Your employees are essential to the growth of your business. Encouraging them with an incentive scheme will mean that their interests can be aligned with the interests of the shareholders and they will be more likely to fully invest themselves and their expertise in the business. As an early-stage business there are various alternatives available to you, some of which (such as Enterprise Management Incentives (EMI) schemes) can provide significant tax advantages to both the company and the employees. Here we answer frequently asked questions about setting up an EMI scheme, from the qualifying criteria to the registration process, and how it could benefit your business.
Jump to individual FAQs:
- What is an EMI share option scheme?
- How do EMI share option schemes work?
- What are the benefits of EMI schemes?
- Are EMI schemes tax efficient?
- What are the limitations or restrictions of EMI schemes?
- What is the legislation that governs EMI options?
- What are the qualifying criteria for employees?
- What are the tax benefits for an employee?
- What happens to EMI options if an employee leaves or is made redundant?
- Is Business Asset Disposal Relief available on EMI options?
- What are the qualifying criteria for companies?
- What is a qualifying subsidiary?
- What are ‘excluded activities’ in relation to EMI schemes?
- What are the tax benefits of EMI schemes for a company?
- How to set up an EMI scheme
- What are the set-up costs of an EMI scheme?
- Do the shares need a valuation?
- Is prior approval required from HMRC for setting up the scheme?
- Is a shareholders’ agreement needed to set up an EMI scheme?
- What is a disqualifying event?
- Is there a deduction or relief on corporation tax with an EMI scheme?
- Does an annual return have to be filed on an EMI scheme?
What is an EMI share option scheme?
An EMI scheme is a way of rewarding employees of start-up and growth companies, with the option to purchase shares at a price agreed in advance. Assuming the value of the company (and so the shares) later increases, the employees can benefit from exercising their options and then selling their shares at a profit. Ordinarily the exercise of an employee share option will be subject to income tax (and usually NICs) charges, but an EMI scheme provides income tax and NICs relief and favourable capital gains tax treatment (subject to meeting certain conditions).
How do EMI share option schemes work?
There will usually be certain requirements that must be met before the options can be exercised and the underlying shares sold, such as:
- A certain period of time occurring between the option being granted and exercised, and/or
- Objective performance criteria being met, and/or
- The company being sold or some other liquidity event occurring.
EMI options are normally governed by EMI scheme rules that provide the company’s Board of Directors with general powers to operate the share option arrangements and by the terms of individual EMI option agreements which set out the terms that apply to each individual employee.
What are the benefits of EMI schemes?
EMI share option schemes are an efficient and effective way of attracting and retaining talented staff in high-growth or high-risk businesses, to motivate and reward them for their hard work in an environment which is often more demanding than a usual 9-5 job. By giving share options in a company rather than cash remuneration, the company can compensate for paying lower salaries (in order to manage cashflows) while giving an equity interest to employees so that they are more likely to be invested in the growth and success of the business as they stand to profit directly as a result.
Are EMI schemes tax efficient?
EMI options have favourable tax treatment. There is no income tax due on grant of the option (regardless of the exercise price), or on exercise – provided the option is granted with an exercise price that is at least equal to the market value of the underlying shares at the date of grant and the relevant EMI qualifying conditions are met.
Instead, capital gains tax (CGT) is payable upon the disposal of the shares in respect of any chargeable gain and business asset disposal relief should be available to reduce the capital gains rate as long as the EMI options or shares acquired pursuant to the exercise of the EMI option have been held for at least 2 years from the date of grant of the option.
What are the limitations or restrictions of EMI schemes?
EMI schemes are actually quite flexible. However, there are some conditions and requirements. These include:
- EMI options can’t be granted to non-executive directors or consultants – only to employees who work at least 25 hours per week or 75% of their working time.
- The maximum value that an employee can hold in unexercised EMI options is £250,000. Anything above this amount won’t qualify for the favourable tax reliefs.
- The types of shares over which options are granted must be ordinary shares that are fully paid up. They can’t be convertible or redeemable shares. They can be either newly issued shares or existing shares that are transferred from a shareholder of the company.
- EMI options cannot be transferred, other than to personal representatives. The options can only be exercised within 12 months of death of the employee.
- The total initial market value of all unexercised EMI options held by all employees is limited to £3 million.
- The option must be able to be exercised within ten years of it being granted.
- If the company is part of a group, only the parent company can grant the EMI shares.
It is also worth a company setting out in its EMI option scheme and agreements exactly when the options will vest or lapse or whether there is a particular exercise period, for example often an employee’s unvested options will lapse on cessation of employment if they are a “good leaver” and vested options may need to be exercised within a specific time period.
What is the legislation that governs EMI options?
