Share incentive schemes
Share incentive schemes such as Enterprise Management Incentives and Growth Shares could be used to reward management and senior employees with participation in the growth in equity value of the company on sale in a tax efficient way.
Enterprise Management Incentives
Enterprise Management Incentives (EMI) is a share option arrangement aimed at small growing companies.
Privately owned companies often provide ‘exit only’ EMI plans – on sale of the company, the option holder receives money equal to any increase in the market value of the option shares from the time of grant of the options to the time of the exit, with the gain being taxed as capital at a fixed rate of 10%.
The EMI has generous tax reliefs:
no income tax on grant (assuming the option was not granted at a discount);
no income tax or social security charge on exercise (assuming the option was not granted at a discount and is exercised within 10 years of grant);
capital gains tax, usually at 10%, on the sale of the option shares; and
the UK employing company will generally qualify for a corporation tax deduction in the accounting period in which the option is exercised equal to the increase in the market value of the option shares between the grant of the options and the exit.
The company must fulfill the conditions listed below to be eligible under the EMI arrangement.
There is also an overall ‘purpose test’ - the option must be granted for commercial reasons to recruit or retain an employee and not as part of a scheme or arrangement of which the main purpose, or one of the main purposes, is the avoidance of tax.
It is possible to request HM Revenue & Customs (HMRC) to give clearance as to whether a company satisfies the corporate conditions.
Qualifying trades: A trade is qualifying if:
it is conducted on a commercial basis with a view to profits; and
it does not consist wholly or substantially of the carrying out of ‘excluded activities’ (see below).
The trading activities requirements of a single company are that the company:
disregarding any incidental purposes, exists wholly for the purpose of carrying on one or more qualifying trades; and
is carrying on a qualifying trade or preparing to do so.
For a group:
the business of the group must not consist wholly or as to a substantial part of carrying out non-qualifying activities; and
at least one group company must be carrying on a qualifying trade or preparing to do so.
A trade will not qualify if one or more excluded activities together amount to a substantial part of it (HMRC says ‘substantial’ is more than 20% of the trade). Excluded trading activities are:
dealing in land, commodities or futures, or shares, securities or other financial instruments;
dealing in goods, otherwise than in the course of an ordinary trade of wholesale or retail distribution;
banking, insurance, money-lending, debt-factoring, hire purchase financing or other financial activities;
leasing (including letting ships on charter, or other assets on hire) or receiving royalties or other licence fees;
providing legal or accountancy services;
farming or market gardening;
holding, managing or occupying woodlands, any other forestry activities or timber production;operating or managing hotels or comparable establishments or managing property used as a hotel or comparable establishment;
operating or managing nursing homes or residential care homes, or managing property used as a nursing home or residential care home;
providing services or facilities for a business carried on by another person if the business consists to a substantial extent of excluded activities, and a controlling interest in the business is held by a person who also has a controlling interest in the business carried on by the company providing the services or facilities; and
shipbuilding, coal and steel production.
Two exceptions to the excluded activities are:
the receipt of royalties and licence fees, where the amounts received can be attributed to the exploitation of relevant intangible assets. A relevant intangible asset is one, the greater part of which (in terms of value) has been created by the company carrying on the trade, or by another company in its group. Intangible assets are defined in line with normal accounting practice; and
ship chartering, where the ship is owned by the company and certain other conditions are met.
Independence: The company cannot be:
a 51% subsidiary of another company; or
under the control of another company (or of another company and persons connected with the other company) without being a 51% subsidiary of that other company.
Arrangements must not exist which could result in the company becoming such a subsidiary or falling under such control.
Gross assets: The company's gross assets cannot exceed £30 million at the time of grant.
Qualifying subsidiaries: The company must have only qualifying subsidiaries. A qualifying subsidiary is a 51% subsidiary of the company and no other person (other than the company or another of its subsidiaries) has control of that subsidiary and there are no arrangements in place by virtue of which these conditions would cease to be met.
This test frequently causes difficulties in 50:50 joint ventures where the company will be treated as acting together with its JV partner to control the joint venture. In these circumstances it is often necessary to alter the share capital held by the company in the joint venture so it holds more than 50% by nominal value (whilst retaining only a 50% economic interest).
Fewer than 250 full-time equivalent employees: The company must have fewer than 250 full-time equivalent employees at the time of grant.
Permanent establishment in the UK: There is no requirement for the company to be UK incorporated or resident in the UK but it must have a permanent establishment in the UK. In group situations there must be at least one group company which meets the trading activities requirement and has a permanent establishment in the UK.
Eligible employees for EMI
Individuals are eligible if they are an employee of the company or one of its qualifying subsidiaries at the time of grant, they satisfy the commitment of working time requirement and they do not have a material interest.
The commitment of working time requirement is that the employee must work at least 25 hours per week on average for the company (or its 51% subsidiaries) or 75% of the working time if less. Periods of absence are ignored for specified reasons such as reasonable holiday, garden leave, ill health, and pregnancy and parental leave.
The material interest test broadly is that the employee if he (and his associates) beneficially owns or has the ability to control more than 30% of the ordinary share capital of the company (or more than 30% of assets on a winding up in the case of a close company). The EMI option itself does not count towards the limit. Complex rules attribute holdings of associates for the purposes of the test.
