EMI: a story of 'tax tails' and 'commercial dogs'?
Why a longer-term commercial perspective appears to be the driving force behind a company entering into an EMI scheme.
Article appeared in Taxation in October 2005.
Introduction
In being an effective tax advisor to a small or medium sized enterprise (“SME”), a phrase encompassing “tax tail”, “wag” and “commercial dog” normally springs to mind. In other words, it is not merely enough to understand the tax consequences of events and transactions going on within a business, but it is vital to have at least one eye on the wider thought processes of the client, together with being alert to the all important “what-if” questions that will inevitably arise.
One of the areas where commerciality and tax advice heavily collide on SME’s, is in relation to share incentive arrangements. In providing such advice, the possibility of utilising Enterprise Management Incentive (“EMI”) share options (Sections 527 to 541 and Schedule 5 ITEPA 2003) as a “tool”, will typically rank high on the agenda.
Given my thoughts on commerciality in the context of tax advice, I was interested to learn of two publications by HM Revenue & Customs (“HMRC”) in recent weeks, considering the reaction of companies to the introduction of EMI. As someone who regularly has discussions with SME’s on equity incentive mechanisms, I thought it useful to take a closer look at these publications and see what conclusions could be drawn for the future application of EMI in this popular SME tax advisory area.
Background
Whilst this article is not intended to provide a detailed explanation of EMI, just to recap, it is a form of tax favoured share option scheme, introduced by the Chancellor in his 2000 Budget.
When first introduced, the Government's stated purpose of the scheme was to aide “small, higher risk” companies recruit and retain “key” individuals to help their businesses succeed and grow. Subsequent amendments were made, with the intention of improving the scheme and increasing its appeal to smaller companies.
A number of parameters exist surrounding the scheme, including the requirement that the maximum market value of unexercised EMI options at the date of grant is £100,000 per employee, with a total cap of unexercised EMI options over the company's shares of £3 million.
In terms of the taxation treatment, no income tax or NIC charges arise when an EMI option is granted. No income tax or NIC charges arise upon exercise, providing the employee purchases the shares for a price equivalent to their market value at grant. The employee is not taxed on any growth in the value of the company's shares between grant and exercise of the option – with tax charges possibly arising where the exercise price is less than market value at grant. For taper relief purposes, Paragraphs 14 to 16 Schedule 7D TCGA 1992 provides that the taper relief clock for “qualifying” shares acquired on the exercise of “qualifying” options should commence at the grant of the option, rather than exercise.
A surprising story?
Take a look at figure 1, which sets out the take-up figures on EMI since inception, published on the HMRC website in the summer (www.hmrc.gov.uk/stats/emp_share_schemes/table6-6-jul05.pdf).
| Year | Number of companies granted options | Number of employees to whom options were granted | Initial value of shares over which options were granted during year (£m) | Average value of share over which options granted per employee (£) | Number of employees whom exercised options | Estimated cost of income tax relief (£m) |
|---|---|---|---|---|---|---|
| 2000-01 | 855 | 5,000 | 145 | 29,000 | 20 | Neg |
| 2001-02 | 1,914 | 20,000 | 300 | 15,000 | 350 | Neg |
| 2002-03 | 1,945 | 25,000 | 250 | 10,000 | 1,250 | 50 |
| 2003-04(1) | 2,027 | 20,000 | 285 | 14,000 | 1,930 | 50 |
| 2004-05(2) | 2,322 | 25,000 | 325 | 13,000 | - | - |
| Total | 5,944 | 75,000 | 1,305 | 17,000 | - | - |
(1): The previously published data
for 2003-04 was provisional and has now been updated.
(2): Data for 2004-05 is provisional, largely based on notifications of options
granted which are generally submitted earlier than annual returns each year.
Whilst an historic upward trend in the number of companies implementing EMI
schemes is perhaps to have been expected, as both the familiarity of the
regime grows and as a result of various legislative changes (including abolition
of the rule that only 15 employees could benefit from EMI and increasing
the limit on the gross assets of companies that could qualify from £15m
to £30m), I was still surprised to note that, in total, just less than
6,000 companies have granted EMI options.
