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Enterprise Management Incentives

This guidance has been replaced by the guidance contained in the Employee Share Schemes User Manual (ESSUM). Please see the ESSUM for further information about EMI.

A guide for employees, employers and advisers

This guidance aims to take you through the qualifying requirements for Enterprise Management Incentives (EMIs). It is divided into sections which explain each part of the legislation contained in Schedule 5 Income Tax (Earnings and Pensions) Act 2003. Detailed points are covered in a question and answer context. It also explains some key terms used.

Unless otherwise stated, the statutory references in this guidance are to the Income Tax (Earnings and Pensions) Act 2003, and the abbreviations ITEPA 2003 and Sch 5 have been used throughout.

Remember that if you grant EMI options you may also have to consider other laws and rules. For example, there may be company law and regulatory requirements to comply with. Such matters are not covered in this guide so you should consider whether you need to take relevant professional advice.

The information contained here is for guidance only. EMI options must at all times comply with the provisions of Schedule 5 ITEPA 2003.

What’s in this guidance

What are Enterprise Management Incentives?

EMIs are tax advantaged share options. They are designed to help small, higher risk companies recruit and retain employees who have the skills to help them grow and succeed. They are also a way of rewarding employees for taking a risk by investing their time and skills to help small companies achieve their potential.

How EMIs work

Tax advantaged share options with a market value of up to £250,000 from 16 June 2012 (£120,000 prior to 16 June 2012) may be granted to a qualifying employee of a qualifying company, subject to a total share value of £3 million under EMI options to all employees.

The shares must be in an independent trading company that has gross assets of no more than £30 million.

The grant of the option is tax-free and there will normally be no tax or National Insurance contributions for the employee to pay when the option is exercised. There will normally be no National Insurance contributions charge for the employer.

The employer must notify Her Majesty's Revenue & Customs (HMRC) of an award of EMI options within 92 days of the grant of the option.

Throughout this guidance all references to employer are to the employing company.

How companies qualify for EMI

For companies to qualify they must have maximum gross assets of no more than £30 million; for groups, this applies to the assets of the group as a whole. The company whose shares are the subject of the option must be independent, and the company or group must be trading. Companies carrying on certain trades will not qualify.

There is more detail on qualifying companies.

How options qualify for tax relief under EMI

If an option is to qualify for tax relief:

  • the option has to be notified to HMRC in time and as required
  • the company whose shares are under option has to be a qualifying company
  • the type of share under option has to qualify
  • the employee has to be eligible
  • the terms of the option have to qualify

What makes an employee eligible

To qualify for EMI an employee has to be employed by the company whose shares are the subject of the option, or by a subsidiary. An employee must spend at least 25 hours a week working for the company or the group. If his hours are shorter, he must spend at least 75 per cent of his working time working as an employee for the company or group.

There are more details on employee eligibility.

How EMIs work

This section outlines the main requirements for options to qualify under EMI, they are:

  • the purpose of the option
  • the maximum entitlement of the employee and
  • the overall limit on options to be granted by the company

The purpose of the option

The options must be granted for commercial reasons to recruit or retain employees in a company, and not as part of an arrangement, one of the main purposes of which is to avoid tax. (Para 4 Sch 5).

Can a company cancel existing options and replace them with EMI options?

If the option is granted to recruit or retain employees the purpose test is met. This will depend on the facts and all the circumstances.

Maximum entitlement

No employee may hold unexercised qualifying EMI Options with market value of more than £250,000 from 16 June 2012 (£120,000 prior to 16 June 2012). The market value is taken at the date of grant. The value to be used is the unrestricted market value, that is, the value of shares under option without taking into account any restrictions or the risk of forfeiture

If an option granted to an employee causes the £120,000 limit to be exceeded, the excess will not qualify as an EMI option.

Are there limits on the number of qualifying options that an employee may be granted within a particular period?

Yes. Once an employee has been granted EMI, or EMI and Company Share Option Plan (CSOP) options up to the £250,000 from 16 June 2012 (£120,000 prior to 16 June 2012) limit, he must wait until three years after the last of these options was granted before he can be granted any EMI qualifying options, even if he has exercised or released some of the options. He can then be granted further EMI options to the extent that any other EMI or CSOP options then held by him are below the £250,000 limit. (Para 6 Sch 5)

How are shares valued for the purposes of the £250,000 limit?

The market value of any shares for this purpose is the price they might reasonably be expected to fetch on the open market, free from any restrictions or risk of forfeiture to which they may be subject.

If the shares under option are quoted on the London Stock Exchange, the market value is based on the prices on the Stock Exchange’s Daily Official List. If shares are not quoted on the London Stock Exchange, the company may offer its own valuation. In that case, HMRC may enquire into the valuation.

Alternatively, the company can ask HMRC Shares and Assets Valuation (SAV) to agree a valuation with them before the option is granted or whenever a valuation is required. Companies, or advisers, may find this helpful.

If the exercise of the option is subject to performance conditions will this affect the determination of market value?

No. Performance conditions are not taken into account when determining the market value of the shares under option.

Is there a limit on the number of employees who may hold EMI options?

No. Any number of employees may hold EMI options in a company or group, subject to a maximum of £3 million as the total value of shares under EMI option in a company.

Qualifying companies

This section sets out the conditions a company has to meet to qualify for EMI, they are:

  • independence
  • having only qualifying subsidiaries (including qualifying property managing subsidiaries after 17 March 2004)
  • gross assets
  • number of employees
  • trading activities

The requirements that companies have to meet for options to qualify under EMI are similar to the requirements for the Enterprise Investment Scheme, the Corporate Venturing Scheme and Venture Capital Trusts. However, both quoted and unquoted companies can qualify for EMI.

Independence

A company whose shares are subject to EMI options must not be:

  • a 51 per cent subsidiary (more than 50 per cent of its ordinary share capital owned by another company), or
  • controlled by another company (or another company and persons connected with it).

Arrangements must not exist which could result in the company becoming a 51 per cent subsidiary or otherwise being controlled. (Para 9 Sch 5)

Control in this context means the power of one company to ensure that the affairs of another company whose shares are subject to EMI option are conducted in accordance with that company’s wishes. This may be through share ownership, voting power, or because of any powers conferred by Articles of Association or other document.