The legislation that governs EMI share option schemes is known as the EMI Code and is contained in the Income Tax (Earnings and Pensions) Act 2003, sometimes known as ITEPA 2003. The relevant parts in this legislation that relate to EMI option schemes are:
- Part 7, Chapter 5 ITEPA 2003, sections 471-478 (concerning basic taxation and provisions on taxation)
- Part 7, Chapter 9 ITEPA 2003, sections 527-541 (concerning income tax exemptions and reliefs for EMI options, and the effects of disqualifying events)
- Schedule 5 ITEPA 2003 (detailed provisions on the requirements that must be met for options to be considered EMI options and sets out how to notify EMI options to HMRC)
- Sections 38, 119 and 169 of the Taxation of Chargeable Gains Act 1992
What are the qualifying criteria for employees?
To qualify for an EMI share option, an employee must:
- Be an employee of the qualifying company or one of its qualifying subsidiaries (so as stated above, non-executive directors or consultants are not eligible).
- Work (or be committed to work, for the company with the exceptions of sick leave or parental leave and so on) at least 25 hours a week, or 75% of their working time (if less than 25 hours).
- Not have a material interest in the company that is issuing the shares or its related companies and not own or control more than 30% of the share capital of the company (or any other company belonging to a qualifying group of companies).
In addition, the employee can only hold EMI options of a value up to £250,000, based on the total initial market value of the shares that are subject to the EMI option at the date of grant. The employee can hold SAYE options alongside EMI options, if they are HMRC approved. However, they can only hold an option in a Company Share Option Scheme (CSOP) if the total of the CSOP and EMI options together is under £250,000.
What are the tax benefits for an employee?
Provided that the employee is granted a share option with an exercise pricec that is at least equal to the market value of the underlying shares at the date of grant (and not at a discounted price) and the other conditions of the EMI Code are met, the normal income tax and NICs that would apply on exercise of the options are relieved from tax. The individual will be assessable to CGT on selling the shares in respect of any chargeable gain and business asset disposal relief may be available. This can reduce a combined income tax and NICs rate of up to 47% to 10%. The employee can also use their annual CGT exemption.
The table below summarises the tax treatments available:
|No income tax liability.||No income tax liability if the exercise price was the market value of the shares or more at grant.||CGT may be payable on any gain over the market value of the shares underlying the EMI award at grant.|
|No NICs.||If the exercise price was less, then income tax is due on the difference between the exercise price and the market value of the shares at grant.||Business asset disposal relief may also be available subject to conditions.|
|No NICs if no income tax is due.|
What happens to EMI options if an employee leaves or is made redundant?
“Good leavers” can normally retain or exercise EMI options, while “bad leavers” normally lose all of their options. The EMI scheme documents will specify what constitutes a good and a bad leaver. If an employee exercises an EMI option within 90 days of leaving the company, the tax advantaged status of the option can (usually) be preserved. Otherwise, if the employee retains the option income tax relief is frozen at the value of the shares underlying the options on the date of cessation of employment and any further increase in value of the shares is subject to income tax and NICs on exercise.
You can find our more about what happens to EMI options if an employee leaves a company in our follow-on article.
Is Business Asset Disposal Relief available on EMI options?
Yes, Business Asset Disposal Relief can apply to EMI options, if the employee qualifies and provided that the option or shares acquired pursuant to the exercise of the option have been held for at least two years. If the employee qualifies for Business Asset Disposal Relief, they can benefit from paying the reduced 10% rate of CGT on lifetime gains up to £1million.
What are the qualifying criteria for companies?
To qualify for EMI schemes, companies must meet certain conditions. Each time an EMI option is granted, the company must:
- Have fewer than 250 employees (or the full-time equivalent).
- Be independent – that is, not a 51% subsidiary of another company, or controlled by another company.
- If the company has its own subsidiaries, it must own and exclusively control all those subsidiaries (owning more than 50% of the ordinary share capital), and those subsidiaries must also qualify.
- Have gross assets of no more than £30 million – this is a consolidated valuation of the gross assets of the group, without any liabilities deducted.
- Be trading, or preparing to trade, on a commercial basis with a view to making profits, in a qualifying trade and not substantially (broadly, more than 20%) in trades relating to ‘excluded activities’.
- Have a UK permanent establishment, or, if the company is a parent company that owns a group, one of its subsidiary companies (which must also meet the qualifying criteria) in a qualifying trade must have a permanent establishment in the UK.
What is a qualifying subsidiary?
A subsidiary is any company which the holding company controls, either solely or with a connected person. A subsidiary qualifies if it’s a 51% subsidiary of the holding company, and no other party controls it, except the holding company or another one of its subsidiaries. Property management subsidiaries won’t qualify unless they are a 90% subsidiary of the holding company.
The holding company can have minority shareholdings – which won’t be regarded as a subsidiary. However, it can’t have a joint venture holding as a subsidiary.
What are ‘excluded activities’ in relation to EMI schemes?
