Two days before the deadline of 7 April 2018, HMRC announced* that the UK has failed to renew its EU state aid approval for enterprise management incentive (EMI) schemes. This means that currently it is not possible to grant EMI options and raises a number of questions for existing options and the future of EMI schemes. The answers to these questions will depend on whether HMRC does eventually agree the state aid question with the EU and the extent to which the approval has retrospective effect. James Went and Kathy Hills look at the implications and what companies can do next.
Many SMEs have come to regard EMI options as an important part of their remuneration package. The core tax benefit from the EMI scheme is that if options are granted at an exercise price of no less than the market value at the date of grant, the increase in value above the exercise price is treated as capital gain and subject to capital gains tax. By contrast, with unapproved options, any increase in value is subject to income tax (and potentially also national insurance contributions). In addition, for capital gains tax purposes, employees do not need to satisfy the 5% shareholding criteria in order to benefit from Entrepreneurs’ Relief, and the period for which the option is held counts towards the 12 month qualifying period. With the Entrepreneurs’ Relief rate at 10% this is a significant tax advantage.
It probably came as a shock to many that the EMI scheme is treated as a state aid, but when you consider the HMRC national statistics for 2017 which show that the estimated income tax and National Insurance contributions loss was £160 million for the EMI scheme for the 2015-16 tax year alone and approximately £1.4 billion since 2003, it is easier to understand. State aid rules apply where benefits are provided to taxpayers selectively and as the EMI scheme is only available for SME companies within defined limits, state aid approval is required for the EMI scheme.
The EMI scheme was originally introduced in 2000 without state aid approval being sought. Approval was given retrospectively in July 2009. Roll forward nine years and history is repeating itself; only with the backdrop of Brexit looming, there is a lot more at play.
So where does this leave us?
HMRC has said in its statement issued on 4 April that it considers that all options granted prior to 7 April will continue to qualify for EMI tax relief. Its view is that state aid approval applies only to the grant of the option. However, it appears from the original approval notification that the reason for the approval being given to 6 April 2018 was to allow for it to be valid throughout the 10 year period during which options granted at this time could be exercised.
It is not clear to us therefore that options granted prior to 7 April will continue to benefit from EMI treatment going forward if state aid approval is not given retrospectively. That said, it seems that in this scenario if pre-7 April grants are called into question, the most likely position is that growth in value from this date will be subject to income tax on an exercise of options, but growth in value from the date of grant to 7 April will continue to benefit from EMI treatment.
SMEs can also take comfort from HMRC’s statement discussed above as it appears unlikely that HMRC would pursue tax on growth in value pre-7 April 2018 in any event.
Options granted since this date may not qualify for EMI treatment. Ultimately, this depends on whether state aid approval (assuming it is given) is given retrospectively to 6 April.
Depending on the package agreed for the UK’s departure from the EU, state aid considerations may fall away in less than a year’s time. HMRC has stated that it is making every effort to obtain state aid approval as soon as possible. However, given a Brexit deadline of 29 March 2019, any approval may only be required on a short term basis and therefore it may not be at the top of the EU’s priority list.
The optimistic amongst us will look to the recent renewal of state aid approval for Ireland’s Key Employee Engagement Programme and Sweden’s Employee Share Tax Regime, which are similar to the UK’s EMI scheme, and remind ourselves that good news comes in threes…
Here are our thoughts on some of the questions you are likely to be asking about EMI schemes during the suspension of the scheme:
Can we still grant options to employees?
Yes, but it is not clear whether these will ultimately qualify as EMI options. It is widely expected that state aid approval will be granted and it is anticipated that if consent is given, this will be retrospective. If consent is not given retrospectively, the option would be an unapproved option. No tax arises on an unapproved option unless and until it is exercised. It is relatively straightforward to surrender an unapproved option and grant a new EMI option if approval is not given retrospectively so, if any companies need to grant options during this period of uncertainty, we don’t think it is necessary to hold off on doing so.
Will HMRC still agree valuations prior to the grant of options?
HMRC is still agreeing EMI valuations, but at the time of writing it will not extend the valuation validity period beyond the normal 60 day period. If a valuation is sought during this time and state aid approval is not given within the 60 day period, it will be necessary to apply to HMRC for an extension. We would expect HMRC to be sympathetic to requests for extensions during this time, assuming that there have been no events within the company which would alter the valuation.
Should existing options be exercised?
Perhaps the first question to answer is whether the scheme allows options to be exercised. Whilst some schemes would allow this, provided that any time/performance vesting conditions have been met, others require a trigger event such as a change of control before the option may be exercised.
For options that can be exercised, the aggregate exercise price will need to be funded by the option holder, as well as any tax arising on the exercise (if the exercise price was set at less than the market value of the shares on the date the option was granted).
Given the statement from HMRC that it considers options granted prior to 7 April will continue to qualify, employees may wish to use exercisable options as a precaution where he or she can afford the costs of exercise, but this will not necessarily be essential to preserve the tax treatment.
Is it still possible to notify the grant of an EMI option?
Again, in the circumstances it is not clear if a notification of grant of EMI options would continue to be valid in respect of options granted on or after 7 April. Given that the timeline to notify is 92 days from the date of grant of the option, we would suggest that the notification should be delayed as far as possible, considering state aid approval may be given during this time which would make the position much clearer.