Qualifying subsidiaries (before 17 March 2004)

For options granted before 17 March 2004, all of a company’s subsidiaries must be qualifying subsidiaries. That is, the company whose shares are subject to EMI options must:

  • possess, directly or indirectly, at least 75 per cent of the share capital and the voting power of the subsidiary
  • be entitled to receive at least 75 per cent of the assets of the subsidiary, in the event of a winding up or in any other circumstances, if they were all distributed
  • be entitled to at least 75 per cent of profits of the subsidiary available for distribution to shareholders.

No other person must be able to control the subsidiary (control having the same meaning as it has for the independence requirement.)

There must be no arrangements in existence by virtue of which any of these conditions would cease to be met.

If a subsidiary company itself has subsidiaries, shares will not qualify to be used in an EMI option unless all these subsidiaries are also qualifying subsidiaries, as defined above.

Example one

Company A has a 75 per cent shareholding in subsidiary company B, and the same per cent rights to votes, assets and income. Company B is therefore a qualifying subsidiary.

Company B has a 75 per cent shareholding in subsidiary company C, and the same per cent rights to votes, assets and income. Company C it also therefore a qualifying subsidiary.

Company A meets the EMI requirements in relation to its subsidiaries.

Example two

Company X has a 75 per cent shareholding in subsidiary company Y, and the same per cent rights to votes, assets and income. Company Y is therefore a qualifying subsidiary.

Company X also has a 60 per cent shareholding in subsidiary company Z, and the same per cent rights to votes, assets and income. Company Z is not a qualifying subsidiary.

Company X therefore fails to meets the EMI requirements, as not all of its subsidiaries are qualifying subsidiaries.

Qualifying subsidiaries (after 17 March 2004)

For options granted on or after 17 March 2004 all of a company’s subsidiaries must be qualifying subsidiaries. That is, the company whose shares are subject to EMI options must hold, directly or indirectly, more than 50 per cent of the share capital of the subsidiary. (Para 11(2) Sch 5).

No other person must be able to control the subsidiary (control having the same meaning as it has for the independence requirement.)

There must be no arrangements in existence by virtue of which any of these conditions would cease to be met.

There is a further requirement if the company has subsidiaries that manage property.

Qualifying property managing subsidiaries

For options granted on or after 17 March 2004, a company will not qualify if it has a property managing subsidiary which is not a 90 per cent subsidiary of the company. (Para 11A(1) Sch 5).

A property managing company is one whose business consists wholly or mainly in the holding of managing of land, buildings or interest in land.

To be a qualifying property managing subsidiary, the company whose shares are subject to EMI options must:

  • possess, directly, at least 90 per cent of the issued share capital and the voting power in the subsidiary
  • be entitled to receive at least 90 per cent of the assets of the subsidiary, in the event of a winding up or in any other circumstances, if they were all distributed
  • be entitled to at least 90 per cent of profits of the subsidiary available for distribution to shareholders.

No other person must be able to control the subsidiary (control having the same meaning as it has for the independence requirement.)

There must be no arrangements in existence by virtue of which any of these conditions would cease to be met.

Gross assets

The value of the company’s gross assets must not exceed £30 million at the date the EMI option is granted. If the company is a member of a group of companies, the limits are applied to the gross assets of the group as a whole.

How are gross assets calculated for EMI?

HMRC Statement of Practice SP2/00 outlines how to do this. For further information see Press Release PR133/00 'More certainty for companies using corporate venturing'

Number of employees

From 21 July 2008, there is a requirement that a company has to have fewer than 250 employees in order to grant EMI options. A qualifying company must have fewer than 250 full time-equivalent employees at the date on which an option is granted. The number of employees requirement applies to employees of the company and all its qualifying subsidiaries, whether or not they are based in the UK. Directors are counted as employees for the purpose of this test, but apprentices, students on vocational training, and employees on maternity or paternity leave at the time an option is granted are not to be counted.

HMRC regard a full-time employee as someone whose standard working week (excluding lunch breaks and overtime) is at least 35 hours. Any employee who worked longer than those hours would still only count as one full-time employee. Where there are part-time employees their full-time equivalence can be calculated on any 'just and reasonable' basis. For example, someone working 21 hours a week would be expected to count as 60 per cent of a full-time employee. Someone working 'one week on, one week off' would count as 50 per cent, while the proportion of an employee working in term times only would depend on the length of those terms in relation to the year as a whole.

Options granted before 21 July 2008 are not affected by this. If a qualifying EMI option was granted before that date by a company with 250 or more full-time equivalent employees, the option remains a qualifying option, but the company cannot grant any more EMI options.

Trading activities

A qualifying trade is a trade carried on wholly or mainly in the UK on a commercial, profit making basis, and which does not, to any substantial extent, include certain excluded trading activities, listed later in this section.

Carrying on research and development from which a qualifying trade will be derived, or benefit, is treated as carrying on a qualifying trade (but preparing to carry on research and development does not count as preparing to carry on a qualifying trade). The derived or benefiting trade must be carried on by the same company, or by another company in the same group.

Research and development means activities that are treated as research and development in accordance with normal accounting practice, but excludes oil and gas exploration or appraisal.

Single companies

If a company is not a member of a group it must exist (apart from any incidental purposes) wholly for the purpose of carrying on one or more qualifying trades. It must also be either:

  • carrying on a qualifying trade
  • or preparing to carry on a qualifying trade (which it must begin within two years of the options being granted)

Holding and managing property used by the company, and holding shares to which investment relief is attributable, if this is not a substantial part of the company’s business, are disregarded. (Para 13 Sch 5)

Parent companies

Where the company is the parent of a group, the business of the group must not consist to any substantial extent of carrying on activities other than qualifying activities. At least one company in the group must meet the same conditions as those described for the single companies. (Para 14 Sch 5).

The business of the group means all the activities of the companies in the group taken together.

