We look at how to make the individual £120,000 EMI limit go further using growth shares...
The tax treatment of enterprise management incentive options if very favourable:
- no income tax or social security on grant;
- no income tax or social security on exercise;
- CGT on the sale of the option shares (with no minimum holding period); and
- a corporation tax deduction for the employing company on the spread for the accounting period of exercise.
It is possible to grant EMI options at a discount to the market value of the shares on the grant date but if options are granted at a discount, the amount of the discount on grant is subject to income tax (and if the shares are readily convertible assets, PAYE and social security) on exercise.
The tax savings can be substantial. We acted for a company in the media sector which exited in November 2009. The exit consideration was $300 million plus an earn-out of up to another $100 million. One third of the company was under option at a nominal exercise price so the gain in the options was in the region of $100 million. We structured the option plan so it qualified for EMI and by doing so we saved:
- $41 million in income tax and employees national insurance contributions;
- $12.8 million in employers national insurance contributions; and
- $28 million in corporation tax (the spread was deducted from profits for the accounting period of exercise triggering a loss which was group relieved by the purchaser thereby enhancing the sale price).
HMRC statistics for the estimated cost of income tax and NIC relief for EMI plans for 2008-9 put the cost at £100 million and £40 million respectively so the plan accounted for roughly 25% of the entire cost of EMI plans to the exchequer for the previous year! We are delighted to say our EMI package withstood intense scrutiny in the due diligence process and we are not surprised it was intense given the tax savings involved!
The attraction of EMI is that:
- management can achieve these tax savings with no risk and no cash cost until exit;
- leavers can be dealt with easily by providing that options lapse (or continue until exit if desired) thereby avoiding the cost buying back shares;
- shareholders can often negotiate an increase in the sale price to reflect the value of the corporation tax deduction to the purchaser (which typically appears in completion accounts as a deferred tax asset).
To qualify, the parent company has to meet certain conditions, broadly it has to:
- be independent;
- have less than 250 full-time employees (or equivalent);
- have gross assets of less than £30 million;
- have only qualifying subsidiaries;
- not carry on certain "excluded activities" to a substantial extent; and
- have a permanent establishment in the UK.
Click on this link to our EMI fact card which describes the EMI plan and our briefing note which sets out the conditions in more detail. We can advise on how to re-structure if these conditions are not met. For example, it is possible to re-organise the share capital of 50:50 joint ventures so they are qualifying subsidiaries for these purposes. The independence condition can sometimes cause difficulties if the company is controlled by an individual through a personal company. In borderline cases we usually apply for clearance from the Small Companies Enterprise Centre.
EMI and Growth Shares
There is a limit of £120,000 on the value of shares which any individual may hold subject to qualifying EMI options, it is measured by reference to the market value of shares at grant. The limit is often not high enough for companies that wish to make substantial awards to key employees after the company has generated substantial value for ordinary shareholders.
One solution is to create a new class of "growth shares" which typically have no rights other than to participate in an exit in consideration in excess of a threshold. Once the threshold is reached, the shares may participate pari passu with other shares in the balance of the consideration achieved or they may be entitled to a specified percentage (or even an escalating percentage) as a class.
It is possible to argue the up front value of the growth shares is relatively low thereby allowing options to be granted within the £120,000 limit. We have extensive experience of implementing these arrangements. The key is to set a threshold at what can be argued to be at least the value of the company as a whole (or preferably a premium to that value) at the time of grant. If the threshold is set correctly, it is often possible to agree a par value of the growth shares with HMRC.
For example, we advised on growth share arrangements for a venture backed company in the education sector worth in the region of £25 million (benchmarked by reference to indicative offers from a recent marketing exercise). Management already had EMI options granted over £100,000 worth of shares each. We agreed a new class of growth shares with several institutional investors to allow top up EMI options to be granted over an additional 10% of the company within the £20,000 of headroom available. The growth shares were entitled to share equally with other classes in the exit consideration achieved in excess of £25 million, we agreed par value for the shares with HMRC and we structured the growth shares so as to ensure the company's VCT status was unaffected.