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Share Option Plans En Vogue?

24 August

With companies still under pressure to both manage cash flow and its relationship with employees (amongst other things), one topic that is cropping up frequently is the possibility of awarding employees with equity rather than wages. In the view of WKH Partner James Price, one positive thing to come out of Labour's tenure was the improvement in tax advantaged employee share schemes.

"Whilst Share Incentive Plans (SIPs) and Company Share Option Plans (CSOPs) are geared to the needs of listed companies, for the SME market the Enterprise Management Incentive Scheme (EMI) really does tick a few boxes. This has been tempered somewhat by the requirement to hold a 5% stake in order to qualify for Entrepreneur's Relief, but it will still be suitable in many cases. Business owners are always faced with a dilemma when looking at equity based reward schemes, the business is their baby and conceding equity is not always a palatable thought. For that reason, an equity style scheme that doesn't actually result in equity being issued - the Phantom Share Scheme - is a natural alternative to EMI."

In this article we look at some of the facts and figures that apply to EMI and Phantom schemes. If any questions arise, or you would like to discuss incentive schemes in general, please contact James Price jprice@wkhca.co.uk

About EMI

Introduced in FA2000, this scheme is designed to help smaller companies retain key employees, it is by necessity discretionary. The first test to pass in order for the options to qualify as EMI options, is the purpose test:

“for commercial reasons in order to recruit and retain an…. employee in a company, and not as part of a scheme or arrangement, the main purpose, or one of the main purposes, of which is the avoidance of tax.”

Features

Maximum initial share value (i.e. market value at grant date) of £120,000 for any one employee.

There is no minimum holding period in order to qualify for income tax relief.

Options can be granted at an option price less than market value at the date of grant.

The shares may qualify as business assets for the purposes of Entrepreneur’s Relief.

The shares over which options are granted can be subject to restrictions, and/or risk of forfeiture.

Tax Relief

There is no charge to income tax upon the option grant.

The amount charged to income tax when the option is exercised is calculated as the market value at the date of grant, less the option price (i.e. that which must be paid to exercise the option).

Having established that there are some attractive tax reliefs for an EMI scheme, careful consideration needs to be given to whether a company qualifies or not.

There are a number of tests that a company must satisfy in order to qualify:

The Independence Test

Must not be a 51% (or more) subsidiary of another company, or else under the control of another company (control as defined in Section 840, ICTA1988).

The Gross Assets Test

The gross assets of the company must not exceed £30,000,000 as at the date of grant, where the company is a parent company, the gross assets of the group must not exceed £30,000,000.

For the purposes of this test, the latest available balance sheet is used, and naturally liabilities are not deducted. Where groups are involved, consolidation adjustments must be made as if you were preparing a consolidated balance sheet.

Qualifying Subsidiary Requirement

If the granting company has control (as defined by Section 416, ICTA 1988) of any other company, then the following conditions must be fulfilled:

- All companies must be qualifying subsidiaries, so a company, or one of its subsidiaries, must:

- Possess at least 75% of the share capital and voting power of the subsidiary.

- Be entitled to receive 75% of subsidiary’s assets in a winding up.

- Be entitled to 75% of distributable profits of the subsidiary.

- The subsidiary must not be under the control, as defined by Section 840, ICTA1988, of any other company.

-There must not be arrangements in place to prevent any of the above conditions from being met.

Trading Activities Requirement

For the Single Company

The company must exist for the purposes of carrying on one or more qualifying trades (see below). Incidental purposes are disregarded.

The trade must be wholly or mainly in the UK, though the company itself does not have to be UK resident or incorporated.

For Groups of Companies

The activities of the group taken together must not consist to a substantial extent of “non-qualifying activities”, and at least one company must exist wholly for the purpose of carrying on a qualifying trade, or be preparing to do so,

It is only necessary for one company’s qualifying trade to be carried on in the UK.

Neither the company carrying on the qualifying trade in the UK, or the parent company need be UK resident or incorporated.

Qualifying Trade

The list below shows a summary of the activities excluded for EMI qualification as defined by Schedule 14 FA2000.

The Eligible Employee

Individual must be an employee of the company or of a qualifying subsidiary of the company.

Must satisfy working time commitment, which is at least 25 hours per week, or else at least 75% of their working time.

Must not have a material interest (generally beneficial ownership of more than 30% of the ordinary share capital) at the date of the grant.

The Shares

Must be fully paid, non-redeemable and form part of the ordinary share capital of a qualifying company.

The shares may be subject to restrictions and/or risk of forfeiture (note that any such restrictions are disregarded for valuation purposes).

Disqualifying Events

If a disqualifying event occurs and the EMI option is yet to be exercised, the employee has 40 days in which to exercise the option and obtain the EMI tax reliefs.

If the employee holds on to the shares then any increase in the market value from the date of the disqualifying event to the date of exercise is chargeable to income tax.

The following may result in a disqualifying event:

- Loss of company independence

- Variation in option terms

- Alteration in share capital, affecting share valuation

- Conversion if shares to different class

- Granting of CSOP options

- Change in qualifying trade

- Change in employee eligibility

Operation Procedures

Once a valuation is agreed, using form Val231, with the Valuation Office, the company is simply required to notify the Inland Revenue’s small company enterprise centre within 92 days of the option being granted.

The Revenue are permitted 12 months in which to consider whether the options are in fact EMI options.

The options will require a written agreement between the employer company and the eligible employee.

Any company with EMI options over it’s shares is required to submit an EMI tax return within three months of the end of the tax year.

PHANTOM SHARE OPTION SCHEMES

This is something of a misnomer as there are never any transactions involving shares. The scheme is deferred cash bonus arrangement, with the amount paid having reference to the growth in share price over the given period of time.

Scheme Operation

Employee is granted the right to call upon the company to pay them a cash sum.

This cash sum is calculated as the difference between the ‘share option purchase price’ set at the beginning of the period and the market value at the end of the period.

When the employee exercises the phantom option the company pays the calculated value as taxable emoluments.

Normally payment will be conditional on the employee having fulfilled performance criteria agreed upon at the outset.

Tax Treatment

There are no reliefs available for these options, it is subject to income tax at the highest rate paid by the employee and is also subject to NICs.

A further point is that the employer must account for income tax on the sum due when the employee first becomes entitled to the sum. The point of entitlement may be different to the date of payment so, as a planning point, the employee should be required to serve an exercise notice in order to become entitled to receive payment.

Pros and Cons

As one might expect there are no limits to the value of share options, they can be used on a discretionary basis to award particular employees.

The advantage of a phantom scheme is that it does not result in the current shareholders ceding any control of the company, and the value of their shares is not diluted as a result of a share issue.

The implementation is relatively inexpensive and there is not a great deal of administration involved.

The major disadvantage is that the scheme attracts no tax incentives for the employees.