An article by David Cohen
With a rising tide of anger, among both politicians, the media and the general public, against executive pay and tax avoidance, it is remarkable that the Finance Act 2013 has brought about a 64% reduction in the rate of capital gains tax payable by a major category of executives who exercise share options. However, as with any tax relief, there are pitfalls which can cause the relief to be lost. Woe betide an adviser whose client is tripped up by one of these pitfalls. Diligent readers of EMI Share Options – a Complete Guide should be saved from such a fate.
Enterprise Management Incentives (EMI) share options can be granted to selected employees by independent trading companies with gross assets of no more than £30 million and less than 250 employees. An individual can hold EMI options over shares worth up to £250,000 (increased last year from £120,000) and the exercise of such an option will generally be exempt from income tax and national insurance contributions (NICs). However, gains made on the sale of shares acquired by exercising an EMI option were almost always subject to capital gains tax at the higher rate of 28%.
In theory, this could be reduced to 10% if the conditions for entrepreneurs’ relief were met but this would have required an employee to hold at least 5% of the ordinary share capital and to control at least 5% of the voting rights. Furthermore, the shares would need to have been held for at least a year whereas EMI options are often exercised on an exit event and the shares are immediately sold.
The Finance Act 2013 removes the 5% condition for EMI participants and allows them to count their period of ownership from the date on which the option is granted. This might suggest that provided an employee can hold onto his option for at least a year, he should be home and dry. But this is to overlook the potential impact of a disqualifying event. There are 10 such events of which the most likely to occur are the EMI company losing its independence or ceasing to carry on a qualifying trade or the employee ceasing to be employed by the EMI company or no longer working for it for sufficient hours per week.
If an EMI option is not exercised within 90 days of a disqualifying event (increased from 40 days for disqualifying events occurring on or after the date of Royal assent to FA 13) any gain arising between the date of the event and the date of exercise is subject to income tax and possibly NICs. But that is not all. Failure to exercise within 90 days will also mean that the special EMI route to entrepreneurs’ relief will be closed off. Hence, apart from in the unlikely event that the option holder has held at least 5% of the ordinary shares in the company for 12 months, CGT will be levied at 28%.
Even where an option is exercised within 90 days of a disqualifying event, entrepreneurs’ relief may still be lost. This is because the occurrence of a disqualifying event will mean that the 12 month period between option grant and share sale will instead end on the date of the disqualifying event. Suppose, for example, an EMI option is granted in May 2014 and that the option is exercised and the shares are sold in June 2015. If the option holder becomes a non-executive director (a disqualifying event) in April 2014, he will not qualify for entrepreneurs’ relief, even though the exercise is within 90 days, because the period from grant to event is less than 12 months.
Difficult issues may arise if the EMI company is taken over within a year of an EMI option being granted. If the option holder is forced to take cash, he will not benefit from entrepreneurs’ relief. If he exercises his option and then exchanges his shares for new shares in the acquiring company, those shares will not be treated as “relevant EMI shares” so the 10% tax rate still be out of reach.
Indeed, there may be a difficulty even if the option has been held for more than a year. This is because a share-for-share exchange will normally not be treated as a disposal for CGT purposes and the subsequent disposal will then be of shares which are not relevant EMI shares. Thankfully, there is a potential escape from this particular trap. The employee can elect for the share exchange to be treated as a CGT disposal as far as his shares are concerned. Making such an election will not always turn out to be beneficial. The electing employee may need to pay CGT (albeit at only 10%) before he receives any cash for his shares and he takes the risk that a fall in share price will mean that some of the gain on which he has paid tax evaporates, leaving him a capital loss when he may not have capital gains against which to offset it.
The position will be more promising if the bidder is prepared to offer option holders an exchange of their EMI options for equivalent new options over shares in the acquiring company. Provided the new options qualify as “replacement options”, any period for which the new options are held can be added to the period for which the original options were held when calculating the minimum 12 month period for entrepreneurs’ relief.
There is a very specific trap which lies in wait for an EMI option holder who exercises her option and then, in time honoured tax planning fashion, gives some of her shares to her husband or civil partner. The transferee will have their own CGT exemption but that benefit may well be outweighed by the loss of the entrepreneurs’ relief which, had she retained the shares, would have attached to 100% of her holding.
Finally, if all these obstacles can be overcome, there will be further complexity with which to grapple if an individual holds some shares acquired by exercising an EMI option and some other shares and is not selling the whole of his holding. Special identification rules apply to determine how many of the shares being sold are to be treated as EMI shares for entrepreneurs’ relief purposes. But that would be the subject of a whole new article!
ISBN: 978 1 78043 254 0
Publication Date: Aug-13
Availability: Not yet published
List price: £65