment, then so long as the company is the parent company, any member of its group must have a UK establishment.
- The company cannot grant options over more than £3M worth of shares.
What Criteria Must be Met by the Employee to Obtain EMI Options?
- The employee must meet the working time requirements. This generally means that they work on average at least 25 hours a week for the company (or a qualifying subsidiary). However, where the employee works less than 25 hours a week for a company, they can still qualify if they spend 75% of their working time working for that company.
- The employee must not have a material interest in the company. This means that they cannot own or control more than 30% of the shares in the company, or be entitled to more than 30% of the assets upon liquidation.
- The employee cannot be a non-executive director. This is expressly prohibited by the legislation.
- The employee cannot hold options over more than £250K worth of shares. This includes any options that have been exercised or lapsed.
What Criteria Apply to the Shares or Options?
- The shares over which the option is granted must be fully paid-up ordinary shares. This means that the subscription price is paid before the shares are issued.
- The shares cannot be redeemable shares. These are shares which can be purchased back from the shareholder by the company, either by the company or by the shareholder.
- The option must be a right to acquire shares. This means that the agreement cannot be to purchase the shares, but simply a right to purchase the shares in the future.
- The option must be contained in a written agreement. This would be an option agreement between the company and the employee, and must state:
- The grant date.
- The number or maximum of shares available under the option.
- The exercise price or the method by which it is determined.
- When and how the option may be exercised.
- HMRC must be notified of the grant of the option within 92 days of grant.
It is worth noting that whilst this leaves a certain amount of scope in terms of how the shares are paid for eventually, some options lead to a loss of the tax benefits. Other criteria about the options and the shares over which the options are held may also apply, but this will depend on the facts of each case and companies should be wary of losing any tax benefits that EMI options can generate.
What are the Tax Benefits?
So long as all the criteria are met, it may be possible for the company to receive a corporation tax deduction when the share options are exercised, in an equal proportion to the capital gain made by the employees.
Further, so long as the exercise price for the shares is equal to or greater than the monetary value, there will be no income tax liability on either the grant of the option or its exercise. Moreover, there is no tax payable on the exercise price itself. If correctly implemented, the employee will only pay capital gains tax on any gain made above the monetary value at the point of sale of the shares. If the employee is entitled to claim an entrepreneur’s relief (“ER”) on the shares, then they will only pay 10% capital gains tax on the gain itself. Another benefit for the employee of obtaining an EMI option is that many of the ER criteria do not apply to the shares (such as holding 5% of the shares in the company) and with the options, the employee doesn’t actually have to purchase the shares for the two-year timeline (being the minimum amount of time that options or shares need to be held prior to sale to qualify) to start ticking; they simply have to have obtained the option over two years ago. Contrast this with shares where they must actually purchase and own the shares for this timeframe. This means that they can legally own the shares for a matter of hours and still benefit from ER if the shares were purchased through an EMI option scheme.
How to Proceed
Whilst giving employees EMI options are a great thing to do to incentivise them and to provide tax benefits to help the business grow, it is very important to make sure that all the criteria surrounding EMI options are complied with so that the benefits materialise. How you would like the option structured can have far-ranging consequences. As such, it is important to discuss matters with lawyers who specialise in EMI options to make sure that all the correct documentation is in place and that it complies with the law. Whilst it isn’t a requirement to obtain prior approval from HMRC, lawyers can help to make sure that the scheme is watertight so that any prior approval is likely to succeed so that you do not inadvertently lose the benefits of an EMI option scheme because a small but really important detail was missed!