In determining whether a group company exists for the required purpose, the following intra-group activities are disregarded:

  • holding shares in, securities of, or making loans to, another company in the group
  • holding and managing property used by a company in the group for non-financial trade purposes carried on by a group company
  • holding shares to which investment relief is attributable, if this is not a substantial part of the company’s business
  • incidental activities of a company which meets the trading activities requirement for a single company

Excluded trading activities

A trade will not qualify if one or more excluded activities together amount to a substantial part of it. Excluded trading activities (in Paras 16–23 Sch 5) are:

  • dealing in land, commodities or futures, shares, securities or other financial instruments
  • dealing in goods, otherwise than in the course of an ordinary trade of wholesale or retail distribution
  • banking, insurance, money-lending, debt-factoring, hire purchase financing or other financial activities
  • leasing (including letting ships on charter, or other assets on hire) or receiving royalties or other licence fees
  • providing legal or accountancy services
  • property development
  • farming or market gardening
  • holding, managing or occupying woodlands, any other forestry activities or timber production
  • shipbuilding, producing coal and producing steel (with effect from 21 July 2008)
  • operating or managing hotels or comparable establishments, such as a guest house or hostel, or managing property used as a hotel or comparable establishment
  • operating or managing nursing homes or residential care homes, or managing property used as a nursing home or residential care home
  • providing services or facilities for a business carried on by another person if:
    • the business consists to a substantial extent of excluded activities,
      and
    • a controlling interest in the business is held by a person who also has a controlling interest in the business carried on by the company providing the services or facilities

Two exceptions to the excluded activities are:

  • The receipt of royalties and licence fees, where the amounts received can be attributed to the exploitation of relevant intangible assets. A relevant intangible asset is one, the greater part of which (in terms of value) has been created by the company carrying on the trade, or by another company in its group. Intangible assets are defined in line with normal accounting practice
  • Ship chartering, where the ship is owned by the company and certain other conditions are satisfied. This exception does not apply to oil rigs or pleasure craft.

The trade or activity must be carried on wholly or mainly in the UK.

How to determine whether a company carries on its trade wholly or mainly in the UK

HMRC Statement of Practice SP3/00 sets out how this is done. For more information see Press Release PR133/00 'More certainty for companies using corporate venturing'.

Does the company have to be incorporated or resident in the UK?

No. There are no residence or incorporation conditions.

What is meant by a substantial part of a company’s trade?

Whether particular activities amount to a substantial part of a company’s trade, or the business of a group, is made on the basis of the facts and circumstances of that case. But, it is generally considered that activities amounting to more than 20 per cent of the trade form a substantial part of the whole.

What if a company goes into receivership or liquidation?

Where a company is in administration or receivership, it is not regarded as ceasing to meet the trading activities requirements because of actions taken as a consequence of this. This is subject to the actions being taken for commercial reasons, not as part of a scheme of arrangement for the avoidance of tax.

Can a company qualify if its trade is the development of computer software?

Yes. A company receiving royalties and licence fees from computer software developed by it, or other companies in its group, can qualify if it meets the other requirements of Schedule 5.

Can a company whose computer software is developed from a third party’s software qualify for EMI?

It will depend on the facts. A company may qualify if the licence fees or royalties it receives are attributable to its software, rather than a third party’s, and if the company created at least half of its software in terms of value.

What types of know-how are covered by the exception to the exclusion of royalties and licence fees rule?

The activity is not an excluded activity if the type of know-how would be treated as an intangible asset under normal accounting practice. The exception is not restricted to industrial know-how.

Can HMRC give any advance assurance that a company will qualify for EMI?

Before options are granted, the company secretary, a director, or an agent acting on the company’s behalf may submit details of the company in writing to the Small Company Enterprise Centre (SCEC).

If the SCEC is satisfied, on the basis of the information supplied, that the company will be a qualifying company once the options are granted, it will say so in writing. However, whether the requirements for qualification will, in the event, be met is a question of fact, which cannot be known for certain in advance.

The SCEC can only give an advance assurance about whether the company will meet the qualifying requirements. It cannot give any assurance about other aspects of EMI, such as, whether an individual is an eligible employee.

What information should the company supply in order to obtain an advance assurance?

The company should supply all the information that may be relevant, unless it has already been provided to HMRC, including:

  • a copy of the latest available accounts for the company and each of its subsidiaries
  • an up-to-date copy of the Memorandum and Articles of Association of the company and each of its subsidiaries, and details of any proposed changes
  • details of all trading or other activities carried on, or to be carried on, by the company and its subsidiaries

What makes an employee eligible?

This section sets out the conditions an employee has to meet to qualify for EMI, they are:

  • employment
  • commitment of working time
  • no material interest

Employment

Individuals are only eligible for EMI options if they are employees of the company whose shares are the subject of the options, or, in the case of a group, employees of any qualifying subsidiary of that company.

What do employment and employee mean for EMI?

The term employment includes:

  • any employment under a contract of service
  • any employment under a contract of apprenticeship, and
  • any service under the Crown

Employee has a corresponding meaning.

Can directors as well as employees be granted EMI options?

Directors are classed as employees of a company, and so as long as directors meet the criteria set out for employees they will also qualify for EMI.

Commitment of working time

Employees are eligible for EMI options only if they are required to spend:

  • at least 25 hours each week (the 25 hours requirement), or
  • if less, 75 per cent of their working time (the 75 per cent requirement)

working as an employee for the company whose shares are subject to the EMI option, or for a qualifying subsidiary.

To check if employees meet the 75 per cent requirement their total working time needs to be established. They need to take into account all their remunerative work. This includes employment and any self employment, for example, as a consultant. They then need to check whether their work as an employee for the EMI company or group amounts to 75 per cent of this time. (Para 27 Sch 5).

Example one

A works as an employee of the EMI company for 16 hours a week so he does not meet the 25 hours requirement. He also works as a consultant for 5 hours per week. He does no other paid work. His total working time amounts to 21 hours a week. As 76 per cent of your working time is for the EMI company, he meets the 75 per cent requirement and will qualify the grant of an EMI option.

Example two

B works as an employee of the EMI company for 20 hours a week so she does not meet the 25 hours requirement. She also works as a self-employed engineer for 10 hours per week. She does no other paid work. Her total working time amounts to 30 hours a week. Only 66 per cent of her working time is for the EMI company, so she will not qualify for the grant of an EMI option.

In calculating the total working time, any time on sick leave, annual leave, maternity, paternity or parental leave needs to be taken into account.

If employees do not work as much time as they had planned to do and this brings them below the commitment of 25 hours each week, or 75 per cent of their working time, they are disqualified from holding an EMI option.

Ceasing to satisfy the working hours requirement is a disqualifying event and the tax treatment of an existing option will be affected.

