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Targeted incentives for key employees

Many companies are keen to provide specific, targeted incentives to key personnel. These incentives can be offered in the form of cash, shares or other assets. However, the use of shares has become increasingly popular in order to align the interests of the executives concerned with those of the existing shareholders.

Share incentives of this kind are often structured as share options.1 No tax is payable on the grant of a share option, whether statutory or non-statutory. The only other way to prevent tax arising at the inception of an employee share scheme, other than a statutory all-employee scheme, is by means of a deferred purchase plan which is a more complex arrangement and also exposes the employee to investment risk.

Tax will ultimately be payable on option gains but if the options are offered under a statutory scheme, significant tax savings may be available.

In our opinion, the first consideration for directors when designing a targeted share incentive scheme should be the commercial objectives of the scheme. Issues for consideration will include:

the specific behaviours that the Board wishes to encourage: incentives that fail to change behaviour are arguably pointless;
the levels of prospective reward likely to influence these behaviours;
the period over which the awards should be made and whether accelerated vesting be allowed, for example on sale or flotation of the business or if the individual has to leave work involuntarily;
the performance conditions, if any, to be attached and how the performance should be measured;
the implications for capital structure, dilution and shareholder rights and perhaps succession planning.

If options are being offered, a further consideration is whether the employee should pay for the option. A paid-for option has some of the characteristics of a share purchase plan, unless the payment is refundable if the option lapses in which case the payment is really an advance of the exercise price.

Only when the commercial considerations are decided should the Board consider the choice of scheme and specifically whether a statutory or non-statutory scheme should be used. We consider first non-statutory share options.

Non-statutory share option schemes

A share option is the right to buy shares at a date in the future at a price or formula fixed at the date of grant of the option. The number of shares that can be acquired may be subject to performance and/or loyalty criteria. If the value of the shares rises above the exercise price, the employee has made a potential profit which can be realised by exercising the option and selling the shares. If the value of the underlying shares falls, however, the option holder is not obliged to exercise. Providing there has been no payment for the option, it represents a "one-way ticket": the holder can win but cannot lose.2

A major advantage of non-statutory schemes is that the grantor does not have to comply with any of the regulations that apply to statutory schemes. The grantor has freedom to choose the term of the option, the exercise price, any performance or loyalty conditions and any other features.

The Association of British Insurers has issued guidance in relation to the offer of share options by listed companies. The UK Listing Authority imposes a number of restrictions on employee share option schemes including the requirement that listed companies should not issue share options at a discount except for all-employee plans such as the SAYE Option Scheme.

Tax treatment

All the gains on a non-statutory option are taxed as income and may also be subject to national insurance contributions.3 The tax however is deferred until option exercise, which means that employees can be given a valuable asset today (the "one-way ticket" mentioned above) and normally pay no tax on it until some future date.4 In a quoted company, the shares can then be sold, the tax paid and the net proceeds taken, assuming the shares have risen in value during the option term. In a private company, exercise of the option may well occur when the shares become quoted or the company is sold or bought out.

The fact that no tax is normally paid on an option until exercise is a valuable benefit. If the options are granted at a nil exercise price, the grantor is effectively making a deferred gift of the shares and the recipient normally pays no tax until it is clear that the value of the options has risen and he or she has made a profit. If options are exercised at nil cost, the shares must be credited as fully paid before they are allotted. This will normally require the company to have distributable reserves.

If the person exercising the option is resident in the UK but not ordinarily resident, then for options issued before 6th April 2008, the exercise is treated as the acquisition of a security at an undervalue and tax is payable on the same basis as a deferred share purchase plan. For options issued after 6th April 2008, the basis of tax will be the same as for a UK resident and domiciled tax payer.

If an option is exchanged for another option, then normally no tax arises even if the new option has more inherent value. This follows from the principle that gains should normally not be taxable until exercise.

Difficulties can arise with non-statutory options in private companies. If the recipient exercises at a time when there is no market or buyer for the shares, he or she will have to find the money to pay the tax. Many people in the USA, where the rules for non-qualified options are similar in some respects, experienced large losses during the "dot.com" boom in 1998-2001; they exercised when the stock price was high, but when they came to pay the tax the stock price had collapsed, leaving them out of pocket.

If there is a market for the shares at exercise, or a cash buyer, national insurance contributions ("NICs") will be due as well as income tax. Employer national insurance at the standard rate of 12.8 per cent. is a significant burden and the need to provide for this can impose a heavy burden on fast growing, quoted companies who need all their cash to finance growth. However, an employer and employee can agree that the employee will pay the employer's NIC bill.