To be eligible to offer an EMI scheme a company must carry on a qualifying trade. This is a commercial trade that is performed with a view to making profit and that is not made up only or substantially of ‘excluded activities’. HMRC usually takes ‘substantially’ to mean more than 20% of the company’s trading activities.
However, the law can be very complex. If your company is a parent company and excluded activities make up more than 20% of your entire group’s trading activities, or if, for example it reinvests its own cash back into investment portfolios, it could then be regarded as engaging in financial activities, which are on the list of excluded activities, so if there is any doubt it is always advisable to seek expert legal advice.
What are the tax benefits of EMI schemes for a company?
A corporation tax deduction may be available when EMI options are exercised (under Part 12 of the Corporation Tax Act 2009). The company may be able to claim a tax deduction equal to the value of the shares acquired on exercise of the option at the date of exercise less the exercise price (basically the same amount as any gain made by the option holder), in the accounting year in which the options were exercised.
How to set up an EMI scheme
To set up an EMI scheme, you will need to discuss with us and/or supply the following:
- Design information, such as what will constitute good and bad leavers.
- Names of employees to be included in the scheme.
- How many share options each employee will be granted?
- Details of the time frames and vesting conditions for exercising their options and buying the shares.
- Share valuation, which will need.
What are the set-up costs of an EMI scheme?
There are two main parts to implenting an EMI scheme:
- The establishment of the scheme and the preparation of its documentation. This normally includes preparing a share valuation and agreeing it with HMRC, applying for advance assurance that the company qualifies to grant EMI options, preparing all EMI option scheme documentation, adoption of the EMI scheme by the company, authorising option awards and notifying the grant of EMI options to HMRC).
- The creation of the EMI needs to be registered with HMRC to permit on-line notification of EMI option awards and then there are annual on-line HMRC reporting requirements.
For a more specific costs estimate and to set up an initial consultation with our employee incentive specialists, get in touch.
Do the shares need a valuation?
We recommend that if the company is unquoted, then the market value of the shares is agreed with HMRC prior to granting any options. Only options granted with an exercise price that is at least equal to the market value of the underlying shares will attract full income tax relief on exercise, so a share valuation agreement provides certainty that tax relief applies (or the extent to which it applies) and will save time in a due diligence exercise on a fundraising or future exit event.
The share valuation that is relevant to the grant of EMI options is a market value for tax purposes of the shares underlying the options as at the date of grant. It is often possible to agree a discount to a commercial valuation of the company because the shares underlying the options will not be influential or controlling holdings and will be non-transferrable except on an exit event.
Once agreed, the valuation is valid for 90 days from the date of issue, so the options should be granted within that period or the valuation should be refreshed.
If the company shares are quoted on the London Stock Exchange or on certain other exchanges, HMRC will accept the mid-market value of the shares on the date the option is granted.
Is prior approval required from HMRC for setting up the scheme?
No, prior approval is not needed. It is, however, possible to obtain advance assurance from HMRC that the company qualifies to grant EMI options. The scheme must be registered with HMRC once options have been granted. This must be done through the employment-related securities (ERS) Online Service. We can help with this if required.
As well as registering the scheme, HMRC must be notified of the grant of an EMI share option within 92 days of the date it was granted.
If an EMI option is not notified to HMRC within this time limit, the tax benefits of the option will not be available.
Is a shareholders’ agreement needed to set up an EMI scheme?
A shareholders’ agreement is not required in order to establish an EMI scheme. However, we would always recommend that a shareholders’ agreement be put in place where multiple shareholders exist, particularly if there are different levels of investors in the company with different rights and vetos. If a shareholders’ agreement is in place, investor consent may be required.
What is a disqualifying event?
A disqualifying event is an event that affects the tax advantaged status of an EMI option. If the share option is not exercised within 90 days of a disqualifying event, the tax advantages for the employee will be restricted.
Disqualifying events include:
- The company ceasing to be independent (for example, it is owned by or becomes a subsidiary of another company).
- The company’s trading activities falling substantially (for example, more than 20% of its total trading activities) into the list of excluded activities.
- The employee no longer qualifying – for example, they cease to be an employee or no longer satisfy the working time commitment of 25 hours a week (or 75% of their working time).
- The option being altered, for example to increase the rights of the option holder, to increase the underlying value of the shares, or so that it no longer meets the requirements of the legislation that governs the scheme.
- The share capital of the company being changed so that it no longer qualifies.
- The shares being converted to a class that no longer qualifies.
Is there a deduction or relief on corporation tax with an EMI scheme?
Yes, the operating costs of the scheme can be a deductible expense on the company’s corporation tax. As stated above, companies can also receive a corporation tax deduction when the employee exercises their option. This deduction will be equal to the market value of the exercised shares, minus any payments received by the company from the employee.
Does an annual return have to be filed on an EMI scheme?
Yes, an annual return must be filed by 6th July following the end of the preceding tax year. This must be done online via the ERS Online Service. We can assist with this if required.