Enterprise Management Incentives (“EMI”) is one of the best employee incentive schemes offered globally and is utilised by thousands of firms. Here, we explore the scheme in more detail.

Introduced in the Finance Act 2000, with one of its main objectives to “cut red tape”, HMRC have done their best to make the scheme as straight forward as possible. Yet despite this, we still see an impressive number of creative ways to invalidate the scheme’s tax-advantaged status.

EMI options allow employees to benefit in the growth of the company without an upfront cost and in a tax efficient manner. For many scale-ups and tech companies, they are considered the norm for attracting key employees, however the finer detail that goes into implementing the scheme is often neglected when funds are low, and a company and founder’s focus is elsewhere.

If properly set up and maintained, employees will benefit from Capital Gains Tax (CGT) rates, currently 24%, and potentially even Business Asset Disposal Relief (BADR) rates of 10% (until 6 April 2025), on the growth in market value from grant to sale.

Improperly implemented or maintained, employees can suffer income tax rates of up to 45%, as well as both employer and employee National Insurance Contributions (NICs). With the latest increase to employer’s NICs, if the scheme is found to be invalid during due diligence, employers can suffer a surprise 15% charge which can potentially slow down or jeopardise an exit.

Despite HMRC simplifying the scheme even further, with recent changes including: removing the written working time declaration, the need to include restrictions in option agreements and (from April 2024) simplifying the notification process from 92 days post-grant to 6 July following the tax year they are issued, there are still many ways to remove the scheme’s tax-advantaged status.

Below we highlight some of the common issues we see when organisations ask us to review their schemes.

Issuing options

A promise, a handshake or even a legal document agreeing to issue options is not enough. Qualifying options need to be actually issued. People often believe they can deal with the paperwork regarding share issues when preparing for an exit, however that is not the case. Once the company has increased in value, especially if a sale is on the horizon, there is very little remedial work that can be done.

Options granted at market value during an exit means little to no gain for the employee – or if granted with a lower exercise price, Income Tax and employee’s and employer’s NIC can sometimes leave employees with half of what they were expecting net of tax.

Company and employee qualification

Although the scheme is often referred to as a ‘simple scheme’, it still has 27 conditions that the Company (or group) needs to meet to be eligible to issue EMI options.

Similarly on the employee side, the working time declaration has been removed but the requirement remains, and option holders are required to work at least 25 hours a week to qualify.

Qualification shouldn’t just be assumed; a careful review should be carried out and documented at the time of grant to ensure all the criteria are met. For example, many founders don’t realise that renting out their office building can impact qualification.

We also often see founders have a differing opinion to HMRC on whether their trade qualifies. HMRC has an advanced assurance process that allows you to confirm eligibility, which will provide peace of mind and save a lot of time on any future due diligence on exit.

Company control

The issuing company needs to maintain independence, not just at the time of grant, but until the options are exercised. This means more than 50% of its ordinary share capital (and votes) must not be owned or controlled by another company or a company and connected persons. Family companies in particular are caught out by this as relatives and their company interests are all aggregated when considering this test.

Additional issues are seen when there are future funding rounds and private equity firms (or similar) invest and take a controlling stake. This is made worse if the option paperwork only allows for the options to be exercised on a full exit.

The rules also include arrangement and “right to acquire” provisions so watch out for convertible loans and similar instruments that could cause the company to fail.

Qualifying subsidiaries and Joint Ventures

It is important to remember the whole group is taken into account when considering the qualification of the scheme. Any subsidiary of the group needs to be a qualifying subsidiary (at least 51% owned and not under the control of any other person) and all activities of the group will be considered when looking at the qualifying trade requirement.

Partnerships, Joint Venture arrangements and foreign entities like US LLCs that don’t have share capital in the same way as the UK also catch a lot of people out.

Similarly, investments and property held within the group are considered when looking at the qualifying trade requirement and if “substantial” (generally considered to be 20% or more), will lead to disqualification.

Valuations

To benefit from the tax advantages of the scheme, options need to be granted at at least their market value, meaning a valuation is needed for each round of options issued. A good valuer can use appropriate discounts (for instance minority and lack of marketability) to increase the benefit of the scheme making them well worth the money.

HMRC offer an approval service to provide certainty to employees and this should always be used, however it can provide false hope. A valuation is only as good as the information in it, and HMRC will not be bound if information is withheld (e.g. a raise or imminent sale) or improperly presented.

If going for a low valuation, you should make sure to save yourself from issues on exit by making sure the option price is at least equivalent to nominal value.

The rights attached to the options (sufficiently certain)

It’s important to understand and get the rights attached to the options correct on issuance. As circumstances change, it can be tempting to amend or vary the rights of options already granted. Even if allowed within the scheme rules, major changes to things like exercise price, share class, dilution, or vesting conditions can be treated as a lapse of the original option and the grant of a new one ruining the tax savings.

Setting out the terms from the start avoids issues and awkward conversations with employees down the line.