Article by Philip Fisher, Employee Benefits Partner at Chantrey Vellacott DFK.
Published in September 2001 issue of Tax Adviser.
The business world has now become attuned to the idea of employee share schemes. This article has been written with the intention of asking the question ‘Are enterprise management incentives (EMI) right for my company?’
There are three real issues that need to be investigated by any company when it is considering EMI as a benefit for its employees.
- What are the benefits of introducing an EMI scheme?
- Is EMI a better bet than other types of share schemes?
- Does the company qualify?
EMI was originally introduced as a way of giving key employees in fast-growing dotcoms and other new companies the opportunity to be paid largely in shares rather than by way of salary which is generally not easily found in start up companies. Because Chancellor Gordon Brown was so keen to encourage these entrepreneurial companies and to help them succeed, he offered especially attractive tax incentives to employees entering into plans.
To make the system easy to implement and operate, many of the restrictions associated with other Inland Revenue Approved Employee Share Schemes were deemed inappropriate for EMI.
Over the period since the original consultation paper, there have been various changes to EMI, some more significant than others. The general drift has been to make the scheme available to more people and to make it even more attractive.
As a by-product of relaxations in the legislation, by the time that the Finance Act 2002 is enacted it is likely that the rationale behind EMI will have changed completely. By that stage, the scheme will no longer be restricted to small companies. It is suggested that the main restriction will be a gross assets limit of £30m. In addition, schemes can now be made available to all employees in qualifying companies.
The original idea that EMI should benefit key employees in entrepreneurial companies has been scrapped although there are still some restrictions on the type of company that can qualify. The big question that is already being asked is whether EMI will eventually be extended to all companies possibly as a replacement for the Company Share Option Plan (formerly the Executive Share Option Scheme).
From the employee’s point of view, the attractions are very good. They can receive options to purchase up to £100,000 of shares in their employing company (or, if that company is in a group, the holding company of that group). They can be offered these options at the current market value. In these circumstances, they will know with absolute certainty that they will never face an Income Tax charge. This assumes that the plan is operated in compliance with the legislation and that there are no significant changes in their employer’s business. On the exercise of their options, they will not pay any tax. To make things even better, when they ultimately come to sell their shares, they will pay less capital gains tax.
There are various allowances available which they can offset against gains on their shares. There is the individual annual exemption, currently £7,500. In addition, Business Asset Taper Relief applies to EMI shares by legislative definition. In this particular instance and in no other, the period of ownership with regard to calculating taper relief is taken from the date on which the employee is granted the option. As things stand at the moment, this means that the full relief with an effective tax rate of five per cent for basic rate taxpayers and ten per cent for higher rate taxpayers will kick in four years from the date of grant.
To emphasise how good this is, it means that an employee could buy some shares in his employing company say five years after grant, sell them that same day at a profit and only pay tax on one quarter of the gain. Indeed, if proposals made by Gordon Brown in his Enterprise for All in July 2001 are enacted, the period could be cut from four years to two. This will greatly enhance the attractions of EMI for any who are not already sold on these plans.
As a further attraction, this scheme can also be operated by offering options to employees to purchase shares at below market value or even for no consideration. However, the tax treatment is rather more complicated and in these circumstances they will be subject to an Income Tax charge and, in certain circumstances, both they and their employer will need have to pay NICs.
Is EMI the best scheme for my employees and my company?
Somewhat surprisingly, the answer to this question is often a simple yes. The tax incentives offered by EMI are so far superior to those under any other Revenue Approved Scheme let alone under Unapproved Schemes that EMI is almost always the winner. In this context, some may wonder why anyone would ever choose to offer Share Incentives to employees under alternative schemes.
There are normally two reasons why alternative schemes might be appropriate. The first, if the company does not qualify to operate an EMI scheme. This might apply in various different circumstances. The most likely are where the company is not independent, i.e. it is a subsidiary of another company. A similar problem arises where the company carries on a trade that does not qualify for EMI. The list of non-qualifying trades includes property development and accountancy.
If the company does not qualify then clearly it will need to consider other possible means of offering share incentives to employees. While these may not be as good as EMI they are often a commercial necessity if the employer wishes to retain and notivate its employees.
Another measure that can trip companies that would like to use EMI is the gross asset measure. This is a pure accounting measure and seems most inappropriate in deciding whether a company is small enough to qualify for this highly incentive based scheme. The limit is currently £15m at the date on which options are granted to employees. There is no withdrawal of relief if the company subsequently increases in size.