If there is a market for the shares in question, and the shares acquired through option exercise are sold, it may be possible to shelter all or part of the income tax by transferring a sum of money into a pension plan. The amount that can be sheltered in this way cannot exceed the person's net relevant earnings for the same tax year. In effect, the person would transfer all or part of their net relevant earnings into pension, claiming the tax relief, and use the taxable option proceeds to finance ordinary expenditure. However, there may be a significant timing difference between the collection of income tax through PAYE and the receipt of relief on the pension investment, which for higher rate taxpayers will be done partly through PAYE and partly through self-assessment.

A further consideration is dilution, that is, the extent to which the grant of a share option results in a permanent reduction in the interests of existing shareholders.

Statutory schemes

If a share option scheme is operated within the rules of one of the statutory schemes, the gains will not be subject to income tax but instead to capital gains tax. For higher rate tax payers this will represent a significant saving. The amount of CGT payable may be reduced by the annual exempt amount. In addition no NICs will normally be payable by either employee or employer.

There are three types of share option schemes which are "statutory", that is, subject to detailed regulations but also tax efficient. One of these, the SAYE Option Scheme, is an all-employee scheme which involves exercising a share option with the proceeds of a savings plan. The other two schemes are the Enterprise Management Incentive and the CSOP Scheme. In each case the employer is allowed complete discretion in selecting the recipients, and can also attach performance conditions to the grant and/or to the exercise of options. The use of performance conditions for both grant and exercise can create a powerful double incentive for selected staff.5

The Enterprise Management Incentive

This scheme ("EMI") was introduced in the Finance Act 2000. It is available only to firms employing fewer than 250 people 6 and with gross assets of not more than £30 million. The EMI offers great flexibility with considerable tax advantages. No tax or NICs are due on the grant or exercise of a qualifying option as long as the exercise price is not less than fair market value at the date of grant. On sale of the shares acquired, gains will be taxed as capital gains.

To qualify, the options must be offered for genuine commercial reasons, such as to retain, incentivise and/or attract new staff, and not for reasons connected with tax avoidance. In some cases, employees who already have unapproved options, which carry no overall tax benefits, may be offered the opportunity to exchange them for EMI options which could offer major potential tax advantages. It might be thought that such an exchange could be construed as tax avoidance. In practice, however, and in the absence of other considerations, HM Revenue & Customs will normally accept that an exchange of unapproved for EMI options is for genuine commercial purposes.

The EMI has proved popular. At the time of writing it is estimated that almost 7,000 companies have established schemes and granted options to more than 100,000 employees.

Independence

Companies offering EMI options must be independent, that is, not owned by any other company, or by any company together with one or more connected parties. The definition of "connected" parties is complex (see Glossary) but includes situations where parties act together to secure control of a company, perhaps through a shareholders' agreement. For example, if an individual and company A each have a minority holding in company B, and enter into an agreement to control company B, the individual will be connected with company A and company B will fail the independence test.

A similar problem arises if a controlling shareholder transfers shares to a company. In practice, however, if a private individual retains majority control, HM Revenue & Customs will not seek to disqualify the company from offering EMI options.7

If a company is controlled by a partnership it will not fail the independence test as long as none of the partners are companies. In venture capital situations, however, the investment may be made by a limited partnership which is managed by a corporate partner (the "general partner"). Partners are connected parties for tax purposes so if the investor has control of the company it will not be eligible to offer EMI options.

If a company owns exactly 50 per cent. of another company, the normal presumption is that the second company is controlled by the first together with persons connected with the first company. HM Revenue & Customs takes the view that, in a complete deadlock situation, the company could not be run at all unless the shareholders were prepared to co-operate. This co-operation would be sufficient to make the shareholders connected parties for the purposes of the legislation. However, in specific cases it has been possible to show to the satisfaction of HM Revenue & Customs that there is no active co-operation, that the shareholders are not connected for tax purposes and that the company therefore remains independent.

A company which is currently independent will fail the independence test if there any arrangements whereby, at some point in the future, it could come under the control of another company or another company and its associates. This could include situations where a minority venture capital investor has an option to acquire a controlling stake if certain performance criteria are not met.

The question of ownership relates to beneficial, not legal ownership. So it may be possible for a company legally to own more than 50 per cent. of another, and for that other company legally to offer EMI options, as long as the number of shares owned beneficially (that is, not as mere nominee for another person) is less than 50 per cent.

Exercise price

EMI options can in principle be offered at any exercise price, whether at fair value, above it or below it. There is no need to agree valuation with HM Revenue & Customs before granting the options although it is usually advisable to do so.

A company may decide to offer options with an exercise price above fair value if it feels that the value agreed with HM Revenue & Customs does not reflect the full commercial value of the shares. Alternatively, the company can introduce an element of gift into the arrangements by offering the options at a low exercise price or even at nil cost. This may be appropriate if the intention is to transfer value unconditionally to the participant, or if a promise of equity was made a long time previously and the participant needs to be compensated for the increase in equity value since then.