Does an employee have to work for a UK resident company?

No. An employee must simply fulfil the working time commitment and no material interest condition, but if he is not subject to UK tax there will be no relief.

No material interest

An employee is not eligible if he has a material interest in the company whose shares are under option, or, if that company is a parent company, in any group company. A material interest is either:

  • beneficial ownership of, or the ability to control directly or indirectly, more than 30 per cent of the ordinary share capital of the company, or
  • where the company is a close company, possession of or entitlement to acquire rights that would give 30 per cent of the assets, if the company were to be wound up, and make them available for distribution among the participators

An employee has a material interest if:

  • he alone has a material interest in the company
  • he, together with his associates, has a material interest in the company
  • any associate of his has a material interest in the company

For the purposes of the material interest tests, associate means:

  • Relatives of the employee, that is a spouse, parent, grandparent, child, grandchild or remoter relative in the direct line. However for the purposes of EMI it does not include siblings.
  • The trustees of any settlement in relation to which the employee or any relative is or was a settlor.
  • If the company has shares in trust, the trustees of any settlement where the employee has an interest.
  • The personal representatives of a deceased person, where company shares are part of the estate and the employee has an interest in the estate.

Settlement here means a trust. Settlor means the person who provided funds for the trust. (Section 20 ITTOIA 2005).

For EMI, associate does not include the trustees of:

  • approved profit sharing schemes and approved SIPs
  • employee benefit trusts and discretionary trusts, in certain circumstances

The trustees of an employee benefit trust (EBT) are not treated as associates unless the employee, together with his associates except for the trustees of the EBT, has had a material interest in the company at any time since 13 March 1989. This applies if the EBT is a qualifying EBT in accordance with S550 ITEPA 2003.

What happens if an employee acquires a material interest greater than 30 per cent after he has been granted an EMI option?

This does not affect the existing EMI option the employee holds, but he will not be eligible for the grant of any more EMI options.

Do options over shares have to be included in the calculation to determine whether an employee has a material interest?

All shares over which the employee has an option have to be taken into account, except shares that are under EMI option.

About the options

This section outlines the conditions an option has to meet to qualify for EMI:

  • type of share
  • capable of exercise within ten years
  • terms of option to be agreed in writing
  • non-assignability of rights

Type of share

The option must be a right to acquire shares that are part of the ordinary share capital of the company, and

  • are fully paid up
  • not redeemable

How do I know whether or not the shares are fully paid up?

Shares are not fully paid up if there is any arrangement to pay cash for them at a future date.

How do I know whether or not shares are redeemable?

Shares are redeemable if they are to be redeemed for cash. Some shares are redeemed at pre-determined dates or events. There may also be conditions that allow shares to be redeemed at the request of the company or the shareholder.

Capable of exercise within ten years

It must be possible for the option to be exercised within ten years of the date of grant, but it does not have to be exercised within that period. For example, if the exercise of the option depends on the fulfilment of performance conditions, it must be possible to do that within ten years.

However, the option agreement does not have to prevent the employee from exercising the option after that time. If the employee does exercise the option more than ten years after the date of grant, there will be no tax relief under Schedule 5 on the exercise. The tax relief on grant will be unchanged.

Can an EMI option allow for a phased exercise in tranches?

Yes. For example, an option over 1,000 shares can be exercised in tranches of 200 shares on each anniversary of the grant’s date, allowing a full exercise of the option on the fifth anniversary.

Terms of option to be agreed in writing

The option must be in the form of a written agreement between the person granting the option and the employee. The agreement must be retained by the company so that it can be inspected by HMRC if an enquiry is opened into the option.

The agreement must state:

  • The date the option is granted.
  • That it is granted under the provisions of Schedule 5.
  • The number, or maximum number, of shares that may be acquired.
  • The price (if any) the employee will pay to acquire the shares, or the method by which that price will be determined.
  • When and how the option may be exercised.
  • Any conditions (including performance conditions) affecting the terms or the extent of the employee’s entitlement.
  • Any restrictions on the shares. If the shares are subject to a risk of forfeiture, the agreement must contain details of the conditions. Shares are subject to risk of forfeiture if the interest in shares that may be acquired is only conditional within the meaning of s423 Income Tax (Earnings and Pensions) Act 2003.

Can an EMI option be granted as part of an employee share scheme?

Yes, providing the conditions of Schedule 5 are met. The company can decide to set up a new share scheme for EMI, or use an established scheme. It can grant an EMI option on the back of a scheme that has been set up to grant options under a HMRC approved Company Share Option Plan (CSOP). However, it is not essential for EMI options to be granted as part of a scheme, as each EMI option may be an individual agreement.

If EMI options are granted pursuant to a scheme, the relevant parts of the scheme rules must be either:

  • incorporated into the agreement by repeating the relevant parts of the text
  • or attached to the agreement with reference to 'the attached copy of the rules' as part of the agreement

Should details of restrictions, conditions and any risk of forfeiture be incorporated in the option agreement?

The option agreement must contain details of any:

  • restrictions attached to the shares
  • conditions such as performance conditions affecting the employee’s entitlement
  • risk of forfeiture

The option agreement can set out these details in the text of the option agreement itself. Alternatively, the details, which may be contained in another document, can be attached to the agreement itself and incorporated into the agreement by reference to the document. Examples of other documents include:

  • the Articles of Association
  • the share scheme rules
  • a shareholders' agreement which an option holder is required to enter into as a condition of exercising his option

In order to incorporate such details, the option agreement may say, for example, 'these shares are subject to restrictions /a risk of forfeiture set out in the company’s Articles of Association adopted on…'.

Where the details are included by reference to a separate document, the option agreement will need to specify

  • the title of the document
  • when it was dated or adopted
  • the dates of any amendments

Does the option have to be granted by agreement or can it be granted under deed or seal?

The option can be granted under deed or seal. In this case a separate written agreement to the terms of the option will need to be signed by the option holder. This document must contain the conditions set out above.

Can the terms of the option agreement be altered after grant?

Whether any changes amount to a new option is a question of fact and degree. Minor alterations that do not affect the terms of the option and do not increase the market value of the shares that may be acquired, and are not contrary to the requirements of Schedule 5 will generally be acceptable. The date of grant of the option will remain unchanged.

