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Top 10 EMI Pitfalls on an Exit

EMI options are a great way of delivering shares to employees. They are tax efficient, straightforward to implement and flexible. It is possible to agree the share value with HMRC before the options are granted (which is very attractive as that means there is certainty of tax treatment) and they can be put in place relatively cheaply. In most cases if a company qualifies to grant EMI options, they will be by far the best way of delivering shares to employees.

However it is easy to go wrong when implementing EMI options and often this isn’t discovered until due diligence is being done by a buyer on an exit. At that point, issues with EMI options can become a very expensive and time consuming problem. It will usually be too late by this stage to fix these problems in a tax efficient way.

If an EMI option is not qualifying, it is taxed as unapproved option which means that the company will have an obligation to account for PAYE and NICs on the market value of the shares at exercise (at combined rates of income tax and employee NICs at up to 47% and employer NICs of 13.8%) less the exercise price paid for the shares.

The market value of the shares at exercise will be determined by reference to the sale price of the shares on the deal. If the deal involves any non-cash or deferred consideration (including an earn out) the optionholder will effectively be subject to income tax and NICs on the value of that non-cash/deferred consideration at completion. In the worst case scenario there could be an income tax and NICs charge effectively on value the optionholder never receives (e.g. if the earn out never delivers) - this is a particularly nasty tax outcome.

Example

An optionholder is exercising on an exit and is selling his shares for £500k cash plus an earn out of up to £300k, which has a value at completion of say £250k (because the earn out targets are likely to be met and it is a short period). The exercise price for the option shares is nominal so has been ignored for simplicity in the example.

The optionholder will be subject to income tax and employee NICs of £352.5k (i.e. 47% of £750k) which will have to be funded out of his £500k initial cash which will feel to him like a 70% tax rate.

If the earn out ends up paying less than £250k he will not get his overpaid tax back.

Even worse, the buyer, as the new owner of the employer company, has to deal with the PAYE/NICs on completion. So even if the optionholder would want to try and take a very cautious “day one” value of the earn out right for the reason above, the buyer may not be willing to do this as it risks under accounting for the tax due.

Top Ten EMI Pitfalls

Here is our top ten of the most common EMI pitfalls we see on the sale of companies (which will hopefully help you to avoid them):-

1. EMI notifications not made EMI options must be notified to HMRC within 92 days of grant – if they are not, they will not be qualifying EMI options. It might be possible to make a “reasonable excuse” claim but in our experience the situations where these can be made are very limited and a buyer will not generally pay out the full proceeds until HMRC has confirmed if the options can be regarded as EMI.

2. EMI notifications made incorrectly If the notification has been made but an error has been made on the form, in most cases our view would likely be that this is a clerical error and does not impact on qualification but this will not necessarily be HMRC’s view. Again a buyer will usually want confirmation from HMRC that the options are qualifying despite the error and this may or may not be forthcoming – it will also add time, costs and complexity to the deal.

3. Working time declarations In a similar vein to incorrectly made notifications we would argue that failure to get a signed working time declaration from the optionholder does not invalidate the option but this is not necessarily HMRC’s view and a buyer may well insist on getting confirmation from HMRC before proceeding on the basis of the options being qualifying. Working time declarations used to be given as part of the paper EMI option notification form, but are not included in the electronic notification that is made these days, so it is something that we have seen slip through the net.

4. Bad record keeping We often see companies who have not kept records of what has been granted to who and when and the signed documents are nowhere to be found. This causes no end of problems in the due diligence process as this information cannot be obtained from HMRC and will in the worst case scenario lead the buyer to treat the options as never having existed (such that if the shares are issued they are taxed as unapproved options – see the disastrous tax outcome described above).

5. EMI qualification not checked and/or not monitored throughout the life of the option. It is vitally important that all EMI qualifying conditions are checked at grant and monitored throughout the life of the option. Common pitfalls include companies with no subsidiaries which carry on any investment activities – these will not qualify unless the investment activities are incidental. This is a different and much harsher test than the “substantial” (broadly 20%, but each case would turn on its facts) threshold which applies to EMI companies with subsidiaries. This means any letting of property or holding of shares (not amounting to a subsidiary) for example will be a problem in a single company whereas it would typically only be a problem if it amounted to more than 20% of the group’s activities where there is a group of companies. Other common qualification issues we see are around licensing of IP (where the value in the IP has not been created by the EMI company), joint venture holdings and control by corporate shareholders (see point 7 below for more details on this one).

6. Leavers We often see the scenario where leavers have been allowed to keep their options and exercise on an exit. These optionholders will be subject to PAYE/NICs when they exercise, on the increase in the market value of the shares from the date they ceased to be employees. The difficulty comes on an exit if there is no record of what the share value was when they left. Companies should undertake valuations when employees leave where the employee is allowed to keep the option. It might be possible to go back and work out what the value might have been if there were option grants taking place at the same time and a value was agreed with HMRC at the time. But it is much better to do this pro-actively rather than have to deal with it on an exit when there will be many other things to deal with and time pressures.

7. Options granted shortly before an exit As mentioned above there is a rule which provides that the EMI company must not be under the control of another company. This is a very wide test (very similar to the EIS test) and requires you to aggregate the interests of any persons connected with the potentially controlling company and even applies where there are “arrangements” by virtue of which the company could (as opposed to “will”) come under the control of another company. Where an exit is in prospect at the time the options are granted you need to look very carefully at this arrangements test. We have seen HMRC take a markedly stricter approach to the interpretation of this provision in recent times and they have even suggested that a unilateral reorganisation in anticipation of a sale may be sufficient to be “arrangements” for this purpose. We do not agree with that view, but what is clear is that options should be granted as far as possible in advance of a sale and before a particular buyer has been identified. Advice should be taken to understand what the risks are, remembering that a buyer will look very closely at this in due diligence and will be aware of the status of the talks at the time of the grant.

8. Errors in the contract Make sure the EMI options are granted over the right number and class of shares, and that any provisions around when the option can be exercised, vesting and performance targets are carefully drafted to reflect the commercial intention. This may sound obvious, but it may be too late to fix any mistakes in the documents found on exit.

9. Valuations It is not compulsory to agree the share value with HMRC when an EMI option is granted but this should be done as a matter of course and companies should ensure that all details (including any possible sales, fundraisings and transfers between shareholders) are disclosed – a valuation is only as good as the information disclosed to HMRC. A buyer will expect to see the agreed valuation and the information submitted to HMRC. If no valuation was agreed (or if the information submitted was incomplete or misleading) the value at the date of grant will need to be determined in retrospect when the parties will have the benefit of hindsight. A buyer may be unwilling to accept that HMRC would have agreed the very low value the sellers are arguing for had they had all of the information at the relevant time.

10. Exercise price and CT deduction The sellers should get value from the buyer on the sale for any exercise price paid to the company on exercise of the options (as excess cash). The sellers should also try and obtain value for the statutory corporation tax deduction which arises on the exercise of the EMI option (being a deduction equal to the market value of the shares at exercise less the exercise price paid, which can be a very large sum). If the company is loss making a buyer may perceive no value in the deduction, but if it is profit making or is likely to be in the short to medium term a buyer will often pay for the resulting tax saving, if not on completion then as and when the tax saving is obtained. These are not really pitfalls unless they are missed!

As ever if you have any questions or would like to discuss any of the above then please feel free to get in touch.


Posted on 26/10/2020 in EMI Options

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