If EMI options are granted with an exercise price less than fair value, then income tax is payable and employer and employee NICs may also be payable. However, the tax is not payable until the options are exercised. The taxable amount will be the difference between the exercise price and the lower of the actual market value at the date of exercise, taking account of any restrictions on the shares, and the actual market value at the date of grant.

EMI options can be offered over restricted shares as long as they are part of the company's ordinary share capital (see Glossary). Common restrictions on shares include prohibition of share transfers unless certain conditions are satisfied, or limitations on voting power in comparison to other shares of the same class. HM Revenue & Customs takes the view that in such a case fair market value can be determined by reference to the restricted value. The effect of this is that if the restrictions fall away at exercise, for example on a company sale, then any additional gain will also be subject to capital gains tax instead of income tax. HM Revenue & Customs has stated that it will withdraw this favourable treatment in cases where it concludes that the restrictions are not "normal" commercial restrictions or where there is attempted tax avoidance.

If the shares are restricted, the option agreement must contain details of those restrictions. This is usually done by attaching the articles of association and/or any shareholder agreement setting out the restrictions.

When an EMI option is exercised over restricted shares, then if the exercise price is equal to the actual market value at the date of grant, a section 431(1) election is deemed to have been made. This ensures that no part of any subsequent capital gain is subject to income tax. However, if the option is granted at a discount, there is no such deeming provision.

Enterprise Management Incentive: Summary

Tax advantaged options over shares worth up to £120,000 may be offered to any qualifying employee of a qualifying company, subject to a maximum share value of £3 million. These limits refer to the total unrestricted [market values](glossary.html#market_value) at the respective dates of grant, of shares over which EMI (plus any CSOP) options have been granted.
Qualifying employees must work at least 25 hours per week (or 75 per cent. of working time if less) and be interested in not more than 30 per cent. of the equity (not including the shares subject to the option itself).
The company must be independent, have gross assets of not more than £30 million (see text) and employ fewer than 250 people. Broadly, any type of ordinary shares can be offered as long as they are fully paid up and not redeemable. The grantor can impose performance and loyalty conditions.
The fair value of the shares at the date of grant is normally agreed with HMRC Shares and Assets Valuation. However, the exercise price can be set below this level (or at nil), subject to certain conditions.
There is no income tax or national insurance (employer or employee) on the grant of the option and none on exercise, except in respect of any discount of exercise price to fair market value at the date of grant. On sale of the shares acquired through the option, capital gains tax is payable.
Options must be capable of exercise within 10 years of grant. There is no minimum exercise period.
There is no need to obtain prior Revenue approval before establishing a scheme. However, it must be registered with the Small Company Enterprise Centre (part of HMRC) within 92 days of the option grant.
Most business activities are eligible, with certain exceptionsincluding dealing in commodities or securities, financial activities, legal and accounting services, property development, shipbuilding, coal and steel production, hotels and nursing homes.

Other option terms

The terms of an option must be set down in writing, including when and how it may be exercised. Broadly speaking, however, a company can attach any conditions it likes to the exercise of an option. These may include loyalty conditions - for example that an option holder must serve a minimum period before an option can be exercised - and performance conditions, such as the achievement of a target level of turnover or profit. Other conditions are sometimes imposed. For example a private company may stipulate that no option can be exercised until the company has been sold or floated.

HM Revenue & Customs will accept indeterminate conditions, such as where the satisfaction of a loyalty or performance term is partly or wholly at the discretion of the grantor. They will also allow the grantor to have discretion as to what proportion of an option grant may be exercised on the occurrence of a specified event. This flexibility is based on the argument that although the grantor can have discretion as to the amount of an option that can be exercised in specific circumstances, at least the existence of this discretion has been set down in writing.

Notwithstanding this flexibility, EMI option agreements should be carefully drafted to ensure that they are clear and that they properly protect the legal position of the company and the option recipients in all foreseeable circumstances. Agreements should make clear that the option rights are separate from any provisions of the contract of employment and that the employee accepts this position; this may provide some protection against disaffected ex-employees whose options have lapsed suing for loss of option benefits. Companies should also consider if the scheme should be operated through an employee trust.

HM Revenue & Customs will also usually agree to a change in a performance or loyalty condition even after the option has been granted,8 provided that the change does not retrospectively permit the exercise of an option that otherwise would not have been eligible for exercise. However there are certain changes to an EMI option which HM Revenue & Customs will not accept, specifically any change in the minimum or maximum term of an option or to its exercise price. Any change which has the effect of increasing the value of a share subject to the option will constitute a "disqualifying event" which will affect the tax treatment of any gains. If exercise is permitted on a company sale by general offer, HMRC will not accept that the option can be validly exercised on a company sale by private treaty.