However it will be a disqualifying event if the changes are a variation in the terms of the option and they increase the value of the shares that may be acquired under the option, or result in the conditions of Schedule 5 no longer being met (S536(1) ITEPA 2003).

If the changes amount to a new option, the existing EMI option is released. Any consideration for the release will be chargeable to Income Tax under Section 477 ITEPA 2003. It will be possible for the option to be rolled over into another EMI option, but only if the company and employee continue to qualify for the relief.

Can an employee choose between exercising the option or receiving the difference between the exercise price and the market value of the shares?

The option holder may have the right to choose not to exercise the option and acquire shares, and instead receive a cash payment for the difference between exercise price and the market value of the shares. This type of arrangement is often known as a 'cash cancellation payment'. If the employee accepts a 'cash cancellation payment' rather than exercising the option, there will be no relief under Schedule 5 and the full amount of a cash cancellation payment will be taxable as employment income. The employer is then required to operate PAYE and account for National Insurance contributions.

If the exercise of the option depends upon the satisfaction of performance conditions, will the agreement need to set out the conditions?

Yes. The agreement must set out the performance conditions. (Para 37(3) Sch 5) There are no requirements in Schedule 5 about the type of performance conditions that can be imposed or whether such conditions must be objective.

If the exercise of the option is dependant on the fulfilment of performance conditions, those conditions must be capable of being fulfilled within the period of ten years beginning with the date on which the option is granted. (Para 36(2) Sch 5).

Non-assignability of rights

The terms of the option must prohibit the option holder from transferring any of his or her rights under it.

If the terms of an option allow its exercise after the holder’s death, they must also state that the personal representatives must exercise the option within 12 months of the date of death. (Para 38 Sch 5).

Notification of grant of options

For options to qualify, they have to be granted to recruit or retain an employee.

If a company grants EMI options, including replacement options, it must notify HMRC’s Small Company Enterprise Centre (SCEC) within 92 days of the date of grant.

Companies must send:

  • notification of the grant in the form required by HMRC
  • a declaration by the employee that he or she satisfies the working time commitment (Para 44(6) Sch 5)
  • a declaration by a director or the company secretary of the employer company that the requirements of Schedule 5 are met and that the information provided is to the best of his or her knowledge correct and complete (Para 44(5) Sch 5)

HMRC provide Form EMI 1 to notify grants of EMI options.

How strict is the 92 day limit?

If a company believes it has a reasonable excuse for not notifying HMRC on time, it should send in the notification as soon as the excuse comes to an end. The company should advise HMRC of all the facts. The delay or failure on the part of the company’s agents is not a reasonable excuse on its own. (Para 53 Sch 5).

Is the employer bound by notification requirements if the option is granted by the trustee of an employee benefit trust or another shareholder?

Yes. The employer will need to obtain the relevant information from the trustee or shareholder to comply with Schedule 5.

Corrections

HMRC can correct obvious errors or omissions in a notification within nine months of a notification being given. The Small Company Enterprise Centre (SCEC) will inform the employer of any changes made. The employer then has three months from the date of issue to reject the corrections. (Para 45 Sch 5).

The employer should let the SCEC know if he realises that he has made a mistake in notifying the grant.

Enquiries

HMRC can open an enquiry to deal with questions regarding the notification, for example to check that the company is a qualifying company (Para 46(2) Sch 5). In this case the notice of enquiry is sent to the employer.

HMRC can also enquire into whether the employee holding the option meets the working time commitment. The employee will be given notice of the enquiry and a copy of the notice will be given to the employer. (Para 46(3) Sch 5).

HMRC may send a notice of enquiry at any time within 12 months beginning with the end of the 92 day period within which the employer is required to notify the grant.

If HMRC discovers that information provided in or in connection with the notification was false or misleading, a notice of enquiry can be issued after this period.

If HMRC do not give a notice of enquiry

If no enquiry is opened, the option is taken to meet the requirements of Schedule 5.

At the end of an enquiry

HMRC will notify the employer or employee that the enquiry is closed and will state whether or not the requirements of Schedule 5 have been met.

Can the employer or the employee bring an enquiry to a close?

The employer or the employee can apply to the Commissioners to direct HMRC to issue a closure notice within a specified period. The Commissioners hearing the application will give a direction, unless they are satisfied that there are reasonable grounds for not giving a closure notice within a specified period. The Commissioners are independent of HMRC. (Para 46 Sch 5).

Normally, the General Commissioners will hear applications. They are a local independent tribunal appointed to hear cases which arise in a particular area. However, employers have the right to have their appeal heard by the Special Commissioners who are a special full-time tribunal. If an employer wishes to have an application heard by the Special Commissioners he should indicate this when the application for the closure direction is made.

Is there a right of appeal?

An employer can appeal against a decision by HMRC that:

  • notification of the option was not given in accordance with the requirements
  • the requirements of the Schedule are not met in relation to the option. (Para 50(1) Sch 5)

An employee holding an option can appeal against a HMRC decision that:

  • he does not meet the working time commitment requirement. (Para 50(2) Sch 5)
  • the notice of appeal to HMRC must be given within 30 days of receiving the closure notice

Income Tax and National Insurance contributions

This section explains the Income Tax and National Insurance contributions treatment of EMI options. It includes details of charges that may arise when:

  • the option price is less than market value of the shares when they are granted
  • the shares under option are free
  • there is a disqualifying event

Tax advantages given by EMI options - Income Tax and National Insurance contributions

There is no Income Tax or National Insurance contributions charged on the grant of a qualifying EMI option.

If an EMI option is exercised within ten years and there has been no disqualifying event, there will be no Income Tax or National Insurance contributions due, provided that the employee buys the shares at a price at least equal to the market value they had on the day the option was granted. If the option is a replacement option, it must be exercised it within ten years of grant of the original option. (S530 ITEPA 2003).

What happens when the option permits the shares to be bought at less than market value on date of grant (a 'discounted option')?

If the option enables an employee to buy the shares at less than their market value at the date the option was granted, there will be an Income Tax charge when he exercises the option. There will also be National Insurance contributions where the shares are readily convertible assets.

The taxable amount is the lower of:

  • the amount of the discount
  • the difference between the market value of the shares at the date of exercise and the amount paid for them

Example

Discounted option

A is granted an option to acquire 1,000 shares. The market value of each share at the date of grant is £5. The price he will pay for them (the exercise price) is £3.

