The Waterfront Partnership

Share Options: Introduction

What is a share option?

A share option is a right, but not an obligation, for a person to acquire shares at a specified price (or at a price to be calculated in accordance with a pre-agreed formula) during a specified period which may be subject to certain conditions.

Why grant share options?

Share options can be used to recruit and incentivise employees where there is insufficient cash available to offer them competitive salaries and bonuses.

They can also be used to align the interests of employees with those of shareholders by giving the employees a stake in the long term success of the business.

In addition, some employee share option schemes benefit from favourable tax and NIC treatment and provide valuable tax reliefs for both employers and employees which can have the effect of reducing overall employment costs for employers.
Why not just issue shares?

Instead of granting share options it is of course possible to simply issue shares to employees. However, there are disadvantages to doing this for both employers and employees.

For employers:

• Employee shareholders will usually be entitled to attend and vote at shareholders meetings and to receive dividends, thereby diluting the voting and dividend rights of the existing shareholders. This is not the case where share options have been granted, because option holders do not obtain voting or dividend rights.

• Where an employee ceases to be employed by the company for any reason, either the company will have to accept an ex-employee holding shares in the company or the other shareholders will have to find the cash to purchase the employee's shares. Share option schemes usually provide that the options lapse in the event that the employee ceases to be employed by the company.

For employees:

• Employee shareholders will have to find the money to purchase the shares. By contrast, option holders are not usually required to pay anything until they exercise their options.

• An income tax charge is likely to arise where an employee pays less than market value for shares. By granting share options any income tax charge can be delayed until the share option is exercised when the employee is in a better position to afford to pay it, for example, on the sale of the business.

• Employee shareholders are at risk of real financial loss if the company's share price falls. This risk is not applicable to option holders, because they are not obliged to exercise their options.

• There is unlikely to be a market for the shares of a private company until a sale of the business has been agreed. Share option schemes often provide that options are only exercisable in certain circumstances, for example, on the sale of the business.

What are the different types of share option scheme available?

There are a number of different types of share option schemes. Three of the most useful schemes for small and medium sized private companies are:

• Enterprise Management Incentives (EMI).
Key Features

EMIs are tax efficient share options that are designed to help small, high risk companies recruit and retain employees who have the skills they need to grow and succeed. The key features of EMI options are:

• Unlike approved company share option plans, EMI share option plans do not need to be approved by HMRC. However, HMRC must be notified about EMI options after they have been granted.

• The grant of an EMI option is tax-free and, as long as the price the employee pays for the option shares is equal to the market value of the option shares as at the date of grant, there will normally be no income tax or National Insurance contributions (NICs) for the employee to pay, and no secondary NICs for the company to pay, when the option is exercised.

• Qualifying companies can grant EMI options to any number of eligible employees provided that the total value of shares under option does not exceed £3 million (calculated at the date of grant of each option).

• An eligible employee can hold unexercised EMI options over shares worth up to £120,000 and, with care, can be granted EMI options over shares worth £239,999 in any three-year period.

• The terms governing EMI options can be quite flexible compared to other tax advantaged share option schemes.

Qualifying for Tax Relief

If an option is to qualify for tax relief under EMI:

• the company whose shares are under option must be a qualifying company; and

• the employee who has been granted the option must be eligible; and

• the type of share under option must qualify; and

• the terms of the option must qualify; and

• the option must be notified to HMRC in time and in the required form.

Qualifying Companies

In order to qualify to grant EMI options a company must satisfy the following requirements:

Independence - It must not be a 51% subsidiary of, or otherwise be controlled by, another company.

Trading Activities - It must carry on a trade wholly or mainly in the UK on a commercial, profit making basis, which does not, to any substantial extent, include certain excluded trading activities.

Qualifying Subsidiaries - All of its subsidiaries (if it has any) must be qualifying subsidiaries. A subsidiary will usually be a qualifying subsidiary where more than 50% of its share capital is held by the company granting the EMI options and no other person is able to control it.

Gross Assets - Its gross assets must not exceed £30 million. Companies that are part of a group cannot grant EMI options if the gross assets of the group exceed £30 million.

Employees - It must not employ more than 250 employees. Companies that are part of a group cannot grant EMI options if the group employs more than 250 employees.
It is possible to obtain advance assurance from HMRC that a company qualifies to grant EMI options by submitting certain information to the Small Company Enterprise Centre.

Eligible Employees

Individuals are only eligible to be granted EMI options if they satisfy the following requirements:

Employment - EMI options can only be granted to employees of the company (or a qualifying subsidiary of the company) whose shares are subject to the options. EMI options can be granted to executive directors, but not to contractors.

Working Time Commitment - EMI options can only be granted to employees that spend either: (a) at least 25 hours each week working for the company; or (b) at least 75% of their working time working for the company. EMI options cannot be granted to directors who do not satisfy the above requirement (e.g. non-executive directors).

No Material Interest - EMI options cannot be granted to employees who already have a material interest in the company. For example, an employee will have a material interest in a company where he and his associates (e.g. wife, parent, grandparent, child and grandchild, but not including siblings) jointly own more than 30% of the ordinary share capital of the company.

Type of Shares

An EMI option must be a right to acquire shares that are part of the ordinary share capital of the company and are fully paid up and not redeemable.

However, EMI options may be granted over shares that are subject to certain restrictions and/or a risk of forfeiture (e.g. good leaver/bad leaver provisions). For example, the option shares may be subject to certain restrictions on transfer (e.g. pre-emption rights) contained in the company's articles of association or a shareholders' agreement which the option holder is required to enter into as a condition of exercising his option.