If options are exercised on a company sale, corporation tax relief is normally available on the benefit passing to employees. However, this relief will be lost if the acquiring company is not listed. Ideally, the rules should provide for the directors to declare the options exercisable immediately before the sale is completed, so that the relief can be claimed. Where the rules of a scheme do not provide for this, HM Revenue & Customs will normally accept a change that permits exercise "immediately" before completion, on the grounds that this does not materially alter the term of the option. In practice they are prepared to stretch the meaning of "immediately" to a period of about 7 days.

The scheme rules should not include any discretion to allow an option to be exercised more than 12 months after the death of a participant. The possibility of such an exercise, however slight, will be enough to disqualify a scheme since a valid EMI option cannot be so exercised.

Scheme limits

The maximum value of shares over which options can be offered under an EMI scheme to any one employee is £120,000, measured at the date of grant.9 If the employee also holds unexercised options under a CSOP Scheme, then these will count towards the £120,000 limit. There is an overall limit of £3 million on the value of shares over which qualifying EMI options can be offered to all employees by a single company.10

These are "all-time" limits; once reached, options must be exercised or released before further tax-efficient options can be granted. Of course, the company is at liberty to offer any number of non-statutory shares options, which carry no specific tax advantages. If the value of shares over which EMI options (plus any CSOP options) have been granted equals exactly £120,000 no further EMI options may be granted to that individual for three years.11 However if the value is slightly less, even by £1, the rule does not apply.

In calculating the above limits, HM Revenue & Customs uses the value of shares before any allowance for any restriction to which they may be subject. This value is known as the unrestricted market value ("UMV"). However, the restricted market value ("AMV") is used in assessing the fair value of the share for the purposes of the option exercise price. Both values are needed for the completion of the annual scheme return and SAV will now normally agree both as part of the fair value negotiation.

Because of the different bases of calculation, care must be taken to ensure that the £120,000 or £3 million limits are not breached unintentionally. Where options are granted under an EMI scheme over shares worth more than £120,000 the excess options are treated for tax purposes as ordinary non-statutory options and accordingly lose their tax advantages. The tax treatment of the remaining options is unchanged. If the options are subsequently exercised in part, the holder can specify whether the exercise is in relation to the EMI or the unapproved portion.

Where the shares are denominated in a foreign currency, UMV and AMV must be converted to sterling for the purposes of the Notice of Grant but the exercise price can be expressed in local currency.

Where the UMV of the option shares is exactly £120,000 then, if any of these options are exercised within a three year period from grant, no further options may be offered to that participant under the EMI scheme within the three year period. The same may apply if the UMV exceeds £120,000 since in this case the UMV of the shares within the EMI regime will be deemed to be exactly £120,000. If there is a possibility that EMI options may be exercised and further options granted within a three year period then the initial grant should be in respect of shares worth £119,999 or less. If the initial grant is to be larger than this, the balance could be issued by means of a separate grant of unapproved options.

An EMI option agreement need not stipulate a minimum or maximum exercise period but the option must be capable of exercise within 10 years. If exercise is dependent on one or more conditions, such as sale of the company, the EMI option will be valid if these conditions are capable of being satisfied within the 10 year period even if there is no certainty that this will be the case.

However, if the actual exercise of the option takes place more than 10 years from the date of grant (or from the date of grant of the original option if the current option is a replacement), the tax advantages of the option will be lost. In practice it is rare for employee share options of any kind to be granted with a maximum life of more than 10 years because very long incentive periods become commercially meaningless.

As noted above the Enterprise Management Incentive is designed for smaller firms with fewer than 250 employees and gross assets of no more than £30 million. Gross assets are taken as the sum of all the assets in the balance sheet without deduction of any liabilities.12

In determining gross assets, HM Revenue & Customs applies generally accepted accounting treatment. If EMI options are granted at a time when gross assets are no more than £30 million, and they subsequently rise to above £30 million, the options retain their tax-advantaged status.

Eligibility of employees

Participants must work at least 25 hours per week for the sponsoring company, or 75 per cent. of working time if less. An employee could in theory work 25 hours per week for more than one employer and thus be able to participate in more than one EMI scheme. The person would be eligible to receive options over shares worth up to £120,000 in each company as long as the companies were not members of the same group. It is also possible for someone who works for example on only one day a week 13 to qualify for participation in an EMI scheme, if that day is the only day on which the person is available for work. If an employee's working hours fall below the above requirements this will be a "disqualifying event".