The final issue that leads companies to grant options outside EMI is the wish to grant options worth more than £100,000 to their employees.
Companies have a choice if this is the case. They could grant all of the options under EMI. Then only the first £100,000 would qualify for tax relief and the balance would be treated as unapproved options. The alternative is to grant £100,000 worth of options under EMI and the balance under an Unapproved Share Option Scheme. The advantage with the latter treatment, which is slightly more complex, is that there will never be any uncertainty as to whether options that are exercised are those which qualify or those which do not.
A similar situation can arise where a company grants in excess of £3m of options to its employees. In either case, if the grant takes place under EMI then there is no legislative mechanism to decide whether options exercised are the approved ones, the unapproved ones or some kind of hybrid mix of the two. In order to avoid a complication of this type it is strongly recommended that where options are to be granted which exceed the legislative limits, the employer establishes that this is the case in advance and prepares two separate option agreements.
In order to do this, it is advisable to obtain an advance valuation from the Inland Revenue’s Shares Valuation Division (SVD) in connection with options to be granted under EMI. This avoids any potential for future problems where shares are not quoted on a recognised stock exchange for these purposes. At present, it is understood that the Revenue only recognises the London and New York Stock Exchanges for approved share schemes. This means that even if a company is quoted on, say, The Bourse or NASDAQ, it will still be necessary to obtain a formal agreed valuation from SVD.
Valuations are helpful for two purposes. First, they allow employers to be certain about the value of options that they are granting, i.e. whether or not the £100,000 is breached. Secondly, they fix the market value of shares at the time of grant. This is absolutely critical where this is below market value as this will form the basis for calculating the tax charge on exercise.
If it is intended that the options will be granted at full market value, then this advanced valuation will ensure that the Revenue’s view of the value of a company’s shares accords with that of its directors or advisors.
For EMI, it is necessary to prepare two separate valuations. One ignoring any restrictions over shares and one taking these into account. The former is relevant for the £100,000 limit while the latter is a true open market valuation that will be used for calculating any taxation liability on exercise. Normally, the undervalue at the date of grant is chargeable to Income Tax. However, the liability is based upon the lower of the market value at the date of grant or that at the date of exercise. Being an optimist, one always assumes that shares go up in value and that the employee will therefore be taxed on the value at grant. Sadly, in reality, particularly for technology companies, this has not been the case since the introduction of EMI.
One of the other major advantages of EMI over Revenue approved rivals is that there is no obligation to obtain advance approval from the Revenue. It is merely necessary to notify them of the grant of options in an approved form within 92 days of the date of that grant. Failure to do so could invalidate arrangements and render options unapproved. This means that in practical terms, if a company decides on 1 October 2001 to grant options to its employees then it could grant those options on 1 October 2001. This compares with a standard CSOP where the lead-time is typically four to six weeks. In practice, it can be considerably longer than this if the Revenue are unhappy with the drafting of the Scheme Rules.
The corollary to the freedom that is offered to companies to implement EMI is that if the arrangements do not comply with the legislation there is a danger that the Revenue will invalidate them.
This may not matter if share prices are relatively stable as the employer could just grant further options on similar terms. However, if the share price has increased substantially in the interim period then the employee could face a large income tax liability as a result. Where the shares are readily convertible assets at the time of exercise, this extra liability will also lead to a cost to the employer who must pay NICs on the liability.
Where the employer and the employee jointly elect, it is possible for the employer’s NICs to be settled by, refunded or partially settled by the employee. This is a ‘voluntary election’ that must be made by the two parties. This presents various interesting moral questions as the government has, to all intents and purposes, passed responsibility for choosing who pays a tax liability on to the employer. This seems wholly wrong as the likely consequence is that junior employees will be obliged to enter such an election and pay their employer’s liability. Key employees can just refuse to enter into a joint election and there is little that an employer can do to persuade them.
Where a company qualifies for EMI this is almost certainly going to be the best arrangement that it can use to reward its employees, at least to the extent of £100,000 worth of shares. The legislation is so sympathetically drafted that it is almost possible for an employer to write his or her own rules. This great flexibility makes EMI schemes very attractive both to employers and employees.
With the new £3m limit per company it seems most unlikely that any company with no more than £15m of gross assets will need to look elsewhere unless they wish to grant individual employees options worth more than £100,000.
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September 2001 by