Whilst I do not confess to closely monitoring all strategic developments in relation to EMI over the last five years, or to being party to any policy discussions with HMRC, my personal reaction was that this figure seemed low, particularly given the taxation opportunities available. Putting this in context, the rate of incorporations is running at 300,000 annually. Was I missing something?
Becoming clearer?
HMRC survey
In the context of the detail at Figure 1, it was interesting to note the publication on 30 September 2003 by HMRC of a survey on EMI, prepared by FDS International Limited (www.hmrc.gov.uk/research/research-report11.pdf). The survey was carried out during autumn 2003, and whilst we appear a little behind in receiving the results, the sentiments emerging are certainly worth considering. They do enable us to further understand some of the thought processes that a company may go through in considering EMI – and their subsequent reactions post implementation. Ultimately, they shed some further light on the HMRC’s “take-up” statistics and provide a commercial view on the topic.
Survey parameters
91 interviews took place with organisations that adopted EMI. The survey attempted to consider why EMI schemes were adopted, how they are used, what features were liked and disliked and the perceived impacts on recruitment, retention and a companies’ performance.
Of course, the weakness here is that the survey does not consider companies who considered EMI and decided not to implement. If it were possible, this would perhaps be a more interesting survey!
Overall strategy
The Revenue will be pleased to learn that the key theme emerging was that companies’ reasoning for adopting EMI was broadly in line with original aim – to promote the retention and recruitment of key staff, in senior or core capacities, with the intention of helping the organisation thrive productively.
Indeed, a wide range of reasons were noted for the introduction of EMI – motivation, reward for staff, to develop a sense of shared purpose, a fairer distribution of the fruits of success, as security for individuals against a takeover, to allow for the continuity of key people, to ultimately provide for management succession, and to allow for an immediate saving on salary costs. Of course, this is all good stuff, but how does the tax angle fit in, and where are the thoughts on the take-up of EMI?
Taxation considerations
The survey does comment that the tax advantaged status enjoyed under EMI is a powerful means to an end, but that it is rarely viewed as the end in itself. Whilst a company appears to have other objectives for implementing EMI, the survey does comment that saving tax is part of the mechanism within EMI that makes it a more effective and attractive tool for achieving these aims compared to other enquiry incentive arrangements.
On reflection, I am probably relieved by the conclusions of the survey in relation to the tax motive. Paragraph 4 Schedule 5 ITEPA 2003 does state that “the options must be granted for commercial reasons to recruit or retain an employee in a company, and not as part of a scheme or arrangement the purpose (or one of the main purposes) is the avoidance of tax”. Whilst I have occasionally considered this point with other advisors, on a day to day level I have practically had very little cause for concern in this area, and have little knowledge of the point being taken by HMRC. This of course is no defence should the point emerge in the future! The typical starting point in even contemplating an EMI, appears to be that the company requires some form of equity incentive. It may only be when it is pointed out that tax costs could emerge from a direct award of shares (with associated commercial points) or the granting of an unapproved option, does the client tend to become more conducive to an EMI. Getting a more effective tax treatment is in many cases restoring the employee and company to the position which the client would otherwise have assumed it to be – perhaps with the exception of the taper relief benefits. The implementation of EMI does appear to occur as a result of the commercial circumstance that the client has already identified.
Locking-in the employee
The report concluded that most employers doubted EMI’s power to retain staff if they really wanted to leave. However, at senior levels and among staff crucial to success, the grant of an option is felt to be an important commitment valued by the recipient. It is considered too soon for even the earliest participant businesses to have reached a firm view of whether or not EMI is delivering the medium- and longer-term benefits they hoped it would, as part of their remuneration policy.
It was illuminating that that the potential for a future float or an “exit” was considered a major element in the strategy surrounding the implementation of EMI. It is also noted that venture capitalists have an important say in the adoption of EMI, who view EMI as a device which aligns the interest of employees (including directors) with their own financial ambitions. This is in accordance with my own experiences, where EMI tends to be implemented as a possible reward for an exit transaction. Does this explain why the take-up is not as I would have otherwise anticipated – it is the case that only a few companies are working towards an exit? While employers may like the idea of linking returns of an employee to the value of the company, practically do they really want an increasingly diverse shareholder base? While placing shares into the hands of an individual may not be viewed positively for internal management purposes, EMI may become more appealing where the shares can only be received (and subsequently realised) on a sale transaction.
