Small and medium-sized enterprises (SMEs) who want to incentivise and retain talented employees frequently turn to EMI share option schemes and with good reason.
EMI share options can be an extremely tax-effective way to recruit, retain and motivate talented and valuable staff members.
As well as being highly tax-efficient, EMI options can also be very flexible – the company and employee must meet certain conditions, but beyond that, there is wide scope in terms of exactly how a scheme is drawn up.
In my 30-odd years in business, I have never known labour markets in the UK to be so tight, and at the same time trading conditions are tough for a lot of small businesses.
As a result, the issue of how to retain key employees whilst keeping payroll costs within sensible limits is sharply in focus right now.
What’s the basic idea?
Employees have the option to buy a fixed number of company shares at a predetermined price, known as the 'exercise price'.
They can choose to buy these shares later, paying only the original price, even if the shares have increased in value.
They can then sell the shares at the current market rate, profiting from the increase in value.
Example
Josephine, an employee of ABC Ltd, is granted EMI options over 100 shares in the company.
The value of the shares at the time the options are granted, agreed with HM Revenue & Customs (HMRC), is £5 per share and the exercise price is also £5 per share.
Three years later the shares have risen in value to £100 per share and Josephine decides to exercise her right to buy the shares for the exercise price of £5 per share.
She might decide to retain the shares, or they may be sold, potentially realising further value.
Josephine has several financial advantages in this case:
- She incurs no Income Tax, National Insurance Contributions (NICs), or Capital Gains Tax (CGT) when exercising her options.
- The company benefits too, as it can deduct the difference between the exercise price and the market value at the time of exercise from its taxable profits.
When she sells her shares, she may be subject to CGT on any profits. However, she has an opportunity to offset this.
She may qualify for Business Asset Disposal Relief (BADR), which would reduce her CGT rate to just 10 per cent on the first £1 million of lifetime gains.
Importantly, the two-year qualifying period for BADR starts from the date the options are granted, not when they are exercised.
How it works
In an EMI Scheme, employees have the opportunity to buy a specified number of company shares at a predetermined price.
This is formalised in an option agreement, and both the company and the employee must meet certain criteria for the scheme to be valid.
An accountant can assist in obtaining HMRC approval to ensure eligibility.
The options can be for different classes of shares, each with its own set of rights, such as voting or dividends.
These options often come with performance and time-based conditions and may be 'exit-only,' meaning they can only be exercised if the company is sold.
Financially, the scheme offers various tax benefits and share valuations are usually agreed upon with HMRC, providing a higher degree of tax certainty.
Two key valuations are:
- The Actual Market Value (AMV)
- The Unrestricted Market Value (UMV)
If the exercise price is set below the AMV, employees should anticipate Income Tax and possibly National Insurance Contributions (NIC) charges.
However, Capital Gains Tax (CGT) is generally only applied to the profit from selling shares that haven't already been subject to Income Tax.
A reduced CGT rate of 10 per cent may be available through Business Asset Disposal Relief (BADR).
The company also benefits by being able to reduce its Corporation Tax based on the difference between the exercise price and the share value at the time of exercise.
Compliance, as always, is crucial so speak to your accountant about these matters whenever you are considering share schemes.
Both parties must continuously meet the scheme's conditions, as certain 'disqualifying events' can limit available tax reliefs.
However, options can generally be exercised within 90 days of such an event to maintain tax benefits.
It's also mandatory to notify HMRC within 92 days of granting options and to fulfil annual reporting obligations.
Are EMI share option schemes suitable for all situations?
EMI share option schemes are subject to specific eligibility criteria, including:
- The issuing company must be independent. In a group structure, the parent holding company should issue the options, and at least one subsidiary must engage in a qualifying trading activity.
- The company or its group must employ fewer than 250 full-time staff.
- Employees must work at least 25 hours per week or dedicate at least 75 per cent of their total working time to the company, both at the time of the option grant and thereafter.
- An individual can be granted options for shares worth up to £250,000.
- The overall value of shares that can be granted under the EMI scheme is capped at £3 million.
- Companies in certain industries are ineligible to participate.
In circumstances where a company wishes to reward individuals with equity, but EMI options are unavailable, Scholes can advise on alternative solutions.
Why not just issue shares to your employees?
Issuing EMI share options is often a more advantageous way to reward employees with equity compared to directly issuing shares.
This approach provides greater tax certainty and offers significant tax benefits for both the employees and the company.
If you intend to reward employees with direct share schemes, a careful analysis of the position and the alternatives available should always be undertaken with appropriate input from tax and legal professionals, like those at Scholes.
How Scholes CA can help
Scholes CA has significant experience helping companies design and implement EMI share schemes in compliance with regulations, as well as aiding with ongoing compliance obligations.
Recent examples of our work:
- For a construction company aiming to retain and motivate a key employee, we crafted an 'exit-only options scheme' for a portion of the company's shares, targeting a business sale in six to eight years.
- For a logistics start-up looking to incentivise a crucial team member, we created an options scheme covering up to 50 per cent of the company's shares, with performance-based conditions and a five-year vesting period.
- A manufacturing firm seeking to retain a select group of employees for a three-year exit plan consulted us. We developed an 'exit-only options scheme' for a small share of the company.
- In the renewable energy sector, we enabled a key employee of a new subsidiary to receive options in the parent company, tied to the subsidiary's financial and operational performance.
- For another manufacturing start-up aiming to keep and motivate specific directors, we set up an options scheme over a share of the company, with performance conditions and a three-year vesting period.
- An online retail company granted two key employees 'exit-only options' for a percentage of the company's shares.
Next steps
Scholes CA assists companies with all aspects of EMI share options schemes and can deal with all relevant aspects. If you are considering rewarding employees with shares or share options – or would simply like to know more about the topics discussed above – contact me personally at ivan@scholesca.co.uk.
We are happy to work alongside a company’s existing accountants and solicitors to put EMI schemes and other share remuneration arrangements in place.
For more information on Scholes CA’s services, please visit our website.
