Companies set up EMI (Enterprise Management Incentives) share plans thinking EMI options will benefit employees on an exit. The employers then forget about the EMI options until the exit arrives. Therein lies a nasty shock if pre-emptive steps have not been taken.
People who are selling their business are often surprised by the size of the due diligence checklist presented to them by the potential buyer. One focus area in particular that may be a shock to the sellers is the due diligence on the company’s EMI options and employee share awards.
We look at:
How the EMI tripwire is created
The buyers will engage large law firms with entire departments who do nothing but due diligence on EMI options and share awards to employees. To prove they are worth hiring, those lawyers will endeavour to find problems with almost every EMI scheme. The danger of leaving the review of your EMI scheme to the buyer’s solicitor is that there is then often insufficient time to clear up matters with HMRC before completion of the sale.
If an EMI option agreement is determined to be non-qualifying for EMI purposes the consequence is not that the employee is prohibited from exercising the option. Instead, the individual employee is treated as not entitled to the beneficial capital gains tax treatment available to EMI options. PAYE and National Insurance will be withheld from the entire purchase price paid to that employee. This can be over 50%, rather than the 10% capital gains tax that an EMI option holder is expecting to pay.
Buyer will err on side of caution
If the buyer of the business is in any doubt as to the tax treatment of the EMI options they will typically err on the side of caution to avoid any questions from HMRC around the declaration of tax.
It will then be up to the employee shareholder after completion to argue with HMRC as to whether any tax can be claimed back. It is invariably harder to get a refund of tax than to make the correct tax payment at the time.
Areas to look out for when exiting a business with EMI options
In our experience, common areas where mistakes will be made along the way are:
Failure to make annual filings via ERS online
Each year, a company must update HMRC to advise of any changes (or none) to the EMI schemes in place. This must be filed on the PAYE Online by 6th July each year. If this has not been done, it may be possible to pay a fine and remedy the situation, however it is recommended that this is not left to a time when it may hold up the sale of the Company.
Incorrect filings of the EMI option grant in the first place
All EMI option grants must be filed with ERS online within 92 days. This is a two stage process, the first filing is to get a unique reference for the scheme which is posted by HMRC, the second is to actually record the options. Unfortunately, some companies are tripped up by thinking only the first filing is needed. It may be possible to obtain a late excuse code from HMRC, but again this takes time to come through.
If there is a deadline for completion the buyer may not wait and the main shareholders may not be prepared to take any risks.
Insufficient attention being paid to the disqualifying events
There are various areas which can make an EMI Option that was qualifying when granted into a non qualifying option before it is exercised.
One particular area where we see problems arise is where there has been an investment from a VC or corporate investor who has bought over 50% of the shares in the company. The company is no longer independent, and so the EMI options are non-qualifying.
Another trip wire is where a company tries to expand by acquiring shares in another company. All subsidiaries of an EMI company must be controlled by that company, meaning that if the company acquires 49% or less of another company it will also become non-qualifying.
Change in employee role
EMI schemes are designed for employees or directors working for more than 25 hours per week (or 75% of their time) in a business or who would have been so working but for the fact that they were put on furlough, were asked to work shorter hours or take unpaid leave as a result of the coronavirus (COVID-19) pandemic. This exception is time limited between 19 March 2020 and 5 April 2021.
If the employee changes their role (for example, by becoming a contractor) they would no longer benefit from the EMI tax reliefs.
Change in trade
A key area to consider is whether the trade of the company has changed so that the company is no longer an EMI qualifying company. The list of trades that will cause the EMI option to fail include legal and accountancy services, dealing in land or shares or property development.
We can look at the time between grant of options and exercise of options. This may raise questions as to the applicability of the general exclusion from tax benefits if the EMI options were granted for tax avoidance purposes. We can consider the ways to demonstrate that this was not the case and make sure the employer has decent paperwork and board minutes in place to support the position.
Failure to advise on the “restrictions” attaching to the shares on exercise
This is an area for oversight. HMRC’s interpretation of “restrictions” is not what you would think.
For HMRC purposes a restrictions is a provision that depress the value of shares. A restriction covers requirements such as leaver provisions which require employee shareholders to sell back their shares upon leaving employment. Another “restriction” would bedrag-along clauses, which can force a minority shareholder to agree to a sale of the whole company.
Change of policy by HMRC
Under the EMI legislation there is a requirement to set out details of restrictions on the shares at the time of grant. Until July 2016 it was acceptable to HMRC that the company could simply refer the employees to its articles of association for details of the restrictions. However, HMRC then changed their guidance stating that this was no longer sufficient and details of the restrictions must be set out either in the option agreement itself or another document attached to the agreement.