A participant may not be awarded options if at the date of grant that person has, directly or with associates 14 an interest of more than

30 per cent. in the share capital or, in the case of a close company a direct or indirect interest in more than 30 per cent. of the assets available on liquidation. However, any shares which are already the subject of an EMI option at the date of grant of the new option do not count towards this total, and nor do the shares over which the new option is to be granted.15 It is therefore possible for an individual to receive a grant of EMI options over more than 30 per cent. of the company,16 and subsequently to receive further EMI options, as long as the total value of the shares under option at the respective dates of grant does not exceed £120,000.

Eligible activities

A single UK business must exist wholly for the purposes of engaging in a qualifying trade, or preparing to do so. A qualifying trade must be carried on wholly or mainly in the UK and must not consist of "excluded activities". These are, broadly, property development, financial activities such as banking, insurance and leasing, including the leasing of property; legal and accounting services, farming, the operation or management of hotels and nursing homes, and dealing in land, securities or other assets. Also excluded, for reasons connected with EU rules on state aid, are companies engaged in shipbuilding,17 steel and coal production.

The terms financial services, and legal and accounting services, are not defined in the legislation and HM Revenue & Customs has issued guidance on how they should be interpreted, which is now summarised:

"Financial services" means the provision of such services by a company acting as principal, such as a bank and insurance company. It does not include companies offering a service of introduction, such as insurance brokers. In practice this means that many firms of independent financial advisers are able to offer EMI options on the basis that although they offer advice about providers of financial services, they do not themselves offer the financial services in question. This interpretation assumes that the contract for the provision of financial services is between the client and the provider. It also assumes that the adviser is acting genuinely as an introducer and not as an agent for a single provider, or only a very small number of providers. Clearly this interpretation will not apply if the financial adviser also offers services as principal, for example fund management.
"Legal services" means services normally provided by legally qualified persons, such as legal advice and the drafting of legal contracts and deeds, irrespective of whether the provider is in fact legally qualified.
"Accountancy services" means services normally provided by qualified accountants such as auditing, tax advice and the preparation of tax returns, irrespective of whether the provider is in fact a qualified accountant.

The receipt of royalties or licence fees is not a qualifying business activity unless these receipts relate to intellectual property, for example computer software, of which at least half was created by the company or a group company.

Although a business must exist wholly for the purposes of the qualifying trade, the following are ignored:

activities which have "no significant effect" on the trade: HM Revenue and Customs takes a strict view of the meaning of "significant";
certain intragroup activities such as the holding of securities in another group company and holding or managing property for the qualifying trade of a group company.

It should be noted that the definition of qualifying trade is itself subject to some flexibility. A qualifying trade may include non-qualifying elements as long as these are not "substantial" in relation to the whole. HM Revenue & Customs regards the word "substantial" as meaning "more than 20 per cent." However, this is not a hard and fast test and HM Revenue & Customs will look at each case on the facts. There is uncertainty as to how the test applies if, say, the activity involves less than 20 per cent. of the business on some measures, such as turnover, profits or employees, but more than 20 per cent. on another, such as assets.18

Research and development from which a qualifying trade will be derived or will benefit is treated as a qualifying trade, but merely preparing to carry on such research activity does not qualify. The derived or benefiting trade must be carried on by the same company, or by another company in the same group. This treatment applies to all activities that are classed as research and development for accounting purposes, except for oil and gas exploration or appraisal.

EMI options can be offered over the shares of a company that is not UK resident. However, irrespective of its residence, if the company is a single corporate entity it must be engaged "wholly" in a "qualifying trade" in the UK, as defined above. If the company is the parent of a group of companies, at least one member of that group must satisfy this condition. However the group will not qualify if the business of the group overall consists wholly or to a substantial degree in carrying on excluded activities.

If the company has subsidiaries, they must be 51 per cent. subsidiaries 19 and not engaged in disqualifying activities of a scale that would disqualify the parent. Difficulties arise in the case of joint ventures, which are not normally regarded as subsidiaries. The normal presumption of HM Revenue & Customs is that a joint venture cannot be successfully managed unless each joint venture investor co-operates with the other. On this argument the joint venture is effectively a subsidiary of both shareholders since they cooperate to control it. Since it is not a 51 per cent. subsidiary it is not a qualifying subsidiary.20 However it is sometimes possible to persuade HM Revenue & Customs that a genuine "deadlock" control situation exists in which case the joint venture is not regarded as a subsidiary.

If a company has a subsidiary engaged wholly or mainly in the holding or managing of land, or any property deriving its value from land, then the parent will not be able to offer EMI options unless the subsidiary is owned as to at least 90 per cent. and there are no arrangements in place whereby ownership could fall below this level.

