Tax efficient alternatives to EMI

The complex conditions for Enterprise Management Incentive (EMI) tax relief mean that EMI may not be available to every private company looking to provide share incentives. We help employers identify tax-efficient alternatives to EMI for employees, directors, non-executive directors and consultants in private companies.

There are a variety of reasons why EMI options may not available, including:

• The employee/director has exceeded the EMI limit on the value of shares that can be held under EMI;
• The employee/director holds other appointments, such as non-executive directorship;
• The number of employees or the company’s circumstances mean that the relevant EMI eligibility conditions are not met; and
• The EMI group independence or qualifying subsidiary requirements are not met.

Alternatives to EMI

When looking for alternatives to EMI it is essential to ensure that directors and employees are offered share incentives that are sufficiently motivating while rewarding genuine performance. Equally, companies should avoid unnecessarily complex share structures and aim to offer share incentives that their workforce can readily understand.

Nil-paid shares, growth shares and joint share ownership arrangements are all potentially tax-efficient alternatives to EMI. They can also provide greater flexibility where the upfront cost of acquiring shares would be too high for employees given what they can afford to pay and the risk they are prepared to take. These alternatives can also be available to non-employees, such as consultants and non-executive directors, who would not be eligible for EMI. They are also likely to be suitable for companies expecting to grow shareholder value in the future, as participants generally benefit from growth in value arising after the shares are awarded.

Employers may consider these alternatives where the value of shares that can be awarded under EMI has been exceeded or where the company does not satisfy the relevant EMI eligibility requirements.

Objectives behind the alternatives to EMI

The primary objective must be to put in place an effective arrangement that motivates employees to commit longer term to growing the business. Another objective is to provide tax efficiency where possible and bring future growth within the capital gains tax (CGT) regime where the relevant conditions are satisfied. The CGT rate will depend on the individual’s circumstances and whether any relief, such as business asset disposal relief (BADR), is available. Income tax and National Insurance contributions can, by contrast, result in a significantly higher overall tax liability.

The type of alternative will depend upon the existing value of the shares and the tax consequences attaching to the share transaction. We can advise on the issues involved and the most appropriate structure for the circumstances.

Nil paid shares

Nil-paid shares involve employees acquiring shares without paying the full purchase price immediately. Instead, participants agree to pay for their shares in the future, for example, on an exit event involving the company. Awards are made by the Board to such recipients as the Board selects.

The advantages for participants include the benefits of immediate share ownership, which may include dividends. By contrast, an EMI option holder will not generally be entitled to dividends before exercising their options. The main advantage is that employees may be subject to capital gains tax when they sell their shares rather than income tax and potentially NICs, provided the relevant conditions are met. If the employer releases an employee from the obligation to pay the outstanding purchase price, the amount released may be treated as employment income.

There are also income tax consequences of an employee holding partly paid shares. The outstanding purchase price may be treated as a loan provided by the employer. This amount, known as a ‘notional loan’, can give rise to an annual benefit-in-kind charge, together with employer’s NICs where applicable, until the purchase price is paid. The benefit-in-kind rules contain an exemption where the employee’s outstanding beneficial loan balance, when aggregated with other relevant employment-related loans, does not exceed £10,000.

The value attributed to the shares for tax purposes will be based on an appropriate fiscal valuation and may differ significantly from the commercial valuation of the company.

Growth shares

Growth shares involve the creation of a new class of share and are made at the discretion of the Board to such recipients as the Board select. The shares will have limited value when acquired because growth shares will only be entitled to a proportion of the growth in shareholder value above a ‘hurdle’. This will usually be linked to the company’s performance or exit value.

The up-front cost to employees of acquiring growth shares should be relatively low where the shares have little or no value at the time of acquisition. This is because the shares do not benefit from any existing value of the company and will only be entitled to a proportion of value created above a hurdle. The main advantage of growth shares is that employees may be subject to CGT when they sell their shares.

When awarding growth shares, key factors will be the share valuation and setting the amount of the hurdle. Specialist valuation advice may be required to establish an appropriate hurdle and initial share value.

Unapproved options

Unapproved options are generally the least tax-efficient arrangement, but they are also among the most flexible because there are no EMI-specific statutory eligibility conditions to satisfy. This means they can be granted to a wide range of individuals, including consultants, non-executives, employees and directors, on such terms and with an exercise price as the Board determines. However, any gain made by the unapproved option holder on exercise will generally be subject to income tax and, depending on the circumstances, National Insurance contributions.

It is possible for the unapproved option holder and the employer to elect that the option holder bears the employer’s National Insurance liability. This can be particularly relevant where the option arrangement is being used for employees or directors.

In summary, the above arrangements can deliver tax-efficient alternatives where EMI is not available or suitable. However, specialist advice is important to minimise potential exposure to income tax and NICs and to ensure the arrangements are implemented correctly.

In our experience costs can be saved by taking time to establish the appropriate structure and objectives before drafting begins.