Qualifying activities for EMI – don’t ask, don’t get!
When it comes to share options, Enterprise Management Incentives (EMIs) are often the automatic choice for smaller companies, provided that they qualify.
One of the requirements is that companies must carry out a qualifying trade. This means that:
(a) The trade must be conducted on a commercial basis with a view to making profits; and
(b) The trade must not consist “wholly or to a substantial part” in the carrying on of excluded activities.
What is an “excluded activity”?
The excluded activities are set out in the legislation. Often they are straightforward - for example, a company operating in the area of property development, the provision of legal or accountancy services or steel and coal production won’t qualify and an alternative option arrangement, like a Company Share Option Plan (CSOP), will need to be considered.
Sometimes, however, it’s not that simple.
For example, one excluded activity is “banking, insurance, money-lending, debt-factoring, hire-purchase
financing or other financial activities” (our emphasis). The main list is self-explanatory – but what does “other financial activities” mean? HMRC’s Venture Capital Manual (VCM3040) explains that activities “comparable” with the main list (broadly speaking, activities which involve bearing the customer’s financial risk) will be excluded, but the provision of services, such as financial advice, should be fine. Similarly, is there a need to consider the leasing prohibition in relation to data centre back-up storage services or the licences position when acting as a Microsoft software reseller? There may be situations where there is no black and white answer and more detailed interrogation of activities is required.
What does “substantially” mean?
As a rule of thumb, if HMRC talk about “substantially”, they mean “20%”. So provided that the excluded activities of a company do not amount to more than 20% of its trade, then the company should qualify in this regard.
However, again this is not necessarily cut and dried. HMRC’s guidance states that whether a trading activity amounts to a substantial part “is a matter of fact and degree” (VCM91170) and points out that a percentage test is clearly not always going to be appropriate.
Where that is the case, then HMRC may take into account other factors, for example how important the trading activity appears to be for the company, or how much management time is taken up with it.
The tests above relate to a standalone company. But what happens if the main EMI company is part of a group with a number of subsidiaries, some of which may be undertaking “excluded activities”?
In this case there is a two-stringed test. Firstly, the activities of the group taken together must not consist of a substantial part of “non-qualifying activities” AND at least one group company must exist wholly for the purpose of carrying on one or more qualifying trades (or be preparing to do so).
Sometimes, companies will find that a non-qualifying trading activity amounts to a substantial part of their trading, without even realising it.
- A company holds significant levels of cash (amounting to 20% of its income) which it reinvests in various investment portfolios. There is a risk that HMRC will view this as an dealing in “shares, securities or other financial instruments”
- A company owns a freehold property, part of which it occupies, and part of which it lets out to third parties. The letting element is not regarded as a trade by HMRC and consequently can prevent the company qualifying for EMI.
In some extreme cases, the situation may be so unclear that it will need consideration by the courts. In the case of Optos plc v Revenue & Customs Commissioners ( STC (SCD) 687), the court needed to decide whether an activity amounted to a “qualifying trade” (in that case, for the purposes of the Enterprise Investment Scheme). Here it was decided that leasing of h
igh end optical units did not amount to a “substantial” part of the company’s trade. The court, however needed to take a number of points into consideration, including the fact that Optos had developed the units; that ancillary services were provided alongside the leased units; that the units could not in fact properly have been leased without those additional services; and that the “leasing” fee could not therefore be divided into distinct elements identifiable for “leasing” and “service provision”.
If you are considering EMI, and you are not sure if your company meets the trading activities requirement, you might approach it as follows:
- Give up altogether and use a less tax efficient share scheme
- Go ahead anyway and take the risk of your EMI scheme being non-qualifying
Neither of these is the correct approach!
We would always recommend seeking advance clearance from HMRC Small Companies Enterprise Centre in these situations. We can do this for you and the cost (usually £750 + VAT) is insignificant in comparison to the potentially lost tax advantage of EMI.
Worse, if you go ahead anyway and grant options to employees with the promise of a 10% capital gains tax charge on sale, any motivational impact of the scheme will be utterly removed by a charge of up to 45% income tax on exercise – plus the possibility of NICs charges - if it turns out your company d
oesn’t qualify for EMI after all.
Put briefly – your company’s trade may qualify for EMI, but if you don’t ask HMRC for clearance, you won’t know – until, quite possibly, it’s too late!
Don’t forget – the qualifying trades test is only one of several qualification requirements for EMI. Please check the position carefully before you grant EMI options.