Enterprise Management Incentive (‘EMI’) options are a highly tax efficient way for small companies to motivate their employees. They allow incentivisation with no up-front payment and no up-front tax liability. Furthermore, once an option is exercised, the employee can enjoy capital gains tax treatment on any value received over the exercise price and, usually, the gain will be subject to the 10% rate of capital gains tax due to Business Asset Disposal Relief (‘BADR’).
This position can be contrasted with unapproved share options which are subject to income tax based on the difference between the market value at exercise and the exercise price paid.
When an EMI option agreement is in force, you generally would not want to make any significant changes to its terms. This is because any significant change could be treated as a lapse of the old option followed by the grant of a new option. If this takes place at a time when the company is too large (or other EMI conditions are not met) then the new option would be treated as unapproved, and the EMI tax benefits mentioned above would disappear. Alternatively, the new option could still be a qualifying EMI option, but if the company has increased in value, then the option will probably now be treated as having been granted at a discount, which will trigger income tax charges. Furthermore, the employee would not qualify for BADR for two years following the date of the re-grant.
Generally, a lapse followed by a re-grant will be bad news. The main point of this Tax Bite is that HMRC have recently confirmed that they will usually seek to argue that amendments to option agreements pursuant to general discretionary clauses should be treated as a lapse followed by a re-grant.
It is fairly common for general discretionary clauses to exist in EMI option agreements such as ‘but the board may permit the exercise of the options at any other time of its choosing’. The ‘problem’ does not exist with this clause per se, but rather with actions that can be taken pursuant to it. For example, if an exit-based option (options which can be exercised only on the occasion of an exit event) is allowed to be exercised early, on an occasion before exit pursuant to a discretionary clause, then HMRC would be likely to see this as a lapse followed by a re-grant.
Forbes Dawson view
This is quite a nasty potential trap and arguably HMRC are being somewhat ungenerous in their interpretation here. The problem is that there is not much you can do about option agreements which are already in existence, and so exercising them outside specifically mentioned circumstances may be problematic. When creating new option agreements, it is worth spending time to set out the circumstances in which the option holders can exercise. Whenever a change is being made to an option agreement or if some form of discretion is being exercised, it would be worth engaging with HMRC on the issue, perhaps through the non-statutory clearance process, before any irrevocable action is taken.
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