Enterprise Management Incentives

www.pettfranklin.com

David PettPartner

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What is a share option?

A right to buy existing/subscribe for new shares in future at a price fixed at time of grant, and normally subject to conditions such as:

◦ continuing employment◦ attainment of performance targets◦ sale of the company/business

The gain on exercise of an employee share option (ie mv of shares acquired, less price paid) is charged to income tax (and, if RCAs, NICs) – whether or not shares can then be sold

Can transfer burden of employer’s NICs (13.8%) on gain on exercise to employee , so effective rate of tax/NICs for higher-rate taxpayer in 2012/13 is likely to be 58.9%

The basic rules: employee share options

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If the shares are “readily convertible assets” (ie are, or willbecome, tradeable or the company is not independent):

income tax charges due under PAYE

National Insurance contributions payable

◦ employees’ 2% (above UEL)◦ employer’s 13.8%

The basic rules – PAYE/NICs

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Employer company can, if independent, claim relief from Corporation Tax for amount of employee share option gain (subject to conditions)

The basic rules: relief from corporation tax

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CGT on sale of shares

But, IT may be charged if:◦ shares are “restricted” and employee has not paid the full

“unrestricted” value on acquisition◦ shares are sold for > MV

Entrepreneurs’ Relief (10% rate of CGT) if interest of ≥ 5% held for 12 months

Base cost = price paid + IT charged on acquisition

The basic rules: tax on sale of employee shares

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The share valuation conundrum

£‘Pro rata’ value

Market value for tax purposes

“Exit”

Time

“Leaver”

Any uplift, from a minority interest value to a pro rata value, on exit, should normally be free of income tax/NICs

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So, what can be done to avoid charges to IT/NICs on future growth in share value without the need for the employee to invest in shares for full unrestricted market value at the outset?

◦ Enterprise Management Incentives

◦ Company Share Option Plans

◦ Share Incentive Plans

◦ Joint Share Ownership Plans

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Finance Act 2000: First example of legislation produced by an “independent” government-appointed advisory group

Aimed at small, independent, high-growth companies

No prior HMRC-approval required, but option grants must be notified to HMRC Small Company Enterprise Centre within 92 days

Share options, but with commercial flexibility as to the exercise price and when it can be exercised (but must be, if at all, within 10 years and within 1 year after death)

Enterprise Management Incentives

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Can set exercise price at below MV (even nil!)

Remember need to pay up nominal value of newly-issued shares

If exercise price < MV, the discount is charged to IT at time of exercise

EMI share options - tax

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No IT/NICs, on exercise of the option, on growth in market value from grant to exercise

If a “disqualifying event” (eg takeover or leaving), relief for accrued gain not lost, and no loss of relief ,if option is exercised within 40 days

Note: if “restricted” shares acquired on exercise of EMI option with exercise price = IAMV, then (IUMV – IAMV) falls out of charge

Purpose test: must be for “commercial reasons ….. not …. avoidance of tax”

EMI share options - tax

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MVMV

Grant Exercise

Option gain exempt from income tax

Ex. price

£

Time

Grant Exercise

£

Ex.price

Exempt gain

Taxable gain

Time

A “Market value” option: no disqualifying event B “Discounted option” : no disqualifying event

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Taxable gain

Exempt gain

Time

Grant Disq. ExerciseEvent

Grant Disq. ExerciseEvent

Ex. price

MVMV

Taxable gain

Taxable gain

Exempt gain

C “Market rate” option: disqualifying event occurs more than 40 days before exercise

D “Nil-cost” option: disqualifying event occurs more than 40 days before exercise

£ £

Time

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CGT payable on sale of shares

Budget 2012: Entrepreneurs’ Relief (ie reduced 10% rate) available if EMI option shares held by employee for one year (and all other conditions for ER satisfied except the need to hold 5%)

◦ not available if EMI option is “exit only”

◦ lobbying for change

EMI share options - tax

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Company/group must have < 250 fte employees

EMI company/group must have gross assets of < £30m

◦ sum of gross assets of each group company

EMI company must be independent

Must be no arrangements for loss of independence

Must not carry on a disqualifying activity

One group company must have a ‘permanent establishment’ in the UK

EMI options: qualifying companies

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All subsidiaries under the ‘control’ of the EMI company must be 51% subsidiaries (and no other person may have control of it)

Any “property managing subsidiary” must be 90% owned No arrangements must exist which would cause the

independence or subsidiaries tests to be failed Beware: pre-emption rights or investment/funding

agreements under which control could be acquired (eg upon conversion of debt securities if bank covenants not met etc) in a “meltdown” situation

Which companies qualify?

