We are experts for EMI options and how to make them work commercially. We focus on the SME market and understand where SMEs are coming from.
How the “market value” of shares used under EMI schemes operates
You are probably aware of the benefits of Enterprise Management Incentive (EMI) options. But whilst the Government says it designed EMI options to be easy to operate for SMEs, when you drill down into the EMI legislation certain aspects are far from easy to understand. One of the areas that we see cause difficulty is in establishing the “market value” of the shares under EMI option at the time of grant.
We look at:
- Why market value matters for EMI options
- How HMRC evaluates market value
- What will be taken into account to reduce market value
Why market value is relevant to EMI options
- Will the option grant qualify for EMI; and
- Will any income tax and in some cases national insurance be payable on exercise.
Market value impacts on whether the options qualify for EMI
One of the requirements under the EMI legislation is that no individual employee can hold options with a tax market value on grant of more than £250,000. A further requirement is that employers cannot place more than £3 million of shares valued at the unrestricted value under EMI option.
A good point about the legislation is that the calculation of tax market value for the purposes of the £250,000 and £3m limits only has to be performed once at the time of grant of the EMI option. The tax market value does not have to be reappraised during the live of the option.
Will the EMI options be exercised free of tax?
Tax treatment of EMI options will depend on whether or not the exercise price is less than the unrestricted tax market value of the shares on the date of the grant. It is always worth negotiating and agreeing with HMRC the tax market value of the EMI shares before the EMI options are granted. Apart from providing certainty to the employees as to their tax liability, negotiating before the business grows in value will produce a better result for the employees.
It is a good idea to agree a valuation with HMRC’s share valuation advanced approval service to ensure the certainty as to the tax position. Doing so reduces the risk of the options being valued unnecessarily high.
Example of how market value works
Imagine that a company is granting 200 EMI options to its employee. The idea is the employee can exercise his option and acquire shares free of charge to sell at exit. Imagine there has been a recent investment round at £10 per share and some years later an exit at £50 per share.
No Negotiation with HMRC
The company does not negotiate a tax market value with HMRC. The board assumes that the value for EMI purposes is the same value as investors paid in the last funding round (£10 per share) and reports to HMRC £10 as the value of the shares under EMI option. In this scenario the employee will pay income tax on £10 per share x 200 when he exercises his option. Income tax rates can be as high as 45% plus NI. If he sells his shares the profit over and above £10 per share will be taxed as capital. So if the shares are exercised and sold on exit at a price of £50 per share – the profit for the employee – £40 per share x 200 – is taxed at 10% capital gains tax.
With negotiation with HMRC
But, imagine the company had negotiated the unrestricted tax market value with HMRC before the EMI option was granted. Depending upon the facts it is possible that a value of £2-3 pounds per share may have been agreed with HMRC. In that scenario the employee would have paid income tax on exercise at say £2 per share x 200 (compared to £10 per share if there was no negotiation). A much larger proportion of the overall profit is taxed to capital gains tax at 10% – in this scenario £48 x £200 per share. The employee is better off.
All of the profit taxed at 10%
If the exercise price had been set at the market value at the time of grant (£10 or £2 per share in our examples) all of the profit made on Exit would be taxable as capital and the current rate is 10% CGT. Often arrangements are put in place for the employee to fund the exercise price to enable them to exercise – known as cashless exercise.
EMI is generous for employers
The EMI legislation is rather generous for employers. When the option is exercise the employer will obtain a corporation tax deduction on £50 per share. This can be an attractive benefit for a company being sold.
How HMRC evaluates market value
Market value means the price which the shares might “reasonably” be expected to fetch on a sale in the open market.
The market value and commercial value of shares can be wildly different. A valuation for tax purposes will take into account adjustments and discounts that may not apply in the commercial world. The tax market value will often be lower than the sale value or investment value but in private companies this is all guess work until an actual event comes along. You always have to ask for what purpose is the valuation being considered.
Information that can be ‘reasonably expected’
HMRC use open market to refer to a sale between hypothetical parties who are unconnected. The reference to hypothetical is because the grant of an EMI option is not a sale of shares and the valuation process requires us to make up what would happen. What can be reasonably expected by the hypothetical purchaser will vary from case to case and the particular circumstances and HMRC are aware of that.
In smaller private companies the information that the hypothetical purchase could reasonably require would be information about profits or anticipated profits if the business has not yet gone to market. If the business produces management accounts HMRC would expect to see them. If the business does not produce management accounts there is no requirement on part of HMRC to prepare them.
It is reasonable to expect a purchaser to require financial data over a period of at least three years and HMRC would want to see that. Knowledge of major contracts and key personnel would also be assumed. Any offers for the business must be disclosed. HMRC would want to see details of the prices at which shares have changed hands in the past few years.
Specialist HMRC share valuation division
Valuations are submitted to HMRC’s specialist share valuation division. According to HMRC, valuations submitted undergo an initial risk assessment and only a proportion receive detailed examination. Valuations considered low risk will receive a limited without prejudice acceptance.
What can be taken into account to reduce market value
The following adjustments and discounts will be considered by HMRC to arrive at market value:
- The frequency of transactions
- Whether investors have a different class of shares with preferential rights
- Minority rights
- Any restricted business activities and whether a high risk activity Is involved
- Any restrictions on shares such as pre emption provisions and the risk of forfeiture.
It is important to understand that this is not empirical science but HMRC practice and discretion comes into play. Some cases will require further negotiations to arrive at a desirable result.
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