Enterprise Management Incentives www.pettfranklin.com

1. Enterprise Management Incentiveswww.pettfranklin.com David Pett Partner

2. The basic rules: employee share options • What is a share option? • A right to buy existing/subscribe for new shares in future at a price fixed at time of grant, and normally subject to conditions such as: • continuing employment • attainment of performance targets • sale of the company/business • The gain on exercise of an employee share option (iemv of shares acquired, less price paid) is charged to income tax (and, if RCAs, NICs) – whether or not shares can then be sold • Can transfer burden of employer’s NICs (13.8%) on gain on exercise to employee , so effective rate of tax/NICs for higher-rate taxpayer in 2012/13 is likely to be 58.9%

3. The basic rules – PAYE/NICs If the shares are “readily convertible assets” (ie are, or will become, tradeable or the company is not independent): • income tax charges due under PAYE • National Insurance contributions payable • employees’ 2% (above UEL) • employer’s 13.8%

4. The basic rules: relief from corporation tax Employer company can, if independent, claim relief from Corporation Tax for amount of employee share option gain (subject to conditions)

5. The basic rules: tax on sale of employee shares • CGT on sale of shares • But, IT may be charged if: • shares are “restricted” and employee has not paid the full “unrestricted” value on acquisition • shares are sold for > MV • Entrepreneurs’ Relief (10% rate of CGT) if interest of ≥ 5% held for 12 months • Base cost = price paid + IT charged on acquisition

6. The share valuation conundrum ‘Pro rata’ value £ Market value for tax purposes Time “Leaver” “Exit” Any uplift, from a minority interest value to a pro rata value, on exit, should normally be free of income tax/NICs

7. So, what can be done to avoid charges to IT/NICs on future growth in share value without the need for the employee to invest in shares for full unrestricted market value at the outset? • Enterprise Management Incentives • Company Share Option Plans • Share Incentive Plans • Joint Share Ownership Plans

8. Enterprise Management Incentives • Finance Act 2000: First example of legislation produced by an “independent” government-appointed advisory group • Aimed at small, independent, high-growth companies • No prior HMRC-approval required, but option grants must be notified to HMRC Small Company Enterprise Centre within 92 days • Share options, but with commercial flexibility as to the exercise price and when it can be exercised (but must be, if at all, within 10 years and within 1 year after death)

9. EMI share options - tax • Can set exercise price at below MV (even nil!) • Remember need to pay up nominal value of newly-issued shares • If exercise price < MV, the discount is charged to IT at time of exercise

10. EMI share options - tax • No IT/NICs, on exercise of the option, on growth in market value from grant to exercise • If a “disqualifying event” (eg takeover or leaving), relief for accrued gain not lost, and no loss of relief ,if option is exercised within 40 days • Note: if “restricted” shares acquired on exercise of EMI option with exercise price = IAMV, then (IUMV – IAMV) falls out of charge • Purpose test: must be for “commercial reasons ….. not …. avoidance of tax”

11. MV MV £ £ Option gain exempt from income tax Ex. price Ex.price Time Grant Grant Exercise Exercise B“Discounted option” : no disqualifying event A“Market value” option: no disqualifying event Exempt gain Taxable gain Time

12. MV MV Taxable gain Exempt gain Ex. price Time Grant Disq. Exercise Event Disq. Exercise Event Grant C“Market rate” option: disqualifying event occurs more than 40 days before exercise D“Nil-cost” option: disqualifying event occurs more than 40 days before exercise £ £ Taxable gain Exempt gain Taxable gain Time

13. EMI share options - tax • CGT payable on sale of shares • Budget 2012: Entrepreneurs’ Relief (ie reduced 10% rate) available if EMI option shares held by employee for one year (and all other conditions for ER satisfied except the need to hold 5%) • not available if EMI option is “exit only” • lobbying for change

14. EMI options: qualifying companies • Company/group must have <250 fte employees • EMI company/group must have gross assets of < £30m • sum of gross assets of each group company • EMI company must be independent • Must be no arrangements for loss of independence • Must not carry on a disqualifying activity • One group company must have a ‘permanent establishment’ in the UK

15. Which companies qualify? • All subsidiaries under the ‘control’ of the EMI company must be 51% subsidiaries (and no other person may have control of it) • Any “property managing subsidiary” must be 90% owned • No arrangements must exist which would cause the independence or subsidiaries tests to be failed • Beware: pre-emption rights or investment/funding agreements under which control could be acquired (eg upon conversion of debt securities if bank covenants not met etc) in a “meltdown” situation