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The activities of the company/group must not consist as to a substantial part (20%) of excluded activities:◦ dealings in land, commodities, securities (etc)◦ dealings in goods otherwise than as wholesaler/retailer◦ banking, insurance, money-lending, debt factoring, financial activities (etc)◦ leasing or receipt of royalties (subject to exemption for exploitation of self-

developed intellectual property)◦ legal or accounting◦ property development◦ farming (etc)◦ forestry (etc)◦ shipbuilding or coal and steel producing◦ operating hotels (etc)◦ managing nursing homes (etc)◦ acting as a service company

Trading activities requirement

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Must be employee of the EMI company or a qualifying subsidiary

Be committed to 25 hours p.w. or 75% of working time

Not have (or be deemed to have) a “material interest”◦ 30 per cent◦ applied at grant, not exercise◦ no “look-back” 12 months◦ interests of “associates” count, but sibling is not an associate◦ EMI option shares left out of account◦ other option shares counted but, if subscription options, ordinary share capital is

grossed up◦ beware existence of EBTs – trust shares disregarded if certain conditions met

Eligible employees

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Overall limit of £3m on aggregate IUMV (at grant) of shares under all EMI options

Individual limit of (now) £120K on IUMV (at grant) of shares under EMI (and CSOP) options to any eligible employee

◦ to be increased to £250,000 “ASAP”

Beware re-grants: the ‘3-year rule’: never grant right up to limit of £[120K]

Enterprise Management Incentives - limits

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Growth over option period may qualify for CT relief (cf EIS relief)

If shares “restricted”, then any difference between IAMV and IUMV falls out of charge to tax

If employee leaves then, unless he is allowed to keep it/exercise it, it merely lapses

Shareholder dilution occurs only at time of exercise

No concern over minority shareholding interests

Why grant/exercise of EMI option rather than invite employee simply to subscribe for shares at market value?

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Must be a written option contract granting an enforceable, albeit conditional, right to acquire shares in a “qualifying company”

either: “long-form” bi-lateral contract

or: rules + “short-form” certificate and agreement to be

bound by rules Grantor can be company or shareholder or EBT (Note:

employer may get CT relief whoever grants/provides the shares)

EMIs: requirements re the option contract

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HMRC form of notification of grant

◦ includes declaration of eligibility by employee

HMRC annual return on Form 40

Notification/reporting to HMRC

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Warning: Remember the 92-day time limit for reporting grant of an EMI option on Form EMI1

Note also the address to which Form EMI1 should now be sent (as from April 2012):

Small Company Enterprise CentreHM Revenue & CustomsFirst FloorFitzroy HouseCastle Meadow RoadNottinghamNG2 1BD

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“Exit only”◦ exercisable only upon a sale or change of control (or flotation?)◦ if employee leaves for any reason, option either lapses or he may retain

whole or part but exercise only if Exit occurs within, say, 5 years

No access to reduced 10% ER rate of CGT on sale

“Vesting schedule”◦ right to exercise accrues over time

“Performance-linked”◦ option lapses insofar as performance targets not met

Types of EMI (and other) private company share options

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If option is capable of being exercised before an Exit, then articles of association should be checked to ensure proper provision for:

◦ protecting against disposal to a third party◦ compulsory offer for sale back for value (good leaver) or nominal value (bad

leaver)◦ permitted transfers to/from an employees’ trust◦ drag along/tag along

Beware company law problems if articles changed after option granted

Articles of association

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Usual rules of ss1014 – 1024 CTA 2009 apply:

benefit curtailed if option exercised unnecessarily early

no express statutory CT relief for costs of establishing EMI option plan – but relief not excluded by s1038 CTA 2009 (and see Final Regulatory Impact Assessment issued by Inland Revenue in 2000)

ensure set-up costs borne by employer company?

CT relief

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The treatment of share scheme accounting issuesapplicable to SMEs will be covered by William Franklin ofPett, Franklin & Co. LLP later in this conference

Accounting treatment

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William Franklin

william.franklin@pettfranklin.com

Office: 0121 348 7878Mobile: 07889 726 767Twitter: www.twitter.com/pettfranklin

David Pett

david.pett@pettfranklin.com

Office: 0121 348 7878 Mobile: 07836 657 658

Twitter: www.twitter.com/pettfranklin

www.pettfranklin.com

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