Managing a sale – don’t forget the share options!
Share options may not rate highly on the list of things the principal vendors will find themselves dealing with on a share sale of a private company. However, ignoring share options until just before completion of the sale may be costly to vendors and option holders. There is also the potential to create ill feeling among option holders if their interests are not looked after at what is often a stressful time.
This note summarises some of the key tax and other issues relating to employees’ share options which the principal vendors ought to address as early in the sale process as possible.
Corporation tax (“CT”) relief for gains on exercise of employees’ share options
It is often the case that share options are not exercisable until an exit event occurs (e.g. a share sale or IPO), or employees may choose to wait and exercise options only when there is a company sale and the ability to sell their shares.
Vendors are often unaware (or only when it is too late) that there may be thousands of pounds of CT relief which the vendor company may claim in respect of the gain on exercise of employees’ share options around the time of a company sale. There may of course be instances where the companies cannot utilise the CT relief (e.g. if it is loss making or has accumulated losses to set against current and expected future profits).
It is vital the principal vendors remember to take CT relief into account early in the sale negotiation (surprisingly it is often missed by vendors). This will involve the vendors or their advisors determining the potential CT relief on employees’ share options and how vendors should benefit from the CT relief on the company’s sale. This might result in a higher sale price or reflected in other ways (e.g. a notional amount of CT relief may be used to set-off future claims by the purchaser under tax warranties/indemnities given by the principal vendors).
For employees’ share options, there is statutory CT relief if certain employee and qualifying conditions are satisfied. The amount of CT relief will be the “option gain” multiplied by the number of shares acquired on exercise of options. The “option gain” is the amount by which the market value of the shares on the date of exercise exceeds the exercise price.
CT relief may be claimed in respect of share options that are exercisable with Income Tax relief on exercise (e.g. under the Enterprise Management Incentive (EMI) and Company Share Option Plan regimes), as well as share options that do not attract exemption from income tax on exercise. This creates a “win/win” for company and option holders alike if share options attract exemption from income tax on exercise.
To summarise if the principal vendors ignore the potential CT relief on employees’ share options they are losing out on a valuable relief that the purchaser should give credit for on a sale of the company.
What are the tax implications for the vendors if share options are exercised
The principal vendors will want to ensure that income tax (PAYE) and National Insurance (NI) due on exercise of share options is accounted for correctly to HM Revenue & Customs (HMRC). This is because the purchaser will normally seek tax warranties/indemnities for tax and NI in respect of share options from the principal vendor shareholders.
There are various tax issues the principal vendors will need to focus on/resolve in the time leading up to completion of the share sale. These include:
- checking that tax advantaged options are capable of exercise with relief from Income Tax. For EMI options, this will include: confirming options were notified to HMRC within 92 days of grant (otherwise the options will not have any tax exemption on exercise); and if the exercise price per share is not less than the market value of a share (determined at the date of grant). If HMRC agreed market values for the grant of EMI options, the purchaser will also want to see the share valuation agreed by HMRC. This is important because if the exercise price of an EMI option is less than the market value, there will be PAYE and NI consequences on exercise.
- liability to meet employer’s NI due on exercise of share options – if non tax exempt options are exercised, the option holder may be liable to meet the cost. The option agreement and option plan should say if the option holder is liable for employer’s NI due on exercise of share options.
- arrangements to enable the option holder to fund the exercise price – if the exercise price is significant in amount, the principal vendors should consider steps to avoid the option holder having to self-fund the exercise price. This might include option holders’ giving an undertaking to pay out of sale proceeds of shares, a cashless exercise facility or the lending of funds. There may be disguised remuneration and financial assistance (for company law) implications that will need to considered as part of any funding arrangements.
Exercise price for employees share options
The option exercise prices paid to the vendor company for the issue of shares on exercise of share options may be significant in amount. Too often the cash amount is not reflected pound for pound in the overall consideration payable to the vendor shareholders. The principal vendors should not overlook the option exercise prices and ensure the sale price is increased where appropriate to take account of the option exercise prices.
For more information on any of the content covered in this blog, contact a member of the team directly on 020 8949 5522.