16. Trading activities requirement • The activities of the company/group must not consist as to a substantial part (20%) of excluded activities: • dealings in land, commodities, securities (etc) • dealings in goods otherwise than as wholesaler/retailer • banking, insurance, money-lending, debt factoring, financial activities (etc) • leasing or receipt of royalties (subject to exemption for exploitation of self-developed intellectual property) • legal or accounting • property development • farming (etc) • forestry (etc) • shipbuilding or coal and steel producing • operating hotels (etc) • managing nursing homes (etc) • acting as a service company

17. Eligible employees • Must be employee of the EMI company or a qualifying subsidiary • Be committed to 25 hours p.w. or 75% of working time • Not have (or be deemed to have) a “material interest” • 30 per cent • applied at grant, not exercise • no “look-back” 12 months • interests of “associates” count, but sibling is not an associate • EMI option shares left out of account • other option shares counted but, if subscription options, ordinary share capital is grossed up • beware existence of EBTs – trust shares disregarded if certain conditions met

18. Enterprise Management Incentives - limits • Overall limit of £3m on aggregate IUMV (at grant) of shares under all EMI options • Individual limit of (now) £120K on IUMV (at grant) of shares under EMI (and CSOP) options to any eligible employee • to be increased to £250,000 “ASAP” • Beware re-grants: the ‘3-year rule’: never grant right up to limit of £[120K]

19. Why grant/exercise of EMI option rather than invite employee simply to subscribe for shares at market value? • Growth over option period may qualify for CT relief (cf EIS relief) • If shares “restricted”, then any difference between IAMV and IUMV falls out of charge to tax • If employee leaves then, unless he is allowed to keep it/exercise it, it merely lapses • Shareholder dilution occurs only at time of exercise • No concern over minority shareholding interests

20. EMIs: requirements re the option contract • Must be a written option contract granting an enforceable, albeit conditional, right to acquire shares in a “qualifying company” either: • “long-form” bi-lateral contract or: • rules + “short-form” certificate and agreement to be bound by rules • Grantor can be company or shareholder or EBT (Note: employer may get CT relief whoever grants/provides the shares)

21. Notification/reporting to HMRC • HMRC form of notification of grant • includes declaration of eligibility by employee • HMRC annual return on Form 40

22. Warning: Remember the 92-day time limit for reporting grant of an EMI option on Form EMI1 Note also the address to which Form EMI1 should now be sent (as from April 2012): Small Company Enterprise Centre HM Revenue & Customs First Floor Fitzroy House Castle Meadow Road Nottingham NG2 1BD

23. Types of EMI (and other) private company share options • “Exit only” • exercisable only upon a sale or change of control (or flotation?) • if employee leaves for any reason, option either lapses or he may retain whole or part but exercise only if Exit occurs within, say, 5 years • No access to reduced 10% ER rate of CGT on sale • “Vesting schedule” • right to exercise accrues over time • “Performance-linked” • option lapses insofar as performance targets not met

24. Articles of association • If option is capable of being exercised before an Exit, then articles of association should be checked to ensure proper provision for: • protecting against disposal to a third party • compulsory offer for sale back for value (good leaver) or nominal value (bad leaver) • permitted transfers to/from an employees’ trust • drag along/tag along • Beware company law problems if articles changed after option granted

25. CT relief Usual rules of ss1014 – 1024 CTA 2009 apply: • benefit curtailed if option exercised unnecessarily early • no express statutory CT relief for costs of establishing EMI option plan – but relief not excluded by s1038 CTA 2009 (and see Final Regulatory Impact Assessment issued by Inland Revenue in 2000) • ensure set-up costs borne by employer company?

26. Accounting treatment The treatment of share scheme accounting issues applicable to SMEs will be covered by William Franklin of Pett, Franklin & Co. LLP later in this conference

27. Contact details William Franklin william.franklin@pettfranklin.com Office: 0121 348 7878 Mobile: 07889 726 767 Twitter: www.twitter.com/pettfranklin David Pett david.pett@pettfranklin.com Office: 0121 348 7878 Mobile: 07836 657 658 Twitter: www.twitter.com/pettfranklin www.pettfranklin.com