Enterprise Management Incentive (“EMI”) schemes are widely considered the most attractive way to incentivise employees with the promise of a future equity stake in the company they work for by granting EMI options.
What is so good about EMI options?
As a quick refresher, the main benefits of options granted under an EMI scheme are:
- Options can be granted without any upfront income tax liabilities for the participants.
- The valuation of the shares under option can be agreed with HMRC before the options are granted.
- As long as the individual pays at least this agreed value on exercise of the option, there will be no income tax liability on exercise.
- Any increase in value from the exercise price will be subject to Capital Gains Tax (“CGT”) on a future sale of the shares.
- Individuals can claim Business Asset Disposal Relief (“BADR”) on this gain if they have held the options and shares for a combined period of 2 years immediately prior to the sale (depending on certain other conditions being satisfied) and pay CGT at 10% on the first £1m of lifetime gains.
- The normal BADR requirements to hold 5% of the ordinary share capital and voting rights are not required for a disposal of shares acquired via an EMI scheme.
- The company will also qualify for a corporation tax deduction when the options are exercised equal to the difference between the market value of the shares at exit and the value at the date of grant.
What are the developments?
Historically, EMI schemes have seemed relatively straightforward to navigate. Yes, there are several conditions that need to be met by the company, the employees, etc, which have meant some companies cannot implement the scheme. However, the rules have always been set out in a logical way and we, as tax advisers, have known the dos and don’ts.
Now it seems HMRC have gradually started to move the goal posts when it comes to having clarity over the validity of an EMI scheme. Below we have outlined some recent developments in HMRC’s approach to EMI schemes.
Discretionary exercise of options
There are certain actions that can trigger a deemed lapse and regrant of an EMI option, for instance, if the circumstances when the option may be exercised and shares acquired is changed. Until late last year, it was commonly understood that EMI option agreements could include the ability for the Board of the company to use their discretion to allow an early exercise of an option, for example. As long as this clause was in the option agreement from the outset, the use of this discretion would not constitute an amendment to one of the ‘fundamental terms’ of the option. The other fundamental terms are the number of shares which may be acquired on exercise and the exercise price.
However, HMRC guidance was released in late 2022, which effectively means that in many circumstances the use of this discretion could lead to a release and re-grant of the option.
Clearly, in situations where the share value has increased since the original grant, this could have significant tax implications, including an increase in the amount required to be paid on exercise to avoid income tax and a restart of the clock for BADR purposes.
Full details of the rules around the use of discretion can be found through the link below:
The general feeling is that this is a deviation from the intention of the legislation. In theory, the argument could be made that the fundamental terms of the option have not been changed as the use of discretion was already anticipated but we may need to wait until someone takes a case to Tribunal to get any further clarity.
Provision of Articles and Option Agreements
Another change in HMRC practice is in relation to the information required to be submitted with the valuation report to agree the value of the shares under option.
As well as the report, financial information and current Articles of Association, HMRC have made it clear they now expect more. Where the Articles are to be amended to include, for example, a new class of share, HMRC now expect the redrafted version to be included in the submission. There is a possibility that these amended Articles may even need to have been adopted rather than just drafted but we have not yet seen this requirement in practice.
There are also discussions within the sector discussion groups suggesting HMRC will soon also require draft option agreements to be included with the valuation.
To me (and to everyone I speak to) this seems illogical and the legal documentation should follow the agreement of the valuation. The agreement of the value of the shares by HMRC can have a significant impact on the Articles and the option agreements. If the valuation is not agreed with HMRC and a different value is argued, the adopted Articles would have to be redrafted and option agreements updated. This simply adds costs for the client and has no real purpose. Clearly, if the rights of the shares changes between agreeing the value and granting the options it is necessary to revisit the valuation. However, all HMRC value agreements already include this caveat so I see no reason for adding this extra layer of complication to the process.
More aggressive view of valuations
In terms of agreeing valuations, HMRC also seem to be taking a harder line on EMI schemes and we have seen an increase in additional questions, requests for information and internal referrals to specialist valuers.
In my view, there seems to be an internal push to challenge more EMI valuations and there is certain disregard for the fact the shares under option are, in the majority of cases, small minority shareholdings.
More often than not, these additional questions are dealt with and there is no change to the submitted value but there is a definite shift in the landscape when it comes to EMI valuations.
It is therefore important that a robust and defensible valuation report is provided in the first submission.
Challenge of structures
In addition to the above, we have similarly seen an uptick in HMRC asking about the ownership and control of the company granting the options.
Certainly, these queries would be understandable if there was any ambiguity around whether the EMI conditions have been met. However, there have been instances where it seems as though there has been a challenge for the sake of a challenge where the answer is fairly basic.
Change of HMRC stance
As with any Government-backed tax relief or beneficial scheme, it is important HMRC ensure this is not abused.
This is clear to see with beneficial tax reliefs such as SEIS and EIS. The rules are so exhaustive, and the reliefs are so difficult to retain because they are so beneficial. Similarly, R&D tax relief has come under scrutiny recently due to some people exploiting the rules.
It would appear the same is true for EMI schemes now. Widely considered one of the best incentivisation tools for employees, I would suggest a lighter touch approach should help boost the economy. Increased employee engagement leads to more successful businesses, which would raise revenues for HMRC in corporation tax, PAYE, NI, etc.
However, the change in landscape when it comes to EMI suggests more than ever that advice should be sought when implementing the scheme.
Advance assurance should be obtained from HMRC to confirm the company will be a qualifying EMI company. A robust valuation report will be necessary to ensure HMRC agreement. It is also essential that thorough discussions are had to understand the terms of the option and what you want to be possible in terms of the option so this can be written into the scheme rules and option agreements on day one.
If there is anything we can do to provide tax and valuation support on EMI schemes, please feel free to contact Alex Hall (alex.hall@claritastax.co.uk or 07399 566264).
