Enterprise Management Incentives: HMRC publish important new guidance

Enterprise Management Incentives (EMI) employee share options can benefit from generous tax advantages. Provided all qualifying conditions are met, any growth in value of the underlying shares is free of income tax and both employee’s and employer’s social security charges on exercise. Business Asset Disposal Relief (BADR), which reduces the applicable rate of capital gains tax (CGT), can also apply when shares acquired on the exercise of EMI options are sold. These benefits, together with their flexibility, have made EMI the share plan of choice for qualifying growth companies.

HMRC recently published important new guidance on how they apply one of the EMI qualifying company conditions – the independence requirement. This is welcome, but HMRC’s newly published view on whether companies will meet the independence requirement as they near a sale, or if investors hold ‘swamping’ rights that let them take control of the company in certain financial distress situations, mean some companies that expect options over their shares to qualify for EMI tax and social security reliefs might now find that position challenged, potentially after the relevant options have been exercised.

This article summarises some key aspects of HMRC’s new guidance and outlines what companies that have, or wish to adopt, an EMI share option plan should consider.

Amongst other conditions, for options over a company’s shares to qualify for EMI tax advantages, the company must not be under the control of another company, or of another company together with any persons connected with that other company (e.g. under the control of a partnership which has one or more corporate members). For these purposes, the ability to determine the composition of the Board, or otherwise to ensure that specific decisions are passed at Board meetings, is a necessary element of control.

Additionally, there must not be any ‘arrangements’ in existence by virtue of which the company could fall under such control. ‘Arrangements’ are widely defined and include any agreement or understanding, even if they are not legally enforceable.

For that reason, in certain circumstances there has been uncertainty on when HMRC consider arrangements exist by virtue of which a company could cease to be independent, such that qualifying EMI options could not be granted over its shares.

This could be challenging for companies approaching a share sale that might wish to make a final grant of EMI options to retain employees during the exit process – when would any window of opportunity to grant EMI options close?

Additionally, HMRC were known to accept that, where private equity investors held ‘swamping’ rights that let them take control of a financially distressed portfolio company to implement a rescue plan, in certain circumstances, these would not be regarded as relevant ‘arrangements’. But HMRC’s approach was unpublished, creating uncertainty as to whether qualifying EMI options could be granted (though companies could seek specific confirmation from HMRC under their EMI qualifying company advance assurance facility).

HMRC’s new guidance clarifies when they consider ‘arrangements’ that prevent a company satisfying the independence requirement – and which therefore prevent qualifying EMI options being granted over that company’s shares – will exist in certain scenarios, including during the approach to a sale, and where corporate investors hold ‘swamping’ rights.

When ‘arrangements’ come into existence on company sales

In summary, HMRC confirm three key points:

• The existence of an offer letter or similar from a prospective purchaser does not, of itself, create an ‘arrangement’ that prevents the EMI independence requirement being met;
• Relevant ‘arrangements’ come into existence when the potential purchaser and the other parties share a mutual understanding that a sale will proceed largely on the terms they are negotiating (which might be demonstrated by Heads of Terms or another similar non-binding understanding); and
• Where there is a genuine requirement for external approval of the sale that is beyond the parties’ control (e.g., from a regulator) ‘arrangements’ will not exist until approval is given or it becomes clear that it will be given.

But there are still issues that could give rise to difficulties in practice that the new guidance does not address. For example, how could a company be sure when a ‘mutual understanding’ has arisen between the parties negotiating its sale such that EMI options can no longer be granted? Also, when is a requirement for shareholder approval of a sale outside the negotiating parties’ control?

This might be the case for a relatively widely held EMI company (e.g. one listed on AIM), but the EMI qualifying company conditions are such that most have relatively few shareholders. If the negotiating directors were also the controlling shareholders it seems unlikely that a requirement for shareholder approval would prevent ‘arrangements’ arising – but what if the votes of only a small number of additional unconnected shareholders, such as Enterprise Investment Scheme (EIS) investors, were required?

Also, HMRC’s guidance says that advance assurance of EMI qualifying company status will not be given while negotiations for a sale are ongoing as “it is not possible for HMRC to be certain that arrangements are not in place”. The company, which will be in possession of the full facts as to the status of those negotiations, may be able to form a view on this, but without HMRC confirmation professional advice may be needed to give the parties comfort.

Investor ‘swamping’ rights and financial distress

HMRC’s basic position is that investor ‘swamping’ rights that could let another company (or, for example, a partnership with a corporate member) obtain control of a company because of underperformance are ‘arrangements’ that prevent the grant of EMI options.

But HMRC will not treat ‘swamping’ rights as ‘arrangements’ that prevent the grant of EMI options if they can only be triggered where the company:

• Fails to redeem any loan notes;
• Breaches banking covenants; or 
• Proposes liquidation (other than a voluntary liquidation).

However, as HMRC also appear to say that, depending on the specific circumstances, these events “may not always amount to distress provisions and each case will be decided on the individual facts”, companies whose corporate investors hold such financial distress swamping provisions would be prudent to seek HMRC’s advance assurance of EMI qualifying company status, notwithstanding the new guidance, to confirm that HMRC accept those provisions do not preclude EMI qualifying company status in the company’s specific circumstances. 

HMRC’s new guidance is welcome, and should be considered by companies that operate, or plan to introduce, an EMI share option plan.

However, HMRC’s newly published position, particularly in relation to investor ‘swamping’ rights, might be narrower than some companies and their advisers had previously understood HMRC’s practice to be.

Therefore, in some circumstances the qualifying status of EMI options granted over a company’s shares as it approached a sale, or where the company’s investors hold ‘swamping’ rights, might now be challenged based on HMRC’s new guidance – potentially by a prospective purchaser on a tax due diligence exercise in the first instance.

Should such a challenge be successful, employees could be subject to unexpected income tax charges on exercise of their options, and capital gains tax without the benefit of BADR on disposal of their shares, which might undermine the incentive effect of those options and reduce the benefit to the employer in employee goodwill.

Additionally, employers could be subject to unexpected PAYE and employee’s National Insurance Contribution (NIC) withholding obligations, and employer’s NIC and Apprenticeship Levy charges (and, potentially, interest and penalties where the relevant options have already been exercised).

Employers with EMI plans should therefore review their specific positions against HMRC’s new guidance.

Points to consider include:

• If EMI options were granted in the run up to a sale, how would the company demonstrate to HMRC and/or the prospective purchaser that relevant ‘arrangements’ had not arisen as at the date of grant?;
• If the company’s investors hold ‘swamping rights’ that fall within those HMRC list as potentially compatible with the independence requirement, how could the company demonstrate that, as those specific provisions are drafted, they are bona fide indicators of financial distress?;
• What is the company’s position if HMRC previously gave advance assurance of EMI qualifying company status but, on the relevant facts, that assurance appears to be at odds with HMRC’s new guidance (e.g. where the circumstances in which investor ‘swamping’ provisions are triggered go beyond the financial distress provisions HMRC list)? Note that HMRC’s new guidance is silent on this, and if companies need to assess whether – and to what extent – they can rely on such advance assurances as a matter of public law they should do so quickly, as their ability to take appropriate action may be subject to short time limits; and
• If it appears that HMRC would not accept that the company qualifies for EMI, what alternative tax-advantaged or tax-efficient employee share plans might be appropriate?

Please contact this article’s authors, or your usual KPMG in the UK contact, to talk through how KPMG’s tax and specialist public law teams could assist you to understand the implications of HMRC’s new guidance for your employee share plans.

For further information please contact:

• Jo Brien
• Chris Barnes