Enterprise Management Incentives: Mind The Traps
Retaining key employees and maintaining high levels of engagement are essential parts of growing a business. This can often present a challenge when trying to ascertain the most efficient way to approach this, especially when considering juggling the interests of investors.
As a solution to this concern, an increasing number of companies in the UK are implementing Enterprise Management Incentives (EMIs) as a highly tax-efficient method of rewarding key employees and ensuring on-going engagement. Under an EMI scheme, performance conditions can easily be put in place, and 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). For more information on EMIs, download our fact sheet, here.
Companies offering options under the EMI must be independent, with gross assets not exceeding £30 million at the date of grant and fewer than 250 employees. Companies engaged in activities such as certain financial or legal services and property are excluded. Overseas companies can offer EMI schemes provided they have a permanent establishment in the UK. The shares may be with or without restrictions (e.g. may be non-voting).
Recipients can be nominated at the employer’s discretion. Employees are granted the right to acquire company shares (worth up to £250,000) at a price set at the date of grant.
The EMI participants gain when the value of the shares rises above the purchase (exercise) price. This therefore focuses behaviour towards building value in the business and improving corporate performance, all good news for other stakeholders. Any concerns about dilution can be assuaged using our modelling service. Gains on shares acquired are subject to capital gains tax. The tax charge can drop as low as 10% in instances where Entrepreneurs’ Relief (ER) is applicable.
This very favourable tax treatment can, however be lost if a ‘disqualifying event’ materialises. We have previously examined some of the most common disqualification positions here.
This means on-going care and attention in how the plan is maintained. Our administration service is a valuable solution for many. You do not want to discover at an exit event that you have overlooked a previous disqualification trigger as you may find you have the unenviable task of addressing key employees with news that an expected 10% tax charge is now 60.8% because the EMI treatment has changed, due to prior disqualification, to unapproved option treatment, meaning income tax (as high as 45%), plus employee NIC (2%), plus employer NIC (13.8%) will all now take effect.
It also often transpires that a company which meets the EMI qualifying criteria has also gained approval for the Enterprise Investment Scheme (EIS). In short, the EIS is a tax break made available to business investors in entrepreneurial companies (see here for more information). However, even though both EMI and EIS can co-exist, they both contain strict conditions that must be adhered to in order to avoid disqualifying the respective arrangements.
One of the most important points to consider is that EIS is only offered in respect of new ordinary shares which do not carry preferential rights. Therefore, it is imperative steps are taken to guarantee that shares distributed under any EMI scheme do not possess restrictions that may, by default, make the EIS shares preferential within the three year EIS qualifying timeframe. If the ordinary shares held by the EIS investors become preferred in comparison to the shares over which the EMI options are granted (within the 3 year period), the EIS status will be lost along with the accompanying tax breaks. The result – very angry angel investors!
The EMI legislation permits options to be granted over a class of restricted shares. Often, this is desirable, where employees might acquire shares in advance of an exit, for example, to ensure that they do not acquire voting rights or dividend rights that might impact on founders’ control or ability to distribute profits. However, beware creating a new class of restricted shares for employee EMI options if the company has sought or is seeking angel investment under EIS.
As always with any arrangements that have a basis in law and tax, there is no substitute for specialist advice. Generalists may know the basics but experts know the details and will steer you clear of the traps. The words of Red Adair spring to mind – “If you think it’s expensive to hire a professional to do the job, wait until you hire an amateur”.
For more information on how you can safeguard your company from the potential pitfalls outlined in the article above, contact The RM2 Partnership via Liz.Hunter@rm2.co.uk, or call the office directly on 020 8949 5522.