09 OCT 2012
Is the 'exit only' EMI option dead?
Enterprise management incentives (‘EMIs') are the most tax-advantaged form of discretionary share option plan. If the relevant conditions are satisfied, option-holders are exempt from income tax on exercise and gains on the sale of option shares are taxed as capital.
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The government announced two significant improvements to the EMI legislation in the 2012 Budget, namely the:
— extension of entrepreneurs' relief (‘ER') to EMI option-holders; and
— increase in the individual EMI limit from £120,000 to £250,000.
The changes make EMI more attractive but are not as generous as at first appears. The majority of private companies that operate EMI grant ‘exit only' options (ie options that only become exercisable immediately before an exit is achieved). A lot of commentary in the immediate aftermath of the Budget suggested companies should restructure existing EMI options to permit exercise pre-exit (to allow participants to benefit from ER). Much of this advice ignores the cash-flow and risk issues associated with early exercise and the practicable issues for private companies in imposing vesting and forfeiture on shares acquired pre-exit.
This article explains why it is unlikely to be attractive to alter existing options to allow early exercise and why it may not be necessary anyway. It also explains how options can be structured in the future to allow EMI option-holders to benefit from ER without incurring cash-flow and risk issues.
The increase in the EMI limit is intended to take effect ‘as soon as possible', the extension of ER to EMI option shares will be enacted by the Finance Act 2013 and is intended to take effect for options exercised on or after 6 April 2012. Both changes are subject to EU state aid approval.
Entrepreneurs' Relief (‘ER')Individuals who qualify for ER are taxed at the favourable rate of 10% on capital gains up to a lifetime limit of £10 million. The relief is available for disposals of securities (or interests in securities) if throughout the period of one year prior to disposal:
— the company is the individuals' ‘personal company';
— the company is either a trading company or the holding company of a trading group; and
— the individual is an officer or employee of the company or one of more companies in the same group.
A personal company in relation to an individual means a company:
— at least 5% of the ordinary share capital of which is held by the individual; and
— at least 5% of the voting rights in which is exercisable by the individual by virtue of that holding.
EMI options are not securities or interests in securities for these purposes so the only way to qualify at the moment is by holding sufficient ordinary shares to meet the 5% tests. Most option-holders are not also 5% shareholders so face paying CGT at top rates of 18% or 28%.
Having said that, it is possible for an EMI option-holder who meets the ER conditions (by holding sufficient ordinary shares to satisfy the 5% tests and by meeting the other ER conditions) to exercise his EMI options on exit and claim ER on the disposal (because ER applies to any disposals of securities in the same company once the tests are met even if the securities disposed of have not been held for a year prior to disposal). It is assumed the 5% tests are not met for the purposes of the remainder of this article.
Extension of ER to EMIThe extension of ER to EMI is not as generous as it at first appears. The requirement for the company to be the individuals' ‘personal company' will be dispensed with for individuals who acquire shares pursuant to the exercise of EMI options. Individuals will, however, still be required to hold the EMI option shares and remain a director or employee for at least a year afterexercise in order to qualify for ER.
Most private companies operate ‘exit only' EMI plans in which options can only be exercised immediately before an exit. Option-holders in these circumstances will be ineligible for ER (assuming the option-holder sells his option shares on exit for cash).
It would be far better if the one-year ER holding period were to run from grant rather than exercise (as it did under the old business asset taper relief regime). The government will doubtless be lobbied on this point but if the changes are enacted as proposed, how can existing EMI option-holders benefit from ER?
Route 1: exchange option shares for loan notes on exitIt should be possible to exercise EMI options immediately before an exit and to exchange option shares for loan notes issued by the purchaser. So-called ‘reorganisation' treatment will usually apply to the loan notes with the effect that any gains will be postponed until sale or redemption of the loan notes. The loan notes are treated for CGT purposes as if they were acquired when the option shares were acquired and for the same base cost.
The author has requested confirmation from HMRC that the one-year holding period will continue to run on the loan notes issued in these circumstances and that the personal company requirement will not apply to securities issued in exchange for EMI option shares. Assuming HMRC confirms these points, EMI option-holders could redeem the loan notes 12 months after completion and claim ER on the gains arising on sale or redemption of the loan notes.
