Tax Bite - Exercise of Discretions in EMI Option Agreements
In October, HMRC published its long-awaited (at least by advisers) guidance on the use of discretions in EMI options.
There has been a long period of uncertainty, during which it was not clear in what circumstances HMRC would regard the exercise of a discretionary power in an EMI option contract as:
- Not affecting the tax-advantaged EMI status of the option; or
- A change to a fundamental term of the option, meaning a deemed release and re-grant of the option and (likely) loss of valuable EMI tax benefits.
Typically such discretions would be exercisable by the board of directors and cover things like waiving or varying a performance condition, allowing an option be exercised over shares that hadn’t yet vested, or allowing a leaver to keep or exercise an EMI option.
The key points in the new guidance can be summarised as follows:
- It is very important that the relevant discretions are built into the documents from the outset. The existence of a discretion provision in a contract is not a problem. Exercising it may be (see below), but if you don’t have the discretion in from the outset, you will be in a much worse position.
- Varying an option to include a discretionary power after grant may be permissible but the change must not alter when and how the option may be exercised, other than in a “minimal way”. This may be difficult to achieve in practice as often these points are only considered when something has arisen that was not anticipated in the original option contract.
- There is a big focus on “when” the option can be exercised, which HMRC see as the specified event (the most common being an exit event) or point in time at which an option can be exercised, ignoring vesting and performance conditions. In HMRC’s view, if no such “trigger date” for exercise has arisen and the board wants to exercise a discretion to allow the option to be exercised, that will (save where the change has a “minimal effect”, which HMRC do not define) be a change to a fundamental term of the option and result in loss of EMI treatment.
- However, so long as the “when” is not changed, HMRC generally won’t have an issue with discretions being exercised to allow performance targets to be varied or waived, or to allow for accelerated vesting of option shares. So, for example with an exit-only option, exercising a discretion to allow options that vest over time to be accelerated to 100% vesting on the exit would be acceptable.
- The position is a little more complicated with options that can be exercised as they vest, rather than on the occurrence of a specified event such as an exit. If such options can only be exercised when fully vested, HMRC say it will be ok to use discretions to amend performance and vesting provisions so long as the date for exercise (i.e. the final vesting) is not changed. But if the option can be exercised each time shares vest, HMRC will see any change to when the option vests as a change to a fundamental term, because the “when” is changed.
- When it comes to leaver provisions, where typically there’s a difference between what happens to the option for a “Good Leaver” vs a “Bad Leaver”, HMRC say:
- It is ok for a Good Leaver definition to include a discretion for the board to treat someone as a Good Leaver;
- So long as the discretion drafted into the contract allows it, it is ok for the board to determine that a Good Leaver can either exercise or keep the option over whatever number of the option shares the board decides (although note, leaving employment is a disqualifying event for EMI purposes, so would mean the option would have to be exercised within 90 days of leaving to preserve EMI tax treatment to the fullest extent); and
- Even if the optionholder could otherwise only exercise the option when fully vested in the future, if sufficiently wide leaver discretion provisions are in the option contract to cover this, it will be ok for the board to determine someone is a Good Leaver and let the leaver exercise the option over so many shares as the board decides.
Some of the distinctions drawn by HMRC in this new guidance seem a little difficult to reconcile, but it is definitely helpful to know that some of the most commonly-encountered discretion situations (such as allowing vesting to accelerate on an exit, or to vary or waive a performance condition on a fair and reasonable basis, or allow a Good Leaver to keep or exercise his option when he would not automatically be entitled to do so) will not cause a loss of EMI treatment, so long as those discretions are included in the contract from the outset.
Finally, there is an acknowledgement by HMRC that there will be some cases where they will have taken a harder line than the new guidance when responding to direct requests from taxpayers or their advisers. HMRC also acknowledge that they won’t be aware of (or won’t be checking for, we assume) all such cases, so anyone who thinks they may have received incorrect advice, leading to PAYE and NIC being applied incorrectly on the exercise of an option, can contact HMRC at shareschemes@hmrc.gov.uk (including ‘ERS Bulletin 46 Discretion’ in the subject line of the email) to seek recovery.
Following this new guidance, our advice remains that including discretion provisions in EMI option contracts is a good idea, to provide as much flexibility as possible, but clearly HMRC will not regard the exercise of each and every discretion as permissible for EMI purposes so companies should always seek advice if considering exercising these discretions. The current market practice is that buyers will often insist on writing to HMRC where a discretion is exercised in this way seeking confirmation that EMI status is not impacted. It remains to be seen whether this will persist notwithstanding this guidance. If acting for a buyer, we can envisage there will still be cases where HMRC confirmation will be needed (e.g. could a general contractual discretion to allow exercise at any time be used to accelerate vesting on an exit?) but acting for sellers we would hope that a more pragmatic approach can now be taken where the situation is squarely within the guidance.
If you have clients who you think may have exercised these types of discretions and treated the options as not (or not fully) EMI-qualifying, it will be worth getting in touch with them to revisit the position and see if it may be possible to apply to HMRC as above. We would be happy to assist clients with that process.
Posted on 16/01/2023 in Tax News, EMI Options