What if ineligible for EMI?
EMI options remain the most flexible and tax efficient way to provide equity to staff. But, not everyone can qualify for the special benefits of EMI options. The list includes people who can be key such as contractors, NEDs and founders with substantial shareholdings. We explain equity incentive ideas for those ineligible for EMI.
Generally, unapproved options are not tax efficient compared to other equity incentives. If the unapproved options are exit only – i.e. exercised on the sale of the business , then the combined rate of income tax and national insurance payable on the gain can exceed 52%, if calculated at current, top tax rates.
The gain for income tax and social security purposes is the difference between the price paid to acquire the shares less the value of shares at the time of exercise. The reason why most unapproved options are exit only is because only on exit do option holders possess sufficient funds to pay the tax. Unfortunately, exercising on an exit means there is no capital growth which could attract lower capital gains tax rates . The gain is subject to tax in full on exercise.
Example of tax payable on an unapproved option
Example of tax payable if an unapproved option was exercised by a founder director on exit:
- Assume proceeds on sale = £500,000 and the founder did not have to pay to exercise the unapproved option
- Income tax liability on exercise of unapproved option @ 45% = £225,000;
- Employer’s social security say @ 13.8% = £69,000;
- Employee’s social security say @ 2% = £10,000;
- Proceeds left after tax on exercise of unapproved option = £196,000.
|Proceeds on Sale||£500,000|
|Income tax liability||@ 45%||(225,000)|
|Employer’s Social Security||@ 13.8%||(69,000)|
|Employee’s Social Security||@ 2%||(10,000)|
The advantage of a share award is the award can be structured so that any growth in value (i.e. the difference between the amount the paid to acquire the shares and the exit value) falls to be treated as capital rather than income. Rates of capital gains tax range from 28% to 18% depending on earnings and 10% if Business Assets Disposal Relief (entrepreneurs’ relief) is available.
Basic tax charge where shares are awarded
The basic rule is that if an employee (or an employed director) is given shares at undervalue or a discount HMRC will seek to charge income tax and in some cases social security. The amount charged to tax will be the difference between the amount paid to acquire the shares and the “tax market value”.
Tax market value
The tax market value in cases where this is likely to be less than any established value for the shares is negotiated with HMRC. Depending upon the circumstances it is usually possible to agree that the tax market value is less than any the investment valuation. The factors which are taken into account in looking at tax market value include, but are not limited to, total voting control of the company, dividend rights, growth projections, and restrictions on the shares such as good and bad leaver clauses. It is necessary to review the accounts for matters such as the level of salaries being pulled out of the business. If the shares subsequently decline in value after the point of award HMRC will not rebate any of the income tax paid.
Flowering shares are initially awarded at a low value since they are subject to milestones. The share gain value, i.e. flower, when the person or company achieves targets.
The tax market value of flowering shares is reduced by the restrictions on the shares. The reduction depends on the facts. The taxable value on receipt is low. Growth in value as the shares “flower” is subject to capital gains tax.
Designing flowering shares
Flowering shares are a different class of share to ordinary shareholders shares. In addition, we usually consider issues such as:
- Voting rights;
- Assets on distribution.
Different share rights
There is plenty of choice. Unfortunately taxation rules are complicated. In addition, ensure the articles and shareholders agreement match your intended position. Note that tax rules are different for self-employed contractors and non-executive directors.
Different rights to dividends
It is possible to issue shares which pay out different rates of dividends. For example, if the investors wanted a certain dividend yield to be satisfied a different class of shares could be used so that founders for example only received a dividend once the investors had received their dividends and investor dividends take priority to founders. The tax market value of shares issued with restricted dividend rights would be reduced compared with ordinary shares. Similarly if voting rights were restricted this would reduce the tax market value.
Different slices of sale proceeds
Developing the idea set out above for dividends, it is possible to issue a separate class of shares which receives sale proceeds as a second slice of sale proceeds after ordinary shareholders or investors have taken the top slice.
Nil paid or partly paid shares
Shares can be issued at full value and the subscription price left outstanding. This arrangement does not suit all founders but in the right type of situation can be attractive.