Enterprise Management Incentives and Board discretion: are you at risk?
EMI options exercised at the Board’s discretion can lose their tax advantages – here’s what employers need to know about HMRC’s new guidance.
EMI options exercised at the Board’s discretion can lose their tax advantages
Enterprise Management Incentives (EMI) options can benefit from generous tax-advantages. Provided all qualifying conditions are met on grant, and no ‘disqualifying events’ occur before exercise, any growth in value of the underlying shares is free of income tax and social security. Additionally, Business Asset Disposal Relief (BADR) may also apply on a disposal of the underlying shares, with the holding period beginning on grant, rather than exercise, of the option. To ensure commercial flexibility so employees benefit as intended, EMI plans often give Boards discretion to allow exercise if certain circumstances arise. However, in some situations the use of these discretions can jeapordise the availability of the above mentioned tax advantages. HMRC recently updated their EMI guidance in this area. We expect these principles will also apply to tax-advantaged Company Share Option Plans (CSOPs). This article summarises HMRC’s position, and outlines what employers should do to prevent unexpected income tax and social security costs.
What’s the issue?
To qualify for EMI tax advantages, an option agreement must give the employee a ‘right’ to acquire shares, state when the option may be exercised, and set out any conditions (e.g. on performance) that affect the employee’s entitlement. Other qualifying conditions must also be met. EMI options are often granted on the basis that they can be exercised once a specified event occurs (e.g. an exit), or after a period of time has elapsed (e.g. on or after the third anniversary of the date of grant).
Additionally, EMI plans often give the company’s Board discretion to allow exercise in other circumstances. This flexibility ensures that employees can benefit from their options in circumstances which, whilst perhaps not envisaged on grant, in the Board’s view justify the employee being allowed to exercise their option. HMRC accept that the use of Board discretion in some circumstances to allow the exercise of EMI options will not affect their tax treatment.
However, in some situations, the use of Board discretion to allow the exercise of an EMI option will, for tax purposes, be treated as cancelling the original option and granting a replacement. In these circumstances, the EMI tax advantages may be impacted such that on exercise:
- Employees will be subject to unexpected income tax charges; and
- The employer will be subject to unexpected PAYE obligations, and employer’s NIC and Apprenticeship Levy charges (where relevant).
There can also be consequential effects in other tax areas (e.g., on the availability of income tax relief for pension contributions). Additionally, the employer or, where options are exercised in the context of a transaction, an acquirer, may be exposed to the commercial risk of demotivated employees. Employers should therefore ensure they are fully aware of the tax implications of any use of Board discretion in relation to EMI options before that discretion is exercised.
What does HMRC’s new guidance say?
HMRC’s guidance was recently updated to clarify their view of how using Board discretion affects the tax-advantaged status of EMI options (we expect that HMRC will also apply these principles to tax-advantaged CSOP options).
In summary, the key principles are that the exercise of Board discretion to:
- Accelerate the extent to which an option may be exercised (i.e. its ‘vesting’) should not affect its tax treatment, provided that the date on which the option may be exercised is not brought forward;
- Vary or waive a performance condition should not affect the option’s tax treatment, provided this is done in appropriate circumstances and on a fair and reasonable basis (e.g., this might allow a ‘good leaver’ to exercise their EMI options at the Board’s discretion and retain the accrued tax advantages); or
- Allow an option to be exercised at any time and under any circumstances that the Board choose will result in the loss of EMI tax advantages, as the shares received by the employee would not have been acquired under an EMI option (which must give the employee a ‘right’ to acquire shares).
Generally, to avoid adverse tax consequences, the relevant Board discretion must be provided for when the relevant option was granted.
HMRC will treat any amendment to an EMI option agreement or use of discretion to create a new right of exercise, introduce a new Board discretion, or change the exercise date, as the grant of a new option (which, depending on the circumstances, could lead to the loss of some or all EMI tax advantages) unless any improvements to the employee’s rights are only de minimis.
What should employers do?
HMRC’s clarification of their views on this issue following a period of uncertainty is welcome. Employers should consider whether their treatment of historical exercises of EMI and, in our view CSOP, options at the Board’s discretion are in line with HMRC’s position, and ensure they understand the tax implications of any future use of discretion.
Where options have been exercised at the Board’s discretion in the past
Where EMI (or CSOP) options have been exercised at the discretion of the Board, employers should review the circumstances in which that discretion was used, and discuss with their tax advisor whether the compliance position taken (e.g. whether to operate PAYE and NIC, or to advise employees to account through self-assessment for income tax and/or Capital Gains Tax without the benefit of BADR) is in line with HMRC’s new guidance and, if not, the implications of this.
Where, based on HMRC’s new guidance, employers have incorrectly operated PAYE and NIC, or employees incorrectly accounted for tax through self-assessment, it might be possible to reclaim the relevant amounts from HMRC subject to applicable time limits.
Before granting new options
Employers should consider the terms of their option plans and individual award agreements taking into account this new guidance before making new grants.
In certain circumstances employers may wish to make changes to the terms of new grants based on this guidance.
Before options are exercised at the Board’s discretion in the future
An individual employee share plan might contain several different provisions that permit the Board to allow the exercise of EMI or CSOP options at its discretion. To avoid triggering unexpected income tax charges and payroll withholding obligations, and potentially damaging the employee incentive effect of the relevant options, employers should confirm the expected tax implications before discretion is exercised under any of those provisions.
Please contact this article’s authors, or your usual KPMG in the UK contact, to talk through how KPMG could assist you to understand the implications of HMRC’s new guidance for your employee share plans.