The Enterprise Management Incentive (EMI) allows smaller companies to set up tax-advantaged employee share schemes. Under an EMI scheme the company grants share options to employees to buy shares in the company at some time in the future.
Like any employee share scheme an EMI scheme gives employees the opportunity to gain from the company’s long-term performance. This can help to incentivise employees to work better for the company. However, there are tax incentives from using an EMI scheme for both employees and companies over certain other share schemes.
Given the significant tax incentives there are conditions that the recipients of the options, the company and the scheme must comply with. These, the tax incentives, some of the procedures that a company needs to follow and how the tax advantages can be lost are explained with examples below.
Tax advantages of EMI schemes – individuals
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Under an EMI scheme both income tax and national insurance contributions (NI) are not payable by the individual on either the grant or the exercise of the shares. This applies provided that the exercise price is not less than the unrestricted market value of the shares at the time that the options are granted. The market value of the shares should be agreed with HM Revenue & Customs before granting the options to prevent issues when the options are exercised.
Where the option price is less than the unrestricted market value at the date of grant then income tax and NI are potentially payable at the date of exercise. The liability for these is based on the lower of:
- the amount by which the unrestricted market value at the date of grant is more than the exercise price; and
- the amount by which the unrestricted market value at the date of exercise is more than the exercise price.
Income tax and National Insurance savings for the employee
An employee has options under an EMI scheme at £5.00 per share. This is the same as the unrestricted and restricted market value of the shares at the date the options were granted as agreed with HMRC. The employee exercises 1,000 options when the market value of the shares is £7.50. As the exercise price was not more than the market value when the options were granted the employee should not be liable to income tax or NI on the increase in value. If the options were in an unapproved scheme then the employee would be liable to pay income tax at the person’s marginal rate under PAYE and NI at the person’s applicable rate.
Assuming that the employee is a basic rate tax payer then on exercising 1,000 options the following are due to HMRC:
- income tax of £500 being 20% of 1,000 x (£7.50 – £5.00) (this may be different for Scottish tax payers where the employee is paying tax at the intermediate rate of 21%)
- employees NI of £331.25 being 13.25% of 1,000 x (£7.50 – £5.00)
If the employee is a higher rate tax payer (paying 40% tax (or 41% if Scottish tax payer) then the income tax saved would be £1,000 (£1,025.0 if a Scottish higher rate tax payer). The saving is even more if the employee is a top rate tax payer being £1,125.00 (£1,150.00 for Scottish top rate tax payers). For higher rate and top rate tax payers the NI saving will be less at £81.25 as they only pay NI at 3.25% on earnings above £50,270.
Where the shares are sold at a profit this will always be subject to capital gains tax. Where the exercise price is at least the market value at the date of grant capital gains tax is payable on the amount by which the sale price is greater than the exercise price. For options where tax was paid on exercise, capital gains tax is only payable on the difference between the sale price and the market value used to set the income tax payable on exercise.
The capital gains tax payable may be at 10% if business asset disposal relief (BADR) applies to the employee on sale. For this to apply:
- the individual must be an employee at the time of the sale; and
- the sale must be at least two years after the date of grant; and,
- if the EMI options were exercised after a disqualifying event, the date of that event was at least one year after the date of grant.
Restricted shares and employment related securities
Care is needed where the shares issued to employees and directors have certain restrictions attached to them that potentially reduce the market value of those shares. If the shares have such restrictions, they will normally have a lower market value and be treated as employment related securities. Where the shares under the EMI scheme have restrictions then, to prevent income tax payable in the future, the exercise price should be at least equal to the unrestricted market value of shares in the company rather than the actual market value of the specific restricted shares.
Where options are exercised at a value less than the unrestricted market value at the exercise date then, when sold part of any gain is taxable as income tax with the rest of any gain subject to capital gains tax. The element of the gain taxable as income tax is the difference between the unrestricted market value and the exercise price divided by the unrestricted market value. For example, if the actual market value and exercise price is £1.60 and the unrestricted market value is £2.00 the percentage of any gain subject to income tax is 20% – being (£2.00 – £1.60)/£2.00.
To prevent this the individual should:
- ensure that the exercise price paid is at least the same as the unrestricted market value at the exercise date; and
- make a section 431 election within 14 days of the exercise stating that the price paid was at least equal to the unrestricted market value.
The section 431 must then be lodged with HMRC by 6 July following the tax year in which the options were exercised.
Tax advantages of EMI schemes – companies
The tax advantages to companies are:
- National Insurance contributions are neither payable by the company when the options are granted nor when they are exercised;
- The difference between the current market value and exercise price, where the market value is higher, is an allowable expense for the company when the options are exercised;
- the costs of setting the scheme up and administering it are also allowable expenses for the company.
National Insurance savings for the company
Using the same example as above where an employee exercising 1,000 EMI options at £5.00 (being the market value at the date of grant) when the market value is £7.50 the company is saving NI of £376.25 – being 15.05% of 1,000 x (£7.50 – £5.00).
