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ER changes divide EMI option holders

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20th Apr 2012
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Changes to Entrepreneurs’ Relief (ER) will create two classes of Enterprise Management Incentives (EMI) option holders when the new rules kick in from April 2013.

The Chancellor sought to alleviate the position on EMI share option schemes in the Budget, but tax experts are now saying not all will benefit.

From next year there will be those who are willing and able to exercise their options in good time to enable a claim for ER and pay tax at 10%; and those who have to pay 28% because of an inability to finance the acquisition of the EMI shares at least one year before an arm’s length sale. 

Kevin Slevin, tax adviser and author of Entrepreneurs' Relief: A Guide for Accountants, pointed out the problem: “A long serving employee who holds share options for many years without being in a financial position to exercise such rights until a sale is about to take place will pay 28% CGT whereas a better placed employee may well be able to organise his finances (often with the assistance of the employer) so that his EMI shares are acquired more than 12 months prior to the ultimate disposal such that the rate of CGT becomes 10%.

“I don’t wish to hark back to the days of taper relief and how EMI shares were treated as owned from the date of the grant of the option because Entrepreneurs Relief was never intended to be a replacement taper relief, but it would make a lot of sense!”

EMI share option schemes had been attractive to many small businesses as a means of enabling selected employees to acquire shares without incurring an income tax charge. 

One downside since the introduction of ER in April 2008 has been that most employees obtaining shares through the operation of an EMI share option scheme suffered CGT at the full rate when they sold their shares, rather than being able to claim the 10% ER rate of CGT.

This situation is often compared with the more favourable treatment afforded under the pre-April 2008 taper relief regime under which most EMI option holders paid an effective CGT rate of 10% on gains crystallised when they disposed of EMI scheme shares.

From 6 April 2013 the need to satisfy the ‘personal company’ test will be removed but only in relation to gains on certain EMI.

The test, which requires a shareholder to possess no less than 5% of both the ordinary shares and voting rights of the company throughout the 12 months prior to the disposal of the shares in question, is to be waived in respect of claims to relief regarding gains on EMI shares.

This will only be so if the shares in question are disposed of after having been held for at least one year following the exercise of the EMI option.

Kevin Slevin pointed out the problem here: “As I understand it the vast majority of EMI share option schemes are designed with a view to employees exercising their options either immediately before a takeover or at the point the company seeks a flotation”. 

Essentially they are to be exercised at the point the controlling shareholders are seeking to exit and in the majority of instances where an EMI option will be exercised the shares will be held for only a matter of hours before they are disposed of.

Accordingly, the one-year rule will not be met and so the CGT rate will be 28% for taxpayers liable at more than the basic rate of income tax.

The only exception to this will be where an employee already holds more than 5% of the shares (and voting rights) throughout the year prior to disposing of his combined interests in the company.  Here, relief will be due as the basic entrepreneurs’ relief provisions will be satisfied.

Those option holders lucky enough to be employed by a company financially backed by a private equity based organisation may find themselves able to take advantage of the suggested Finance Bill 2013 amendments.  Here, there will almost certainly be a well-planned exit strategy in place allowing the employer to:

  • alert option holders to exercise their options at least one year before a change of ownership
  • arrange the necessary employee loans to enable EMI option holders to fund payment of the exercise price in good time

Exercising an option at least one year before a takeover is expected to take place, allows ER to be claimed by continuing employees on a disposal on or after 6 April 2013. They simply have to show that, throughout the one-year period ending on the date they disposed of the shares, they were employed by the company and can be properly described as a trading company.

Slevin added: “Clearly, there is a difference in the financial risk being taken by employees investing more than a year before the ultimate share disposal compared to the risk taken by those investing at the last minute before a takeover, but is it a good idea to have two classes of EMI option holders – those who have and those who have not got the opportunity to exercise the options they hold in good time?”

Replies (5)

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By Ruddles
23rd Apr 2012 10:35

Slightly off-topic

Does the change offer a basic planning opportunity? Say company is considering issuing 10% of its share capital to 10 employees (1% each). Straight issue of shares - no ER. But grant options that meet all the EMI conditions, and the options are exercised next day - ER after 12 months. Too good to be true?

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By gbuckell
23rd Apr 2012 11:18

Para 4 Sch 5

It does sound too easy and I suspect might be caught by ITEPA 2003 Sch 5 para 4 which prevents options from being qualifying options where they are issued as part of a scheme to avoid tax

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By dwgw
23rd Apr 2012 16:13

Why would that be tax avoidance?

 Not sure why that would be deemed to be avoidance.  If the EMI conditions are met, there's nothing to stop options being exercised immediately and it's likely to trigger either an income tax charge (if exercised at a discount to market value) or the employee will pay MV for his or her shares.  Nor is CGT being avoided, it's just that the EMI scheme would be structured so as to enable ER to be claimed and a lower rate of CGT secured.

I don't see how that could be tax avoidance.

Surely the relaxation in these rules is designed to encourage employees to actually own shares (and not just to exercise options immediately before a share sale)?  Another planning opportunity - dividends can be paid.

  

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By naomi2000
24th Apr 2012 16:45

Practical company share scheme problems

The new two speed system will put small companies under pressure to permit early option exercise. It is common for smaller companies to restrict the exercise of options to immediately before a sale /etc .

Permitting early exercise can increase the running costs and stress of operating a share scheme for a smaller company as well as causing cashflow headaches when there are employee leavers.

 

 

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Replying to RFSummers:
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By dwgw
24th Apr 2012 18:11

Tailor the EMI scheme to do what you want

naomi2000 wrote:

The new two speed system will put small companies under pressure to permit early option exercise. It is common for smaller companies to restrict the exercise of options to immediately before a sale /etc .

Permitting early exercise can increase the running costs and stress of operating a share scheme for a smaller company as well as causing cashflow headaches when there are employee leavers.

Restrictions on exercise are usually because of a fear of dilution.  In my experience, that's more of an emotional issue than a real one.  EMI shareholdings needn't dilute control in any meaningful sense and dividends can be paid separately.  If it's properly planned, there's rarely a reason why early exercise should be a problem, unless the company doesn't really want any employee participation.

The potential cash flow headache can also be addressed by writing in suitable good leaver/bad leaver provisions.  If employees leave, there's no requirement that they be paid out any more than they put in, which might only be the nominal value of their shares.  If they don't like that, too bad.  They should be grateful to be given the opportunity; it's up to them if they choose to pass it up by leaving early.

The beauty of EMI schemes is their flexibility.  If companies try to set them up on the cheap and without any real thought, they'll probably get a scheme that causes them problems.  If they treat it as the investment it should be and work with their advisers (which requires a bit of strategic thinking but doesn't cost much more), they'll get a scheme tailored to their commercial needs and providing real incentives to key staff - which is exactly what EMI was intended to do!  

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