It is also possible for EMI options to be granted over a separate class of ordinary shares with reduced rights. For example, the option shares may have limited voting rights. However, option shares should have at least minimal voting rights (e.g. to vote on any proposals to alter the rights of the shares of that class) and some rights to receive dividends or other distributions (e.g. on winding up), otherwise it may be hard to maintain that they are shares. Furthermore, reducing the rights attaching to shares usually decreases their value and employees will not be properly incentivised by EMI options if the shares they are able to acquire do not have any significant value.

Terms of the Option

The terms of an EMI option must be set out in a written agreement between the company granting the option and the employee option holder.

The option agreement must contain details of any restrictions or risk of forfeiture attached to the option shares.

It is becoming increasingly common for companies to make EMI options subject to performance conditions. Details of any such performance conditions must be set out in the option agreement.
EMI options must be capable of exercise within ten years of the date of grant, but they do not have to be exercised within that period. For example, if the exercise of the option depends on the fulfilment of certain performance conditions, it must be possible for the employee to fulfil such conditions within ten years.

EMI options can be exercised in tranches. For example, an option over 100 shares can be exercised in tranches of 10 shares on each anniversary of the date of grant, allowing a full exercise of the option on the tenth anniversary.

EMI options must not be transferable (except to personal representatives on the death of option holder).

Notification to HMRC

EMI options must be notified to HMRC within 92 days of the date of grant. This deadline is strictly enforced by HMRC and if missed the options will not qualify as EMI options.

Limits on Grants of EMI Options

A company may not grant EMI options where there are unexercised EMI options over its shares having an overall value of more than £3 million (valued at the relevant dates of grant).
An employee may not hold EMI options over shares having a value of more than £120,000 (again, as valued at the time of grant).

Tax Reliefs

Income Tax and National Insurance Contributions (NICs)

There will be no income tax charge or NICs payable by the employee or the company on the grant of a qualifying EMI option.

There will be no income tax charge or NICs payable by the employee or the company on the exercise of a qualifying EMI option where:

• the option is exercised within ten years of the date of grant; and

• there has been no disqualifying event; and

• the exercise price (i.e. the amount the option holder pays for the option shares on exercise) is equal to the market value of the option shares as at the date of grant.

The market value of the option shares can be agreed with HMRC before the option is granted. There is no legal requirement to agree a valuation with HMRC before granting EMI options, but it is sensible to do so in order to avoid a dispute arising in future. For example, if the company's estimated valuation is later determined by HMRC to have been inaccurate:

• options granted by the company may not qualify as EMI options, because an individual or company limitation on grant was breached; or

• option holders may have to pay income tax and primary NICs (and the company may have to pay secondary NICs) when they exercise their options, because the exercise price is less than the market value of the option shares at the date of grant.

It is possible to grant EMI options at a discount (i.e. the option permits the option holder to purchase the shares at less than their market value as at the date of grant or even for nothing at all). However, on exercise of the option there will be an income tax charge and NICs payable on the difference between the exercise price and the market value of the option shares as at the date of grant (or, if less, the market value of the option shares as at the date of exercise).

In addition, where the option shares are purchased at a discount and are subject to certain restrictions or a risk of forfeiture, an income tax charge may arise after the options have been exercised when the restrictions are lifted.

Capital Gains Tax

A capital gains tax (CGT) charge for the employee may arise on disposal of the option shares where the option shares are sold for more than they cost. The gain on the option shares that may be subject to CGT is calculated by deducting from the sale price the exercise price and any costs of disposal.

An individual is entitled to make gains up to the annual exempt amount each tax year without having to pay CGT. The annual exempt amount for tax year 2008-09 is £9, 600.

CGT is presently payable at 18 per cent. This is chargeable on all gains above the annual exemption. Taper relief is no longer available to reduce the amount of the chargeable gain. However, if the employee held at least 5% of the ordinary share capital of the company for at least 12 months prior to disposing of the option shares he may be entitled to claim entrepreneurs' relief.

Entrepreneurs' relief applies to the first £1 million of qualifying capital gains and exempts four ninths of such gains from GCT. At current rates, this will give an effective CGT rate of 10% on those gains.

Corporation Tax

On the exercise of EMI options the company will normally be able to claim corporation tax relief on the amount that the employee would (but for the EMI tax relief) have paid income tax (i.e. the difference between the market value of the option shares at the date of grant and the market value of the option shares at the date of exercise).

Disqualifying Events

It is important to note that the tax advantages of EMI options can be lost in certain circumstances, which are defined in the EMI legislation as ‘disqualifying events'. The following are examples of disqualifying events:

Loss of independence - The company that granted the EMI option becomes a 51% subsidiary of another company. In these circumstances it may be possible for the new holding company to grant a qualifying replacement option to the employee.

Option holder is no longer eligible - For example, the option holder's employment with the company ceases.

Changes to the terms of the option - Whether changes to the terms of an EMI option amount to a new option is a question of fact and degree. Minor alterations that do not affect the terms of the option and do no increase the market value of the shares under option, and are not contrary to the requirements of the EMI legislation will generally be acceptable.

However it will be a disqualifying event if the changes are a variation in the terms of the option and they increase the value of the shares that may be acquired under the option, or result in the conditions of the EMI legislation no longer being met.

If the changes amount to a new option, the existing EMI option is released. Any consideration for the release will be chargeable to income tax. It may be possible for the option to be rolled over into another EMI option, but only if both the company and employee continue to qualify for relief.

• Unapproved Share Option Schemes.
• Phantom Share Option Schemes.