Requirements that an EMI scheme must meet
For an EMI scheme to qualify for the tax advantages it must meet the requirements of Chapter 9 of and Schedule 5 to the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003). These cover the company, individuals and the terms of the share option and the associated shares. Looking at each of these in turn:
To operate an EMI scheme the company must meet the following conditions:
- have gross assets of £30 million or less;
- have less than 250 full time equivalent employees;
- have a permanent establishment in the UK – this does not mean that it must be a UK company as the permanent establishment may be a factory;
- be a company limited by shares;
- be a company carrying out a trade that is not an excluded activity. Excluded activities include:
- banking, insurance, money lending or other financial activities;
- dealing in land, commodities, futures, shares or other financial instruments;
- leasing, including lettings of ships unless certain criteria are met;
- provision of legal or accountancy services;
- property development;
- operating hotels, nursing homes, residential care homes or similar establishments;
- ship building;
- producing steel;
- producing coal;
- receipt of royalties or licence fees unless related to assets created by the company;
- not be a subsidiary of another company. However, holding companies where all the subsidiaries are qualifying companies can qualify to operate EMI schemes covering the employees of all such group companies.
The individuals receiving the options must meet the following conditions:
- be an employee of the issuing company or of a subsidiary;
- work for at least 25 hours as an employee of the company or work at least 75% of their working time as an employee of the company; and
- not hold, or have the right to acquire, more than 30% of the shares or voting rights of the company.
Provided that the employee is eligible the company has discretion on who to grant options to and the number of options to grant to each employee.
The options then need to meet the following requirements:
- the options are granted for a genuine commercial reason and not just to avoid tax – ie they are granted to retain or recruit the employee;
- the shares subject to the option must be ordinary, fully paid and non-redeemable shares;
- the options must be exercisable within ten years of grant;
- the market value of all unexercised EMI options to one employee must not exceed £250,000 at the time of the grant and once the limit is reached no more can be granted within three years – only those exceeding the limit will be unapproved options;
- an employee can only be granted EMI and Company Share Option Plan (CSOP) options with a market value of £250,000 in any 3 year period, even if some options have already been exercised or released;
- the terms must be agreed in writing and include:
- the date the option is granted;
- that it is granted under the provisions of Schedule 5 to ITEPA 2003;
- the number, or maximum number, of shares that may be acquired or the formula that will be used for calculating this;
- the price (if any) the employee will pay to acquire the shares, or the method by which that price will be determined;
- when and how the option may be exercised;
- details of all restrictions on the shares, not just those that reduce the market value;
- any conditions such as performance conditions affecting the employee’s entitlement; and
- whether there is a risk of forfeiture;
- the terms must not allow the options to be transferred, but otherwise are at the discretion of the company;
- the number of unexercised EMI options a company can have at any one time is capped at a market value (at date of grant) of £3 million.
The company must within 92 days of granting EMI options report this online to HMRC.
The company must then complete annual EMI returns until all options have either been exercised or have lapsed.
When all options have been exercised or have lapsed the company should inform HMRC in the annual return that the termination condition has been met.
Loss of tax advantages
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Care is needed to ensure that the tax advantages are not lost as there are a number of events that can cause this to happen. These include:
- Not reporting the granting of EMI options within the period of 92 days;
- Change of control – the company becomes a subsidiary of another company, unless the existing options are replaced by those in the new parent company;
- Change of the trading activities to an excluded activity or never carrying out the proposed qualifying activity;
- The company having more than 250 full time equivalent employees;
- The employee’s working hours change so that the employee works for the company for less than 25 hours a week and less than 75% of their overall paid work;
- The employee ceases to work for the company, including by redundancy, retirement, illness or death;
- The company’s share capital is changed in a manner (eg change in rights or restrictions of the shares, share capital reduction) which has an effect on the value of the shares under the EMI;
- The company’s shares are converted to another share class unless the whole of the share class is converted into the new class and certain conditions are met;
- Granting company share option plan (CSOP) options to an employee that takes the total number of EMI and CSOP options that the person has been granted in the last three years over the £250,000 market value limit – it is only on the excess that the tax advantages are lost;
- The terms of the EMI options are changed so that they no longer meet the EMI requirements.
If any of these events occur, the employee should exercise the options within 90 days to retain the EMI advantages. However, if the date of exercise is within 12 months of the initial grant of the options, then the tax advantages are always lost.
If the options are not exercised within the 90 day period, then the option becomes an unapproved option from the date of the disqualifying event. This means that any growth in value of the shares up to the date of the disqualifying event is subject to capital gains tax, without BADR. The growth after that date is subject to both income tax on the employee and NI contributions on both the employee and the employer.
The above is an overview of the EMI scheme provided for information only. You should take professional advice before setting up an EMI scheme.