Disqualifying events

If a disqualifying event occurs, then unless the options are exercised within 40 days of the event, they will lose their tax advantages. In effect the options become unapproved and income tax will be due on exercise on the full gain in value up to that point.

The principal disqualifying events are:

the company whose shares are being used comes under the control of another company, or another company together with a person connected with it;21
the company ceases to carry on a qualifying trade or preparing to do so;
a company that qualified by virtue of preparing to carry on a qualifying trade did not in fact do so within a period of two years;
a participating employee ceases to satisfy the working time requirements (the other participants will be unaffected);
the terms of the option or the share capital structure are varied and the value of the shares under option is thereby increased;
restrictions on the option shares are removed and their value is thereby increased, unless the alteration of rights was done for a genuine commercial purpose;22
the option shares are converted into another class of share, unless all the shares of that class are converted and either (i) the majority of shares of that class are held otherwise than by directors, employee or associated companies (i.e. by arm's length investors) or (ii) the company is employee controlled prior to the conversion.

It is not a disqualifying event if a company's gross assets exceed £30 million following option grant, and nor is acquiring a non-qualifying subsidiary,23 so that companies that grant EMI options are not penalised if they grow.

Implementation

In general, the EMI has been designed to be as simple as possible to implement. There is no formal approval process. Instead, companies are required only to register the options. A simple registration form ("Notice of Grant") is completed, giving details of the recipient, the option grantor, the number of shares over which the option is granted, the exercise price, and certain other matters. Registration must take place within 92 days of the date of grant. HM Revenue & Customs has 12 months after the end of the 92-day period to notify the company if it believes that there are any irregularities in the registration, although it can make enquiries at any time if it believes that information supplied to it has been incorrect or inaccurate.

In unquoted companies the value of the shares to be used for the option grant is normally agreed with HM Revenue & Customs before the Notice of Grant is submitted. However, this is not necessary and an estimated figure can be supplied, for later negotiation with HM Revenue & Customs. It is not even necessary to supply an estimated figure: in this case the exercise price should be entered as the fair value and the correct fair value negotiated later. Tactically, however, it is usually better to negotiate fair value at the earliest opportunity, especially if the company is growing rapidly. This prevents HM Revenue & Customs being influenced by events subsequent to the actual grant of the options.

If a company is unsure whether it, or any employee, is eligible to offer EMI options, application can be made to the Small Companies Enterprise Centre in Cardiff for a ruling in writing. Officials are normally prepared to give preliminary views over the telephone, but on any issue of substance it advisable to make a written application. A response will usually be received within two to three weeks although in urgent cases officials may correspond by fax. Companies should not be tempted to withhold information or enter into artificial arrangements in order to secure clearance since any subsequent HM Revenue & Customs investigation is likely to identify and penalise irregularities.

The CSOP Scheme

In recent years, most eligible smaller companies have regarded the Enterprise Management Incentive as their preferred method for granting share options. However some companies will not be able to offer EMI options, because of their size, the nature of their activities or for technical reasons. In such cases, a Company Share Option Scheme ("CSOP Scheme") may be suitable. Following the abolition of business asset taper relief, the tax treatment of CSOP gains is similar to that for EMI schemes.

The CSOP has its own set of rules and restrictions. Under a CSOP, no employee may hold qualifying options over shares in a company, or any associated company,24 with an aggregate value of more than £30,000 at any time. This figure is calculated by reference to the share value at the date of grant, or, if there has been more than one grant, at the respective grant dates.

If options are granted in excess of this figure, all the CSOP options held by the participant are regarded as unapproved and the tax benefits are lost.

CSOP options must be offered with an exercise price not less than fair market value. If they are granted at a discount, income tax is payable in the year of grant on the benefit. For companies that are not listed, fair value of the shares is negotiated with HM Revenue & Customs.

If a CSOP option is exercised within three years from the date of grant then, unless the option holder is a "good leaver" as described below, the option is treated for tax purposes as if it were a non-statutory option. Income tax and NICs, where available, will be due on any gain. The employer can decide what events, if any, will give a participant the right to exercise early. The early exercise of individual options within a scheme will not invalidate the scheme itself. A CSOP option will also lose its tax advantages if it is exercised more than 10 years after the date of grant.

If an option holder ceases to be a qualifying employee or director because of "good leaver" reasons, specifically injury, disability, redundancy or retirement on or after the specified age, no income tax is payable on any gain provided that the option is exercised within 6 months of the relevant event.25 Illness is not given as a "good leaver" reason. In the case of death, personal representatives may exercise, if the rules permit, within the three year minimum vesting period and no income tax is payable if the option is exercised within 12 months.

