The Enterprise Management Incentive (EMI) scheme is a popular tool among UK businesses to attract and retain top talent by offering tax-advantaged share options to employees.
However, navigating the complexities of EMI compliance can be challenging. There are detailed tax rules which have to be followed set out in the EMI Code. Any oversight or error can cause significant issues, particularly when on a business exit or sale, where non-compliance can jeopardise the scheme’s tax benefits and impact the value of the transaction. Below are some common pitfalls companies face when implementing EMI schemes and ways to avoid them.
1.Eligibility Criteria
One of the most common errors is failing to meet the basic eligibility requirements for an EMI scheme. HMRC has set specific criteria that companies must meet to qualify. Granting options under the EMI scheme to companies that do not meet the eligibility criteria means the options would never qualify as EMI options, resulting in the loss of associated tax benefits.
One of the eligibility requirements is that the company must have gross assets of £30 million or less at the time the options are granted. Once this threshold is exceeded, the Company will cease to be eligible, and any further options issued by the Company will not qualify for EMI tax benefits. Note, however, that existing options granted prior to the threshold being exceeded are not affected. After all, the point of the EMI Code is to promote growth by incentivising and rewarding employees and it would be counter-productive to punish growth by disqualifying options issued by a Company which has grown.
The Company must be trading, and its activities must not fall within a list of excluded activities. If the Company changes the nature of its activities so that it is no longer trading, or the activities change so that they fall within the list of excluded activities, this may count as a disqualifying event. Certain industries like banking, insurance and property development are excluded from the scheme.
How to avoid:
Companies must conduct thorough due diligence before setting up an EMI scheme. This includes audits of their financial position to ensure gross assets remain within the £30 million limit prior to grant of EMI options and a careful assessment of their business activities to confirm they do not fall into excluded sectors.
Seeking professional advice if there is a significant change in the nature of trading activities.
Seeking professional advice from accountants or legal experts specialising in EMI schemes can help companies navigate these requirements and avoid costly mistakes.
HMRC Small Company Enterprise Centre will provide advance clearance that proposed schemes will meet the EMI Code requirements.
2.Incorrect Valuation of Shares
Failing to assess the correct market value of shares is another frequent issue. The valuation directly impacts on the tax advantages of the EMI options, so it must be accurate. Although there is no requirement to obtain a formal HMRC valuation of EMI option shares, most advisors strongly recommend that a company does so. This is to ensure that the company does not exceed the individual and company limits on the grant of EMI options and that the EMI options are granted at market value (if that is what is intended). When making these calculations it is important to use Unrestricted Market Value (UMV). UMV is the value of the shares over which the options are to be granted, which ignores any restrictions which apply to those shares (for instance, a restriction which requires an employee to sell the shares if they cease to be an employee). If an HMRC valuation is obtained, then the options must be granted in the window of time allowed. Once the window set by HMRC has expired, the same issues and consequences may apply as for failure to obtain a valuation at all.
While EMI options can be granted at a discount to market value, it is important to note that the tax treatment of discounted options differs. If an option is granted at a discount, the difference between the market value of the shares at the date of grant and the exercise price will be treated as taxable income when the option is exercised.
For example, if the market value of the shares at the date of grant is £10 per share but the option is granted at an exercise price of £5 per share, the £5 discount is subject to income tax at the time of exercise. This contrasts with options granted at market value, where no income tax is due on exercise, and any gain is taxed as capital gains upon the sale of shares.
How to avoid:
Use professional valuation services to ensure your share valuation is realistic and defensible. Valuation is usually done by an accountant or professional share valuer.
Although not a requirement, it is advised to submit the valuation to HMRC for approval to avoid potential disputes. The approval process usually takes four weeks.
3.Failure to notify HMRC on time
Companies must notify HMRC by 6 July following the end of the tax year the grant was made in (but if the option was granted before 6 April 2024, then 92 days after the date of grant).
Failure to notify HMRC by the deadline means share options no longer qualify and become unapproved options, resulting in loss of tax advantages associated with the EMI scheme.
It is important to note that HMRC’s online portal does not allow you to retrieve forms after submission. Therefore, it is important to obtain screenshots at time of submission.
How to avoid:
Set up reminders for the notification requirements.
Consider engaging legal or accounting professionals to manage the notification process, ensuring that it is handled accurately and on time. They can also help navigate complex issues related to option grants and ensure all requirements are met. It is important to also note that appointing an agent can take time (it may take up to two weeks for the company to obtain an agent authorisation code).
Obtain screenshots of submission on HMRC online portal. This can serve as evidence of compliance.
4.Changes in Control
Significant changes in a company's ownership may be a disqualifying event.
The “independence test” requires the company to be independent and not under the control of another company at the time the options are granted and at all subsequent times until exercise of the options. For example, if a company undergoes a funding round which results in the investor becoming a controlling corporate entity (i.e where more than 50% of the Company’s share capital is directly or indirectly owned by another company), the test will not be met. Similarly, if a company undergoes internal restructuring and becomes a wholly owned subsidiary of a new group, the test will not be met.
It is common to find that EMI option agreements have specific provisions dealing with a change of control. These may allow options to be exercised within a short period (usually 90 days), designed in a way to preserve the EMI tax reliefs.
EMI tax benefits can sometimes be preserved following a change of control of the EMI company through a rollover of EMI options whereby the new parent company grants replacement EMI options in exchange for the surrender of the original EMI options. There are specific rules in the EMI Code which have to be satisfied for a rollover.
How to avoid:
Review the impact of any share ownership changes on the EMI scheme with a legal advisor who can assess whether the changes will affect the EMI options and if needed, recommend an appropriate course of action.
Seek legal advice on EMI option rollovers. Replacement options must meet HMRC conditions to preserve EMI tax benefits.
5.Changes to terms of EMI options
Companies may believe that they can easily alter the terms of existing EMI options if the option holders agree. But this can be disastrous if HMRC takes the view that, in effect, a new option has been created.
Any change that increases the value of the EMI option shares is a disqualifying event. If options are not exercised within 90 days, income tax will be due.
Any non de minimis changes will also be treated as a grant of a new EMI option. This can cause problems if the company or the individual no longer qualifies under the EMI code or the value of the shares has changed. What HMRC views as de minimis will depend on the facts. A de minimis change means minor changes to existing rights. HMRC guidance on this topic has been published and can be see online in the relevant manuals.
How to avoid:
Companies should take advice to confirm that the proposed changes to the terms of EMI options will not affect the tax position of existing options.
Possibly, seeking advice from HMRC on whether the proposed amendment will be approved as a de minimis change without losing tax benefits.
Conclusion
EMI schemes offer significant benefits, but compliance is key to maintaining these advantages. By understanding and avoiding common pitfalls, businesses can ensure that their EMI schemes remain compliant. Regular consultation with legal and financial professionals is crucial in navigating the complexities of EMI compliance, safeguarding the scheme’s benefits for both the company and its employees.
Related Expertise
Disclaimer: This publication is provided by Laytons LLP for informational purposes only. The information contained in this publication should not be construed as legal advice. Any questions or further information regarding the matters discussed in this publication can be directed to your regular contact at Laytons LLP or Laytons’ Corporate team.