Weaknesses and improvements
The limit per person on the total value of the options was held not to be adequate by itself to suit the needs of some of the most senior executives. Some companies also operated unapproved options schemes alongside EMI to provide a “top-up”. Indeed, in the context of the retention of staff, a £100k threshold was not considered to be a significant amount. In addition, companies that operated share options before EMI would like to be able to bring those retrospectively into the advantageous EMI regime. Otherwise longstanding option-holders can been seen as disadvantaged. Furthermore, some companies would like a change to the three year rule, allowing them to cancel previous underwater option grants and reissue at lower valuations.
Interestingly, a strong play was made over the extent to which some companies resent the degree to which external advisors seem to be both necessary and costly. With hindsight, companies do not always see the costs incurred as commensurate with the work involved on implementation. The survey observed that in most cases, implementing EMI has involved fees of between £5,000 and £10,000 being paid to professional advisors. As painful a comment as this may be to tax advisors, it is certainly a factor which looms large in the survey and is something that we should certainly not be oblivious to. From experience, the implementation of EMI tends to become less economic, the smaller the number of scheme participants. Is this why the take-up is not as one would otherwise expect?
Some comment was made that perhaps HMRC should provide a pack, such that companies can implement EMI without the need for professional advisors. However, as a counter, one survey respondent did note that a number of people have run into many difficulties without properly understanding EMI and the implications arising. It is interesting to note further respondents indicating their disappointment at not being informed by HMRC of changes in the scheme legislation, or stating that they never received a note from the Revenue saying that they have “got it right” on implementation.
Going forward
Prior to even receiving the survey results, I had been reflecting on how recent tax changes would impact on the role and take-up of EMI.
From a positive standpoint, EMI does appear to provide a useful mechanism for managing issues arising from the restricted securities legislation (Chapter 2 Part 7 ITEPA 2003). Here, providing the option is granted at the (actual) market value at the date of grant, then on exercise, a deemed Section 431 ITEPA 2003 election is made (Section 431A ITEPA 2003), providing protection from a future charge to income tax on any chargeable event, but with no tax charge arising from the election process. In addition, Part 3 Schedule 23 FA 2003 provides for a Corporation Tax deduction to possibly be available to the company on exercise of an EMI option, irrespective of whether any income tax charge arises at that point. The deduction is computed, broadly, by reference to the difference between market value at the date of exercise, with the price paid on exercise. On both points the attractiveness of EMI appears to increase, although from before it would appear that taxation is not a key driver on implementation.
However, given that the £100k employee limit within Paragraph 5 Schedule 5 ITEPA 2003 is based upon the unrestricted market value of a company’s shares, could this have an impact on future take-up? As discussed in recent weeks in this publication, the Revenue have taken the view now that the difference between the actual market value and unrestricted market value of shares, in a typical private company, as a starting point, is something in the order of 25%. Therefore, has the £100k limit effectively now been reduced to £75k? Arguably, this is a tax change which could have a negative impact on the take-up of EMI. I have not observed too much attention being drawn to this point recently, but one would expect some growing realisation to occur over the coming months.
Summary
I must confess to being surprised by the apparently low level of take-up of EMI, but I have taken from the survey process a greater awareness that tax motivations alone are not going to be the significant factor in taking a company into EMI. Ultimately, a longer term commercial perspective appears to be the driving force, with perhaps some necessity for a future sale transaction on the horizon.
Where a company has concluded on implementing a share option scheme, then strong tax reasons do appear to exist for going down the EMI route. Whilst the tax benefits surrounding EMI have increased in recent years, the fact that the £100k employee threshold appears to have been reduced to approximately £75k is something which could an impact on the decision of certain companies to implement going forward.
So after all this, could the tax tail really wag the commercial dog?!
Marc Abrams is a Senior Manager of Tenon, leading accountants
and business advisers. Email: marc.abrams, Tel: 0115 955 2000.
