We take a look at some planning ideas for unlisted companies operating employee incentives now that the new CGT regime has come into force.
We understand p/e ratios applied to determine the value of small companies have almost halved in the last year, this has gone largely unreported but it presents an opportunity if you have outstanding EMI options.
If you are able to agree a lower share value with HMRC, why not grant fresh EMI options at the lower value in exchange for the surrender of existing ones?
This practice was uncommon before 6 April 2008 because the taper relief clock was re-started on the grant of the new options resulting in the option-holder losing banked taper relief on the surrender of the existing option. Now that taper relief has been abolished this draw-back no longer applies.
Suppose a key employee was granted an EMI option to acquire 99,999 shares when the "unrestricted market value" was £1 per share. The individual EMI limit was not enough so he was granted an unapproved option to acquire a further 139,998 shares at the same time.
If it is now possible to agree a value of 50p per share with HMRC, he could be granted a new EMI option to acquire all 239,998 shares as an EMI option in exchange for the surrender of his existing options. The whole new option would qualify for EMI tax relief as it would be within the new individual EMI limit (£119,999 / 50p = 239,998).
Replacement option grants by unlisted companies are uncontroversial. In contrast to listed companies, shareholders of unlisted companies typically have no objection particularly if the exercise price of the new option is the same as the old one.
We frequently advise on option re-grants. There are a number of issues to consider such as reporting, accounting, vesting conditions and the exercise price to apply to the replacement options. Please contact us if you are interested.
Can EMI option-holders qualify for entrepreneurs relief?
On the face of it, EMI option-holders cannot qualify for the new entrepreneurs relief unless they have held at least 5% of the ordinary share capital of the company and have been able to exercise at least 5% of the voting rights for a year or more. Option-holders with no shareholdings will clearly not qualify.
One suggestion is the company could issue a special class of voting shares to one or two key employee option-holders which entitle them each to 5% voting rights but have no other rights. This would enable the option-holder, for example, to exercise his EMI options on an exit and sell the option shares to the purchaser immediately and qualify for the 10% rate on the first £1 million of capital gains.
This strategy may not be appropriate unless existing shareholders are prepared to give away some voting rights to key option-holders pre-exit but, if so, please contact us.
What if you don't qualify for EMI?
Often companies don't qualify for EMI for a variety of reasons, for example:
- 50:50 joint ventures can cause a company to have non-qualifying subsidiaries;
- corporate shareholders can be connected to each other such that the company is not "independent";
- companies with 250 or more full-time equivalent employees will no longer qualify after the Finance Act 2008 receives Royal Assent.
For a full description of the EMI qualifying conditions click here. We can assist with difficult cases but if all else fails what are the alternatives?
The CSOP alternative
It may be possible for unlisted companies which fail the EMI conditions to introduce a company share option plan (or "CSOP") instead. We are currently advising one of our clients on a CSOPs alternative as they will fail the 250 employee test after Royal Assent.
The tax breaks for CSOPs are still not quite as good as for EMI despite the abolition of taper relief because:
· the individual CSOP limit is only £30,000 (as opposed to £120,000 for EMI); and
· the relief from income tax on exercise only applies to CSOP options held for 3 years or more (except for exercises by certain "good" leavers before then) whereas there is no holding period for EMI.
Nonetheless it is still generally preferable for companies that pay corporation tax to structure their equity based awards as options in order to qualify for the corporation tax savings on exercise. Companies in this position should therefore consider the CSOP alternative.
Companies do not have to meet the same demanding conditions as for EMI in order to qualify for CSOPs. The one sticking point for CSOPs is that shares used in the plan cannot be subject to restrictions unless they apply to all shares of the same class. It is permissible to require departing employees to offer their shares for sale but not their transferees (whereas the EMI and even the SIP legislation is more relaxed on this point).
Why not contact us for a "health check" to see if you qualify for a CSOP?
The nil paid share alternative
Another alternative to EMI is for employees to subscribe for shares nil paid or purchase shares from an employee share ownership trust (or shareholder) on deferred payment terms. In either case, the idea is that the amount ultimately payable for the shares is equal to the market value of the shares on acquisition - if this is judged correctly all gains are taxed as capital.
Nil paid shares were more tax efficient than unapproved options but less tax efficient than EMI when the effective tax rate on gains was 10%. The position is less clear-cut since the introduction of the new flat CGT rate of 18%.
Companies which pay corporation tax obtain a deduction on the exercise of options whereas there is no deduction for nil paid shares. We won't bore you with the maths but when you look at the overall tax position it is now roughly neutral when comparing unapproved options with nil paid shares.
Nil paid shares can still be attractive, however, where:
- the employee qualifies for entrepreneurs relief (he will need to hold more than 5% of the voting rights in a trading company to qualify); or
- the company is unlikely to be paying corporation tax when the shares are sold (typically on an exit); or
- the company does not qualify for a statutory corporation tax deduction on the exercise of options (because it is a subsidiary and the parent is not listed on a "recognised stock exchange").
We can consider all these alternatives for you - just get in touch!