How can a company incentivise employees through equity in a tax efficient way?

There are a number of government approved equity incentive schemes which provide for significant tax breaks if they can be implemented and are suitable.

Enterprise Management Incentives

The most common (and probably easiest to implement) is the Enterprise Management Incentive (“EMI”) scheme. Under this scheme, options to acquire shares are granted to qualifying employees.  They can usually be exercised on an ‘Exit’ event, with provisions for what happens if the employee leaves the company (often depending on whether they are a ‘good’ or ‘bad’ leaver).

Provided the options are granted with an exercise price which is at least equal to the market value of the shares at grant, no income tax will arise on the value of the shares when the options are exercised. In addition, if the options are held for at least 2 years before they are exercised, business asset disposal relief (formerly entrepreneurs’ relief) may be available on the sale of the shares (even if the employee holds less than a 5% interest in the company – which would be the usual requirement for this relief).  This means that if options are exercised just before a sale, and the shares then sold, the sale proceeds could be subject to a tax rate of 10% rather than of up to c.50% (with PAYE and NICs).

It is possible (and advisable) to agree the current market value of the shares with HMRC before the options are granted.

There are a host of conditions which need to be met by the company to qualify for EMI.  Most small trading companies will qualify.  Many of the conditions are similar to those for S/EIS and a company which has S/EIS investment will usually also qualify for EMI (see “What are the SEIS / EIS conditions?” for some of the conditions).  A couple of particular points to watch out for are:

  • The company cannot be controlled by any corporate (or a corporate plus persons connected to that corporate) and the shareholding structure should be examined carefully if there are any corporate shareholders;
  • The company must have a permanent establishment in the UK, and unlike for S/EIS, a UK holding company (which does not trade) with an overseas trading group is unlikely to qualify as HMRC’s position is that the trade or part of it, must be carried on in the UK through that permanent establishment;
  • Employees must satisfy the ‘working time requirement’ in order to qualify for EMI. This means that they must work on average at least 25 hours per week or, if less, at least 75% of their total working time for the company or its group. In addition they cannot have a greater than 30% shareholding in the company.

Other government approved schemes

As well as EMI there are a number of other government approved share incentive schemes which provide income tax advantages, including the Company Share Option Plan and Save As You Earn scheme. These are generally less popular due to the lower value of options/shares which can be awarded and involve more complex administration.

Growth shares

If a company and/or employees cannot qualify for EMI or other approved schemes, or those schemes are not appropriate for any reason, then a company can consider issuing ‘growth shares’ to employees.    This is a new class of share which, generally, participates in the proceeds of sale on an exit above a certain ‘threshold’.  

The threshold is generally set at just above the current market value of the company, with the idea being that the shares have no value when they are issued (and so the income tax charges described above do not apply).  Any growth in value should be taxed at capital gains tax rates. Restrictions can be applied to the shares to deal with leavers, and the shares may have no dividend or voting rights.

The setting of the threshold and valuation of the company is key to minimising the risk of any income tax charges arising on the growth shares.  Unfortunately there is no process for agreeing this value with HMRC in advance (unlike for EMI) and professional valuation advice should usually be sought.

Care needs to be taken where the company has S/EIS investment because any S/EIS shares cannot have a preference over the assets on a liquidation over other classes of share.  Careful consideration of the rights of the growth shares and S/EIS shares needs to be given.