Eligibility

A company can offer CSOP options to as many or few employees as it wishes and can apply whatever selection criteria it chooses. However, all the participants must be employees, full time or part time, of the company or full-time directors.26

There are no restrictions on the activities of companies that may offer options under a CSOP Scheme. However, the company must either be independent, that is, not controlled by another company, or the subsidiary of a listed company. The shares must be ordinary shares of the employer, or a company that has control of the employer. The shares must be fully paid up and not redeemable.

The shares may be restricted but not in relation to other shares of the same class. Where there is more than one class of share capitalthe majority of the class used for a CSOP Scheme must be owned, generally speaking, by persons who did not acquire them through an employee share scheme, i.e. by virtue of being directors or employees.27 This is to ensure that the shares are "worth having" and not some form of sham. For example, a company could offer CSOP options over non-voting shares as long as a majority of that class of shares was not owned by the participants.

If the company wishes the articles of association can require that an employee who acquires shares and subsequently leaves employment is obliged to offer them for sale.28 In an unquoted company, this helps to prevent small shareholdings being retained by former employees who may then lose contact with the company. However, the articles must also provide that all holders of shares of the same class must be bound in the same way and cannot sell on more favourable terms.29 This may have negative implications for any employed founder shareholders.

If the company is a close company no employee with a "material interest", being a direct or indirect interest of more than 25 per cent. in the share capital or assets of the company, may participate. The shares subject to the proposed option count towards this limit.

Performance and/or loyalty conditions can be attached to both the grant and the exercise of CSOP options. Any exercise conditions must be objective, but otherwise can be freely drafted. Conditions can be altered if events occur which make them inappropriate. However, new conditions must not be harder to satisfy than before and prior approval from HM Revenue & Customs must be obtained. Performance or loyalty conditions can include discretionary features, for example the power to waive a lapsing condition, but only if exercise of the discretion would operate in favour of participants.

The Approved Company Share Option Plan: Summary

In a CSOP, any number of employees may be granted options to buy company shares worth up to a total of £30,000 each.
If options are exercised between three and ten years from grant, or the employee is a "good leaver" within this period (see text), no income tax or national insurance is payable on exercise of the option or on the sale of the shares acquired.
CGT will be payable on any gains arising on the sale of the shares, but may be reduced by the annual personal CGT allowance. Participants may be able to spread sales over two or more tax years and/or share allowances with a spouse or civil partner.
The employer has complete discretion as to who is awarded options, and for what reason. In addition, objective performance conditions can be attached to the exercise of options, and these conditions can be made specific to each individual.
The employee must not have a material interest in the share capital or assets of the company whose shares are being used if it is a close company: the rule is the same as for the Share Incentive Plan.
An employee may participate in both a CSOP and an EMI as long as statutory limits are not exceeded. Any CSOP options will count towards the £120,000 maximum for the EMI options.

Employers can offer a "cashless exercise" facility, whereby the employee effectively pays the exercise price out of the proceeds from the sale of some or all of the shares acquired. However, this must be an arrangement that the employee enters into voluntarily otherwise it will amount to a non-compliant restriction on the shares. The employee must own the shares to be disposed of before they are sold.

Care should also be taken in relation to the prices reported for a cashless exercise of options over the shares of a quoted company. If the exercise takes place via a single sale of securities,30 the actual price achieved for the sale will be accepted by HM Revenue & Customs as accurate. This will also apply if the sale has to be spread over two days, but if the period is more than two days the "quarter up price" from day one is used. This may be different to the actual price achieved. If there are many sales over several days, and if employees receive the average price, the average price may be used, but if HM Revenue & Customs suspect tax avoidance they can substitute the price from the Official List.

A CSOP Scheme with a savings feature could be a viable alternative to an SAYE Option Scheme. HM Revenue & Customs permits savings-linked CSOPs if the savings element is merely to ensure that employees will have sufficient funds to exercise their options. Unlike an SAYE Scheme, a CSOP Scheme allows the employer to select who will participate. A savings based CSOP also has no savings cap and provides more flexibility as to option term. Unlike the SAYE scheme, however, valid CSOP options cannot be offered at a material discount.

If a company operates an EMI scheme, it may also operate a CSOP. An employee can hold options under both arrangements at the same time, as long as the total value of shares over which options can be exercised, taking CSOP and EMI together, does not exceed £120,000 by reference to the respective dates of grant.

Before a CSOP can be introduced, the scheme documentation and ancillary papers must be submitted to HM Revenue & Customs for approval. Approval is likely to take several weeks or longer if there are queries. However, once approval is obtained the options can be awarded immediately and the resolution(s) adopting the scheme can be forwarded to HM Revenue & Customs at a later stage.