(1) Market value on exercise is £12

The Income Tax charge is on the discount (market value at date of grant less the exercise price) £5 x 1,000 less £3 x 1,000 = £2,000 (amount of discount).

(2) Market value on exercise is £4

The Income Tax charge is on the market value at exercise (because it is lower than the market value at date of grant) less the exercise price
£4 x 1,000 less £3 x 1,000 = £1,000.

(3) Market value on exercise is £2

The market value on the date of exercise is less than the exercise price. There is no Income Tax charge.

What if the shares under option are free?

Income Tax is charged if the employee does not pay anything for the shares when he exercises the option. The charge is on the market value of the shares at the time the option was granted, or if lower, the market value of the shares at the time the option is exercised.

Example

Option granted at no cost

B is granted an option to acquire 1,000 shares. The market value of each share at the date of grant is £5. The exercise price is nil.

(1) Market value on exercise is £15

The Income Tax charge is on the discount (market value at date of grant less the exercise price) £5 x 1,000 less £0 = £5,000 (amount of discount).

(2) Market value on exercise is £3

The Income Tax charge is on the market value at exercise (because it is lower than the market value at date of grant) £3 x 1,000 = £3,000.

What happens if an option is exercised after ten years?

There will be no tax relief when the option is exercised. (S529 ITEPA 2003).

PAYE and National Insurance contributions

If there is an Income Tax charge upon exercise of the option, and shares acquired under the option are readily convertible assets, the employer must operate PAYE and account for National Insurance. (S700 ITEPA 2003)

What are readily convertible assets?

Broadly, readily convertible assets are shares that can be sold on a recognised stock exchange or for which trading arrangements are in place, or are likely to be put in place, at the time when the shares are acquired. An employee will have to pay National Insurance contributions when he exercises an EMI option if the shares are readily convertible assets and there is an Income Tax charge on the shares. (S702 ITEPA 2003)

Further details are available in our Employment-Related Securities Manual.

Can employers recover their National Insurance contributions liabilities on share options from their employees, or transfer the liabilities to the employees?

Yes. Measures introduced in the Child Support, Pensions and Social Security Act 2000 allow employers to recover National Insurance contributions payable on share options from employees.

The amount chargeable to Income Tax may be reduced by the amount of the employer’s (secondary) National Insurance contributions if there is a joint election in place. A joint election is an election signed by both employee and employer to transfer the employer’s (secondary) National Insurance contributions liability to the employee.

Disqualifying events

A number of changes or developments can disqualify an option from EMI relief. These are called disqualifying events. A disqualifying event restricts tax relief.

The following are disqualifying events:

  • loss of independence
  • the company no longer meets the trading activities requirement
  • the employee is no longer eligible
  • changes to the terms of the option
  • alteration to the share capital of the company
  • a conversion of shares
  • or grant of a CSOP option that takes the option holder over the £250,000 limit

Loss of independence

The independence requirement for companies is set out. Loss of independence is a disqualifying event, unless in the case of a company reorganisation, there is a qualifying replacement option.

The company no longer meets the trading activities requirement

Details of the trading activities requirement are set out.

If the company whose shares are under option no longer meets this requirement it is a disqualifying event. Some companies may have originally met the trading activities requirement because they were preparing to carry on a qualifying trade when the option was granted. There is a disqualifying event if:

  • these preparations come to a halt
  • or the company (or in the case of a parent company of a group, any group company) does not begin to carry on the qualifying trade within two years of the date of grant of the EMI options (S534(4) ITEPA 2003)

The employee is no longer eligible

There will be a disqualifying event if an employee who has been granted the EMI option no longer meets the employment requirements set out. There will also be a disqualifying event if the hours committed are not actually worked. (S535 ITEPA 2003).

Changes to the terms of the option

Any variation to the terms of the option will be treated as a disqualifying event if it:

  • increases the market value of the shares that are subject to the option
  • or results in the requirements of Schedule 5 no longer being met. (S536 ITEPA 2003)

Any alteration to the share capital of the company

An alteration to the share capital of the company whose shares are under option will be a disqualifying event if it:

  • affects (or would but for some other event affect) the value of the shares
  • and consists of or includes:
    • the creation, variation or removal of a right relating to any shares in the company
    • the imposition of a restriction on any of these shares, or
    • the variation or removal of a restriction to which these shares are subject and the change
  • is not made for commercial reasons
  • or is made for the purpose of increasing (or one of the main purposes is to increase) the market value of the shares that are subject to the option. (S537 ITEPA 2003)

A conversion of shares

If the shares under option are converted from one type of share to another it is a disqualifying event unless

  • the conversion is a conversion of shares of one class only (the original class) into shares of one other class only (a new class)
  • all shares of the original class are converted into shares of the new class
  • immediately before the conversion one of the following conditions is fulfilled. Either:
    • the relevant company is employee-controlled by virtue of holdings of shares of the original class
    • or the majority of the company’s shares of the original class are not held by or for the benefit of
    • directors or employees of the relevant company
    • an associated company of the company whose shares are
      under option,
    • or directors or employees of such an associated company. (S538
      ITEPA 2003)

Grant of a Company Share Option Plan option which takes the option holder over the £250,000 limit

There is a disqualifying event when an employee is granted a Company Share Option Plan option on top of unexercised CSOP and EMI options taking the employee beyond the £250,000 limit on holding options over shares. (S539 ITEPA 2003).

What happens when there is a disqualifying event?

If the EMI option is exercised within 40 days of the disqualifying event, the tax advantages are preserved.

If the EMI option is not exercised within 40 days (including occasions when the option is not capable of exercise within this time limit) there will be a tax charge on exercise.

Tax charge on option to buy shares at market value

Income Tax (and National Insurance, where the shares are readily convertible assets) is charged on the amount by which the market value at the date of exercise exceeds the market value immediately before the disqualifying event.

Example

Disqualifying event – tax charge where option is granted at market value

A is granted an option to acquire 1,000 shares.
The market value of each share at the date of grant is £5. The exercise price is £5.

The market value of a share immediately before a disqualifying event is £9.

The market value on the date of exercise is £25.

The taxable amount is limited to the growth in value after the disqualifying event (£25 - £9) x 1,000 = £16,000.