It would be possible for option-holders to realise some cash on completion by selling some option shares without incurring CGT by utilising annual exemptions, etc. If the cash raised is insufficient to fund the exercise price, option-holders may require temporary loans to fund the balance of the exercise price due (which could be repaid out of the loan note redemption monies).
This strategy will only be effective if:
— the purchaser is prepared to offer loan notes (many US purchasers are not);
— the participant remains an employee or director for at least one year post-completion;
— the purchaser is a trading company for ER purposes;
— HMRC frames the legislation so the one-year holding period continues to run on loan notes issued in exchange for EMI option shares and so the personal company requirement does not apply to the loan notes.
This strategy is attractive because:
— companies with outstanding EMI options need do nothing now;
— a corporation tax deduction should be available by statute on the full spread on exercise (ie the difference between the exercise price and the net present value of the option shares on exercise calculated by reference to the deal value).
It should be said, however, that participants only receive the bulk of their cash 12 months following completion and they risk the purchaser defaulting on the loan notes.
Route 2: grant replacement options and exercise earlyIf existing EMI options are not exercisable, participants could be granted replacement options in exchange for the surrender of their existing options. The replacement options would allow exercise at any time. The option-holder could be required to enter into a contingent purchase contract (‘CPC'), which would give the company a call option to purchase unvested shares at cost if the option-holder leaves or if any performance targets are failed (ie so as to put the participant in a similar position as if he remained an option-holder).
If an exit occurs more than a year after exercise, the option shares could be sold for cash and the participant would potentially qualify for ER on the disposal. If an exit occurs within a year of exercise, the participant could exchange some of his option shares for loan notes as in route 1 above.
Alternatively, the option terms could be altered to allow early exercise but HMRC regards this (based on case law) as a change to a fundamental term amounting to the grant of a new option. If a new option is granted (whether as a replacement option or because an existing option is amended), fresh form EMI 1s will need to be submitted to the Small Companies Enterprise Centre within 92 days of grant for the new option to qualify for EMI tax relief.
There are a number of drawbacks with this strategy:
— If existing options are ‘in the money' and the new option is granted over the same number of shares at the same exercise price, the new option will be granted at a discount. EMI options granted at a discount are subject to income tax on exercise on the amount of the discount on grant. If the option shares are readily convertible assets at the time of exercise, PAYE and NIC will apply.
— If the exercise price is substantial the option-holder would have to fund it and will incur real commercial risk.
— Even if the strategy works as planned, the employing company will lose out on corporation tax relief as a deduction will only be available for the (lower) spread on exercise as opposed to the spread on exit.
— The company's articles may need to be amended to allow the call options in the CPCs to operate and it is not necessarily straightforward for the company to purchase and cancel its own shares (particularly if it has no distributable profits).
— Participants will become shareholders thereby acquiring minority shareholder rights/potentially diluting other shareholders below the 5% threshold.
It seems to the author that when considering existing options, route 1 is likely to be more attractive than route 2 in most cases.
Future EMI option grantsCompanies wishing to grant EMI options in the future may wish to consider granting options over a new class of ‘growth shares', which have no rights other than to participate in liquidation or exit consideration above a threshold (so it is possible to agree a low upfront value for the growth shares with HMRC for EMI purposes).
EMI options to acquire growth shares can be exercised early as in route 2 above without triggering tax charges on exercise and without requiring participants to incur any real commercial risk. If the exercise price is nominal, it will usually be acceptable to provide in the articles that forfeited shares can be converted to worthless deferred shares (so avoiding the need for the company to purchase and cancel the shares). This structure may become a common alternative to the traditional ‘exit only' EMI option plan.
The growth share structure can be extended so as to allow individuals who it is intended will be shareholders (as opposed to option-holders) to acquire shares via the exercise of EMI options (so as to allow them to benefit from ER without satisfying the personal company requirements).
Watch this spaceMuch of this structuring will be unnecessary, however, if the government alters its proposals so as to allow the one-year ER holding period to run from the grant of EMI options. The best strategy may therefore be to do nothing in the hope that the government will improve its proposals.
Colin Kendon, Partner, Bird & Bird