Alternatives to EMI options

EMI options are usually the best choice

EMI options are the most tax efficient and flexible type of arrangement available. It will always be the currency of choice for a diverse range of business sectors and sizes operating predominantly in the private sector although some quoted companies and foreign parents can qualify for EMI.

Example of how tax on EMI options works:

Say an employee was granted an option over 100 shares worth £5,000 at the time of grant over a very small percentage of the company and five years later the business was sold and the employee received say £150,000 – the employee would only pay tax at 10% on the gain made when he sold the shares.  If the employee did not have to pay to exercise the option he would have to pay tax on £5,000 but even at the highest rate that is only £2,250 (ignoring NI) which the employee could afford if he has just received £150,000.

When you consider how other types of share award made to employees are taxed (discussed below) you can see how attractive EMI options are.

Not everyone can qualify for EMI

There are, however, various conditions which have to be met by the company and the employee to be eligible for the favourable tax treatment EMI options offer. For example, the company or the group must be an independent trading company or the holding company of a trading group not carrying on certain activities. At the time of grant, the company must have gross assets of less than £30 million. The company must also have less than 250 employees.

Working time requirement

An employee is only eligible for EMI options if he works for an average of at least 25 hours a week or, if less, 75% of his working time; and, at the time of grant, he does not have a material interest in the company or any other group company. A material interest means owning or controlling more than 30% of the ordinary share capital. Consultants and non-executive directors will not qualify for EMI options and there is no change there.

Alternatives to EMI options

The first job is always to find out what the intended outcome is and work backwards to work out how to achieve the outcome. An incentive will not work as an incentive unless the employee, director, consultant is on board and understands what the business is trying to achieve.  The dilution caused by the issue of shares needs to be reviewed – we always recommend a share capital table is prepared so that the impact is known.  There are usually other points to check out such as whether the articles and shareholders’ agreement are adequate and HMRC tax payment and reporting requirements. We can help you with all of the issues arising.

In most cases, the decisions break down into the use of unapproved options, gifts of shares or creating new types of shares – flowering shares - as discussed below.

Unapproved options

Generally speaking unapproved options are not tax efficient compared with other types of equity arrangements. In a nutshell, if the unapproved options were exit only – i.e. exercised on the sale of the business or on a merger (as is the case with many unapproved options) – the combined rate of income tax and national insurance payable on the gain made on exercise can be over 55% calculated at top rates of current tax. The gain for income tax and national insurance purposes is the difference between the price paid to acquire the shares less the value of shares at the time of exercise.  So if the option is nil cost – i.e. the employee does not pay money to exercise – the full gain is taxed.

Example of tax payable on exercise of unapproved options

Say an employee was granted an option over 100 shares worth £5,000 at the time of grant over a very small percentage of the company and five years later the business was sold and the employee received £150,000 – the gain for tax purposes is £150,000 and income tax and national insurance is charged.  The highest rate of tax is around 55% which totals £82,500 or more if the employer passes his national insurance charge onto the employee.

In most cases the option is exercised and the shares are sold simultaneously.  But if the employee retained the shares and they increased in value there would be more tax to pay on sale.

Share awards

The advantage of a share award is that the award can be structured so that any growth in value (i.e. the difference between the amount the employee pays to acquire the shares and the exit value) falls to be treated as capital rather than income. Rates of capital gains tax range from 20% to 10% if Business Assets Disposal Relief (formally known as entrepreneurs’ relief) is available.

The basic rule is that if an employee (or an employed director) is gifted  shares or not required to pay the “tax market value” for the shares  HMRC will seek to charge income tax on the benefit of the gift or undervalue of shares. Providing there is no market for the shares there will be no employer’s or employee’s national insurance to pay. The tax market value has to be negotiated with HMRC.  Negotiation cannot take place until the shares have been provided meaning the employee is left in a position of uncertainty over how much tax to pay until the “tax market value” is settled with HMRC.

Example of tax payable on a gift of shares

Say an employee was gifted 100 shares worth £5,000 at the time of gift over a very small percentage of the company and five years later the business was sold and the employee received £150,000 – the employee pays income tax (and sometimes national insurance) on receipt of the gift based on a value of £5.000 at his highest rate of tax say 45%.  On sale he is taxed at 20% on the profit made of £145,000.

Flowering shares

The broad idea behind flowering shares is that when the shares are awarded they have a low value usually because they are subject to milestones or are over a small percentage of the equity. When triggers or targets are met the shares become more valuable – i.e. flower. The tax market value of such shares on award is reduced for tax purposes. This is to take in account the restrictions on the shares. So the reduction depends upon the facts. However, if the employee pays the tax on receipt of the shares any growth in value as the shares “flower” should be subject to capital gains tax. Flowering shares are a different class of share to those held by ordinary shareholders. Issues such as voting rights, forfeiture, dividends and assets on a distribution all add to the mix and vary depending upon requirements.

Example of tax payable on flowering shares:

Say an employee was awarded 100 shares worth £5,000 before the restrictions were put in place and £1,000 with restrictions over a very small percentage of the company and five years later the business was sold and the employee received £150,000 – the income tax charge the employee would have paid when he was awarded the shares is based on £1,000 at the highest rate of tax say 45%. When the shares are sold the profit of £149,000 is taxed at 20%.

By way of contrast if the employee had held an EMI option the gain would have been taxed at 10% or over 55% if the option was treated as unapproved for tax purposes.

There are many surveys and statistics which show that companies with employee share plans in place out perform those without.  We implement a wide range of solutions for a range of business needs.  The examples are illustrative only.