Limits to holding EMI
An individual may not hold unexercised options to acquire shares worth more than £250,000. There is also a limit of £3 million on the total value of unexercised options. Market value for the purposes of these two limits is the capital gains tax value at the time of grant ignoring restrictions.
Exercise price for EMI
Options can be granted at any exercise price including a nil exercise price. Options are usually granted at a price equal to the market value at the time of grant in order to prevent any income tax or social security charges arising on exercise. Market value for these purposes is the capital gains tax value taking account of restrictions.
EMI option grant process
HMRC will agree share valuations in advance of the grant of EMI options and it is usual practice to do so to avoid granting the option at a discount. HMRC will usually agree a valuation window of 60 days during which the option may be granted. HMRC will also agree valuations at any time up to 12 months after the 92 day period in which option grants must be notified to HMRC.
There are very few requirements in the EMI legislation relating to the option terms. The main ones are that options cannot be transferred (other than to personal representatives) and they must lapse within 12 months of death. Option shares must be fully paid up and not redeemable.
Options may be granted by agreement which must contain prescribed information such as the grantor, grant date, the maximum number of shares that may be acquired, the exercise price or how it will be determined, when and how the option may be exercised, any performance conditions and any restrictions applicable to the shares. Holders are also usually required to enter into a power of attorney so options can be exercised on their behalf on an exit.
The grant must be notified to HMRC online within 92 days of the grant date. The plan also needs to be registered with HMRC online before notifications can be accepted. HMRC has the right to raise enquiries during a period of 12 months after the end of the 92 day period in which option grants must be notified. If no queries are raised it will be taken that the EMI option qualifies for tax relief.
Disqualifying events for EMI
The EMI legislation prescribes certain ‘disqualifying events’ which have no effect if the option is exercised within 90 days of the event. If the option is exercised later, however, gains in excess of the market value of the option shares at the time of the event are subject to income tax and in some cases social security charges.
Growth Shares are a special class of shares which reward holders with the growth in value of the company above a ‘hurdle’ which is specified on issue. Growth Shares generally allow gains to be taxed as capital by holders and could be used when EMI cannot be used.
Acquisition of ordinary shares, rather than Growth Shares, are usually not attractive since that will involve up-front cash costs. In addition, if market value is not paid by the employee for the ordinary shares, an income tax charge (and possibly social security charges depending on the circumstances) on the difference between the market value of the shares and the amount will require to be paid.
The arrangement could instead be structured using Growth Shares as follows:
The articles of the company are amended to create a new class of Growth Shares of 1p each with no rights other than to participate in sale proceeds on an exit (or distributions on a winding-up) pro rata with ordinary shares but only after ordinary shares have received the specified hurdle amount per share.
The employee enters into a subscription agreement which requires them to pay 1p per Growth Share according to a vesting schedule.
The subscription agreement provides the company a right to purchase unvested Growth Shares for 1p each if they leave for any reason and a right to purchase vested Growth Shares at fair value (or 1p should the employee resign, be dismissed for cause or breach non-compete obligations post-cessation).
The employee undertakes to pay income tax on the ‘unrestricted market value’ of the Growth Shares (which is, broadly, the value of the shares for tax purposes ignoring the vesting and forfeiture conditions) within 14 days of acquisition.
The company takes professional valuation advice which values it at say £1 million with 100,000 ordinary shares in issue. In such a case, the up-front value of the Growth Shares with a hurdle of £10 could be considered as no more than par.
The employee declares the receipt of Growth Shares in his tax return and his tax inspector accepts the Growth Shares have a market value of no greater than their nominal value (1p per share) so there is no income tax to pay as a result of making the election as the employee paid market value for the shares.
Three years later the company is sold for £10 million. There are 100,000 ordinary shares in issue and 3,000 Growth Shares held by the employee. The first £1 million of sale consideration is paid to the holders of ordinary shares and the remaining £9 million is paid pro rata to holders of ordinary shares and Growth Shares. The employee receives £9 million / 103,000 = £87.38 per Growth Share or £262,136 in total. All gains are taxed as capital at the top rate of 20% so he pays capital gains tax of £52,427 ignoring annual exemptions.
Note: This example assumes HMRC will agree the unrestricted market value by deducting the hurdle from the value of ordinary shares. Some inspectors, however, take the view that Growth Shares have a hope value over and above the intrinsic value when compared to ordinary shares. If so it may be necessary to agree the Growth Share have a higher value (resulting in some up front tax charge).
Some additional features
Different hurdles can be set each time Growth Shares are issued. Putting the vesting and leaver provisions in the subscription agreement, rather than in the articles, means these arrangements remain private and can be different for each holder if required.
The subscription agreement often contains a power of attorney which appoints the founder of company as attorney on behalf of the holders to sell the Growth Shares to a third party purchaser upon an exit being achieved.
The legal title to the Growth Shares can be held by a nominee to keep the identity of the holder private, if necessary.
It may be possible to structure the Growth Shares so holders qualify for entrepreneurs' relief so that capital gains will be taxed at a fixed rate of 10% (up to a lifetime limit of £10 million). The key conditions being in the 12 months prior to disposal:
the company must be a trading company or the holding company of a trading group;
the individual must have been an employee or office-holder; and
the company must be the individual's ‘personal company’ (being a company in which the individual holds at least 5% of the ordinary share capital when tested by nominal value and 5% of the voting rights).