Tax charge on option to acquire shares at less than market value or at nil cost (a 'discounted' option)

Income Tax (and National Insurance, where the shares are readily convertible assets) is charged on both the

  • amount of 'discount'
  • amount by which the market value of the shares at date of exercise exceeds their market value immediately before the disqualifying event (as above)

Example

Disqualifying event - tax charge when option is granted at a discount

B is granted an option to acquire 1,000 shares.
The market value of each share at the date of grant is £5. The option exercise price is £3.

The market value of a share immediately before a disqualifying event is £9. The market value on the date of exercise is £25.

The taxable amount when B exercises the option will be on both:

  • the discount (£5 - £3) x 1000 = £2,000
  • the gain on exercise (£25 - £9) x 1000 = £16,000

The total taxable amount will therefore be £18,000.

What if the market value of the shares on the date of exercise is less than their exercise price?

There is no Income Tax charge. The amounts chargeable to Income Tax when you exercise an EMI option, including in the event of a disqualifying event, cannot be more than the amount chargeable if it were not a qualifying option.

What if the shares acquired are subject to restrictions or a risk of forfeiture?

If shares are acquired that are restricted or that carry the risk of forfeiture, Income Tax may arise after the options have been exercised when the restrictions are lifted. If an election is made under section 431 ITEPA 2003 before the options are exercised, the restrictions are ignored at the date of exercise so that tax is payable when the option is exercised as though the shares were not restricted. The election is often beneficial, as the amount of tax payable may be lower at the date of exercise than at the later time when the restrictions are lifted.

In normal circumstances, tax is not payable on the exercise of EMI options over restricted shares, but it may be payable if restricted shares are acquired at a discount or more than 40 days after a disqualifying event. In circumstances when the exercise is tax-relieved, the option holder is deemed to have made a section 431 election so that no further tax charge arises when the restrictions are lifted.

Where restricted shares are acquired at a discount, the amount liable to tax is the difference between the 'chargeable market value' and the amount paid for the shares. The 'chargeable market value' is the lower of the market value at the date of grant and the market value at the date of exercise. Where no section 431 election is in place, the market value to be used is the actual market value, taking into account the restrictions. Where a section 431 election is in place the 'chargeable market value' is the lower of the actual market value at the date of grant and the unrestricted market value at the date of exercise.

Where restricted shares are acquired more than 40 days after a disqualifying event, tax is calculated on the increase in value after the disqualifying event. If no section 431 election has been made, the actual market value is used in the calculation. If there has been a section 431 election, the actual market value is used at the date of grant and at the date of the disqualifying event, and the unrestricted market value at the date of exercise.

Example

Tax charge on exercise of discounted options over restricted shares

C is granted on option to acquire 20,000 shares.

The actual market value of each share at the date of grant is £1. The unrestricted market value of each share at the date of grant is £1.50.

The option exercise price is 60p.

The actual market value of each share at the date of exercise is 80p. The unrestricted market value of each share at the date of exercise is £1.20.

The taxable amount without a section 431 election is:

(£0.80 - £0.60) x 20,000 = £4,000

The taxable amount with a section 431 election is:
(£1.00 - £0.60) x 20,000 = £8,000

With a section 431 election the taxable amount will be increased but there will be no further charge to tax when the restrictions are lifted.

Where restricted shares are acquired more than 40 days after a disqualifying event, Income Tax is charged on the amount by which the market value at the date of exercise exceeds the market value immediately before the disqualifying event.

If no section 431 election has been made, the market value to be used is the actual market value taking into account the restrictions.

If there has been a section 431 election, the market value to be used is the actual market value at the date of grant and at the date of the disqualifying event, and the unrestricted market value at the date of exercise.

National Insurance contributions

National Insurance contributions are payable if the exercise is taxable and the shares are Readily Convertible Assets (RCAs). RCAs are, broadly speaking, shares that can be sold on a recognised investment exchange or for which trading arrangements are in place or are likely to come into place.

Other charges

If an employee exercises an EMI option and does not pay Income Tax on the option gain because of the EMI tax relief, he may be liable to tax if a 'stop loss' provision exists. This is a provision that allows an employee to sell his shares for an amount greater than their market value at the time of disposal. The taxable amount is the consideration given on disposal less the market value at the time of disposal and less any expenses incurred in connection with the disposal. (S446X ITEPA2003).

If an employee releases an option, and receive some consideration in return for the release, he will have to pay Income Tax on the amount of the consideration. This will be the case whether or not the consideration is in cash.

Capital Gains Tax

Capital Gains Tax is a tax that may be due when an individual makes a gain on the disposal of his shares. He can make gains up to the annual exempt amount each tax year without having to pay Capital Gains Tax. There is an annual exempt amount for each tax year but it cannot be carried forward if it is not used.

For more information about Capital Gains Tax please follow this link

Calculating the gain

If shares are sold for more than they cost, Capital Gains Tax may be payable on the gain. The gain on the shares is calculated by deducting from the sale price

  • the amount paid for them, plus
  • costs of disposal, for example, stockbroker’s commission

If anything was paid for the grant of the option, this also forms part of the cost.

If Income Tax was paid when the option was exercised or after the shares were acquired, the amount charged to Income Tax will also form part of the cost. If an employee pays part or all of your employer’s National Insurance contributions when he exercises his option and he gets Income Tax relief for this payment, the Income Tax relief will not reduce the cost for capital gains purposes.

If the sale price is less than the cost, there is a loss for Capital Gains Tax. This loss if claimed can be set against capital gains of the same year and any unused loss can be carried forward to future years.

For gains arising before 6 April 2008, taper relief could reduce the amount of a gain chargeable to Capital Gains Tax. The amount of taper relief depended upon the length of the period for which the chargeable asset had been owned and upon whether the asset was a business or a non-business asset. For a business asset disposed of after 5 April 2000 the maximum taper relief would normally be applicable once the asset had been held for a period of two or more whole years. Where an asset was not a business asset for the whole of the period of ownership, an apportionment might be required.