However, partly because of the growing burden of regulation on employee share schemes, including share options, a number of companies particularly in the US are now offering direct (taxable) gifts of shares and/or LTIPs.»
That is, the holder cannot lose from the option itself, but if he exercises the option and continues to hold the shares he will then be exposed to the full risks and rewards of ownership.»
Except that, if exercise occurs after death, no income tax or National Insurance Contributions are payable.»
Several countries, such as the US, seek to tax the grant of options at a discount in certain circumstances.»
The Association of British Insurers disapproves of the grant (as opposed to the exercise) of share options being linked to performance conditions.»
This limit was inserted by the Finance Act 2008. Employee numbers are not aggregated for companies in common ownership. Part time employees are counted as fractions of full-time employees, based on the ratio of their actual working hours per week to a standard week of 35 hours. Companies whose employee headcount fluctuates substantially on a seasonal basis do not need to average their headcount over the year; what matters is the actual number of employees at the relevant time.»
A similar problem used to arise on the transfer of shares to a trust with a corporate trustee. However following a recent change in the law, the identity of the trustee is now treated for tax purposes as being separate from the identity of the trust.»
HM Revenue & Customs will even agree to performance conditions being altered in different ways for different employees.»
This limit was raised from £100,000 to £120,000 in the Finance Act 2008.»
We understand that, for reporting purposes, HM Revenue & Customs requires that options granted as EMI options but subsequently disqualified must be included in the total of EMI options granted despite the fact that the legislation refers only to qualifying options.»
This does not prevent those who were issued with options over shares worth exactly £100,000 under the previous limit being granted further options up to the new limit.»
In a group of companies, the gross assets of each subsidiary are taken and summed. Because of intra-group balances, this may differ from the consolidated gross assets figure.»
This could apply in the case of a mother returning from maternity leave who wants to work a restricted number of hours. As long as her new hours still represent 75 per cent. of her working hours, she will continue to be eligible.»
See Glossary. Associates include relatives but in the case of EMI schemes, the term "relative" includes spouses, antecedents and descendants but not siblings or remoter relatives.»
Shares over which non-EMI options have been granted do however count towards the total.»
The 30 per cent. limit applies to the nominal value of ordinary share capital of all classes, irrespective of the rights attaching to the shares. So if an employee holds 10 per cent. by nominal value of the ordinary shares in issue, but by virtue of voting, dividend or capital rights these shares have an economic interest of more than 30 per cent. in the company, it will still be possible to grant such an employee EMI options (however shares with fixed income rights are not regarded as ordinary share capital).»
But excluding military vessels and ships below a certain tonnage.»
Additionally, a company will be ineligible to offer EMI options if it supplies services to a company which is engaged in an excluded activity and a controlling interest in both companies is held by the same person or associates of that person. The meaning of Control is that given by section 995 of the Income Tax Act 2007 but in this case is extended to include situations where a person is a director of a close company and also holds (personally or with associates) more than 30 per cent. of the share capital of that company.»
A 51 per cent. subsidiary is defined in the Taxes Acts as any subsidiary where more than 50 per cent. of the share capital is owned directly or indirectly by the parent. Thus a company owned as to 50.01 per cent. would qualify as a 51 per cent. subsidiary.»
The same rule applies to indirectly held subsidiaries. For example, a parent company has an interest of 50 per cent. in another company if it is 62.5 per cent. owned by a subsidiary which in turn is 80 per cent. owned by the parent.»
Except that in certain circumstances, EMI options can be rolled over into equivalent EMI options in an acquiring company.»
One such purpose might be the alteration of a company's articles of association to make it possible to float the shares on a public investment exchange.»
Insofar that this relates to the ownership structure. However, if the subsidiary is of significant size in relation to the parent then the trading activities of the subsidiary may be large enough to disqualify the parent.»
A company is associated with another if either is under the control of the other if they are both controlled by the same person(s). »
There is no statutory requirement to specify a retirement age for CSOP schemes. Accordingly there is no exemption to the Employment Equality (Age) Regulations 2006 which prohibit discrimination on grounds of age. Specifying a CSOP retirement age might therefore be seen as a breach of the Regulations but we consider it unlikely that this will lead to problems in practice. »
If the plan rules provide, the option will remain valid following grant notwithstanding that the participant ceases to be an employee or director.»
This rule does not apply in respect of shares acquired through a public offer. It also does not apply if the majority of the class is owned by directors and/or employees who are able to control the company. »
This includes those who, not being such directors or employees, have acquired shares from individuals who themselves acquired shares as a result of being a director or employee.»
The "terms" include the method of sale and the consideration: the latter may be a fixed price or formula; more commonly however a fair value will be set by the auditors or some other expert in the circumstances of the time.»
The company and employee can agree either (i) to sell sufficient securities to pay the exercise price or (ii) to sell all the securities and remit a cash amount to the employee, net of the exercise price and taxes.»

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