After 5 April 2000 shares would be a business asset if the shareholder was an employee of the company, its subsidiary or a qualifying joint venture company and he did not have an interest of more than 10 per cent in the company, or, if his interest was more than 10 per cent, the shares were in a trading company or in the holding company of a trading group. Shares acquired by exercising an EMI option were treated for taper relief purposes as if they had been acquired when the option was granted, not the date on which it was exercised. If there was a disqualifying event, this extension of the taper relief holding period still applied provided the option was exercised within 40 days of the disqualifying event. More on taper relief can be found in Self Assessment Helpsheets 279 and 287 and in the Capital Gains manual.

How much Capital Gains Tax is due and when is it payable?

From 6 April 2008, Capital Gains Tax is payable at 18 per cent. This is chargeable on all gains above the annual exemption. Taper relief is no longer available to reduce the amount of the chargeable gain. Capital Gains Tax is payable on 31 January after the end of the tax year in which the shares are sold.

Gains made before 6 April 2008 were charged at a rate that depended upon the option holder’s level of income liable to Income Tax. Capital gains after taper relief had been applied were added to the income liable to Income Tax and were charged at the appropriate rates.

What if an employee transfers his shares to a spouse or civil partner and he or she sells them at a gain?

Provided that the employee and his spouse or civil partner are living together, Capital Gains Tax is not normally payable when he sells or gives his shares to his spouse. He is treated as making neither a chargeable gain nor an allowable loss. When the spouse sells the shares, her cost will be the same as his.

What happens when a company reorganises?

This section takes you through the requirements for replacement options in the event of a takeover or merger. It also looks at rights issues.

Takeovers and mergers

If a company whose shares are the subject of qualifying options (EMI company) is taken over or merges, it loses its independence. This is a disqualifying event unless the company taking over or merging with the EMI company (acquiring company) grants a replacement option in exchange for the qualifying option within six months.

This can occur when the acquiring company:

  • obtains control of the EMI company by making a general offer to acquire the whole of the issued share capital of the company or to acquire all the shares which are of the same class as the option shares
  • obtains control of the EMI company or as a result of a compromise or arrangement sanctioned by the court
  • becomes bound or entitled to acquire the shares of dissenting shareholders
  • obtains all the shares of the EMI company as a result of the interposition of a new holding company, in a situation where the following conditions are satisfied:
    • the new company acquires all the shares in the EMI company and the consideration for the shares in the old company consists wholly of the issue of new shares in the acquiring company with a corresponding description
    • the new company has not previously issued any shares other than subscriber shares. (Para 39 Sch 5)

Replacement options

A replacement option has to satisfy certain requirements in order for it to be a qualifying option. The company granting the replacement option does not have to meet the gross assets test when the new option is granted, but it has to meet the following conditions:

  • The total market value of the shares under the replacement option must be the same immediately after its grant as the market value of the shares under the old option immediately before its release. The total amount payable to acquire the shares must be the same.
  • The £3 million overall limit on the value of shares under option must be satisfied with respect to the new option, but the test is based on the value of shares under option in the old company at the date of the grant of the original option. The valuation at the date of exchange of options takes into account shares that are under option at this date. Where options have been exercised or have lapsed, these need not be taken into account in determining whether the options are within the limit.
  • The company granting the replacement option must satisfy the independence and trading activities requirements at the date of grant of the new option.
  • The new option must be granted to the option holder by reason of his employment and he must be an eligible employee at the time of the grant.
  • The company must notify the grant to HMRC’s Small Company Enterprise Centre within 92 days of the grant of the replacement option.

A replacement option is treated for the purposes of Schedule 5 as if it had been granted on the date on which the old option was granted.

What else needs to be done?

This final section lists a few procedural reminders.

A company whose shares are the subject of an EMI option at any time during a tax year must fill in an EMI tax return, Form EMI 40, and send it to HMRC within three months of the end of the tax year.

Employees will need to give details of any EMI option they have exercised in a Self Assessment tax return for the tax year in which the option was exercised, if the exercise was liable to Income Tax but was not taxed in full by the employer.

Once the company has notified HMRC about an EMI option, it should monitor it to ensure that it continues to meet the requirements set out in this guidance. It needs to be aware of circumstances that could turn into disqualifying events.

Notification

HMRC provide Form EMI 1 to notify grants of EMI options.

HMRC Shares and Assets Valuation

If EMI options in an unquoted company are granted the company can, if it wishes, agree the market value of the shares with HMRC Shares and Assets Valuation (SAV). To agree a market value with them the company will need to propose a value for the shares and provide background information to support the proposal. It will need to complete form Val 231 for EMI options.

The form outlines the information needed to support the proposed valuation. When it is complete, it should be sent it to HMRC Shares and Assets Valuation (SAV).

If the form is not used or the company does not supply all the information requested, it may be asked to supply the missing information before a valuation can begin. This could delay the agreement of the valuation. When HMRC Shares and Assets Valuation (SAV) receive your completed form, they will tell you within ten working days if they need any further information.

Asking HMRC to agree a valuation is not the same as:

  • notifying HMRC of the grant of EMI options
  • or making the annual tax return required for EMIs

Companies need to contact the Small Company Enterprise Centre separately to fulfil these requirements.

HMRC Shares and Assets Valuation

Shares and Assets Valuation (SAV)
(Share Schemes)
Ferrers House
PO Box 38
Castle Meadow Road
Nottingham
NG2 1BB

Tel: 0845 601 5693
Fax: 03000 562 705

EMI terms explained

 
Term Definition
CSOP option A Company Share Ownership Plan (CSOP) option granted to an individual under the provisions of Schedule 4 ITEPA 2003
Disqualifying event An event which results in an option ceasing to be an EMI option qualifying for relief
EMI option An Enterprise Management Incentive option granted to an individual under the provisions of Schedule 5 ITEPA 2003
Employer The company employing the individual to whom options are granted under the EMI option
Qualifying company A company, which satisfies the requirements of Part 3 of Schedule 5 ITEPA 2003
Qualifying subsidiary A subsidiary, which satisfies the requirements of Part 3 of Schedule 5 ITEPA 2003
Qualifying trade A trade, which satisfies the requirements of Part 3 of Schedule 5 ITEPA2003
Recognised Stock Exchange A stock exchange designated as a recognised stock exchange by order of HMRC under Section 841(1) (b) Income and Corporation Taxes Act 1988
Schedule 5 Schedule 5 Income Tax (Earnings and Pensions) Act 2003
Working time commitment Working time that satisfies the requirements of Part 4 of Schedule 5 ITEPA 2003