EMI For Employees

There has been a great deal of coverage in the professional press relating to the new Inland Revenue enterprise management incentives scheme. This was introduced in the Finance Act 2000 and it has been possible to enter agreements since last July.
To date the subject has largely been considered from the angle of the employer. I hope that this article will redress the balance and give employees the information that they need when being asked to enter an employer's incentive scheme, so that they understand the possible consequences of accepting an offer to enter an agreement and the tax implications.
While most aspects of this scheme are greatly to the advantage of employees, there are some questions that employers may wish to have swept under the carpet. This may particularly apply to the dot coms for whom Gordon Brown reputedly created the scheme. Most of the time, there will be no downside for technology company employees who are offered options, but on occasion the tax régime could penalise them.
This article takes the hypothetical company MNO.com and answers typical questions raised by two employees: D, a senior director who does not yet hold any shares in the company and T, a new trainee. D is to be granted options over £100,000 worth of shares with an exercise price of nil. T will get options over £5,000 of shares based on current market values and will have to pay £5,000 for them. In each case, the options will be exercisable between three and ten years from the date of grant.
This is explored by reviewing the questions asked by both D and T and the answers to those questions. In many cases the answer is common to both but where there is a difference, the first answer relates to the position of D, while the second will relate to that of T.
Q. Why would I want shares in MNO.com?
A. This is a great opportunity to share in the future growth and anticipated success of the company. If our plans are successful, the company intends to float on the London Stock Exchange in three to five years time. At that point, shares could be worth a great deal. The company believes that this will largely be due to the efforts of loyal employees and wants to let them share in the rewards.
In addition, the company wants to keep its best employees and believes that by offering them this opportunity it can do so.
Q. How does this scheme work?
A. You will be given options to buy shares in MNO.com. The share price will be fixed at the time that you are given the option. Provided that you remain employed with the company, you will be able to exercise the option (buy the shares) three years later without any tax charge at all at that time. This gives you the chance to participate in the anticipated exponential increase in share value of the company.
Q. What is an option?
A. An option is a right to purchase shares in the company at a price fixed on the date on which the option is granted.
For D: You will not have to pay to exercise your option.
For T: The price will be fixed at the market value of the shares at that time as agreed with the Inland Revenue.
Q. What can I do with this option?
A. This option has no value in itself and cannot be transferred. However, after three years you will come into a period during which you will be able to exercise your option. This means that you will be able to purchase shares in the company at the price fixed when the option was granted.
For D: As you will pay nothing for the shares, you are guaranteed to benefit from the exercise.
For T: If the shares have gone up in value, then you will have made an immediate profit. If the shares are worth no more than the fixed option price, then you need not exercise your option.
Q. How long does the option remain open?
A. Provided that you remain in the company's employment, you can exercise your option at any time between the third and tenth anniversaries of the date of grant.
Q. What happens if I leave the company?
A. If you leave the company during the first three years after the option has been granted, the option will usually lapse and you will not be able to benefit. If you leave after that, you can exercise your option and become a shareholder prior to departure. In limited circumstances, you will be able to exercise your option soon after leaving the company even if you leave within three years. Unlike other share schemes, this will not lead to unfavourable tax treatment compared to the position if you waited for the full three years.
Q. Can I ever exercise my options early?
A. You can if the company is sold, when you will have the chance to exercise your options or possibly to roll them into options in the purchasing company. If you leave the company as a result of injury, disability, redundancy, retirement or on your death you can also exercise early.
For D: In these circumstances if you exercise the options, you will face an income tax liability deducted directly from monthly pay through the pay-as-you-earn system. This charge is based on the difference between the amount that you pay to purchase your shares (nil) and their value at the date on which you do so. In addition, you will have to pay the employer's National Insurance contributions on the value of the shares. This assumes that the shares continue to be readily convertible into cash on that date. A rollover into new options might be possible to avoid any charge.
For T: You will face no tax liability at that stage.
Q. Are there any other situations in which I might be able to exercise my options early?
A. Yes, if a disqualifying event takes place. This would include your becoming a part-time worker, the company changing its business, the company being taken over and various technical amendments to the plan. If any of these happened, the company would notify you and you would have 40 days to exercise your options. The tax consequences will be as outlined in the previous answer.
Q. What is the normal income tax treatment of options?
A. For D: The income tax consequences are as outlined for early exercise.
For T: There will be no tax charge until you come to sell your shares provided that your options are exercised in accordance with legislation and scheme rules.
Q. And when I come to sell my shares?
A. For D: You will pay capital gains tax based on the difference between the amount on which you have already been taxed and the proceeds of sale.
For T: When you sell your shares, you will pay capital gains tax based on the difference between the proceeds from the sale of the shares and the amount that you have paid for the shares.
Q. What is the rate of tax that will be payable?
A. Tax on sales of shares is normally payable at 40 per cent for a higher rate taxpayer and 20 per cent for a basic rate taxpayer. However, the amount of the gain on which you are taxed will reduce depending upon the period of ownership of the shares. If you have owned the shares for over one year, then you would only pay tax on 87.5 per cent of the gain, after two years on 75 per cent, after three years on 50 per cent and after four years on 25 per cent. This means that for a higher rate taxpayer who holds the shares for four years the effective tax rate will be 10 per cent, while for a basic rate taxpayer it will be 5.5 per cent. This is why it is better to keep within the legislation and rules, so that capital gains tax is paid rather than income tax. An extra benefit is that an element of capital gains is exempt from tax each year. This is currently £7,200 a year.
Q. Can I lose money as a result of entering this scheme?
A. You will have to pay £1 for the whole of your option entitlement. Beyond this, provided that you exercise your options in accordance with the legislation, it is not possible to lose money up to the point where you acquire shares.
For D: You will pay tax through the pay-as-you-earn system and will be required to pay the company's National Insurance contribution liability on the lower of the value when the option was granted or when you exercise it. This is in accordance with your agreement. If the shares subsequently go down in value, you will not be able to recover the National Insurance and the income tax can only effectively be offset as a capital loss against future capital gains.
If the company was to go out of business as has happened to some other companies in the industry, then you would have paid tax to acquire the shares and not have the benefit of selling the shares at a profit at a later date. In those unfortunate circumstances, you would be out of pocket. From this point of view, this is an investment decision like any other.
For T: If the shares go down in value prior to the time at which you can exercise them, then you need not take any further action and the only loss that you will suffer is the £1 paid for the option. Once you own shares, like any other investment, they could go down in value to below the amount that you paid for them and you might make a loss on sale.
Q. Is there anything to stop me from exercising my options and then selling the shares immediately?
A. No. If you do that then you remove any investment risk.
Q. What is the benefit of entering this scheme?
A. You have the opportunity to acquire shares in the company at a low value. Also, you convert a large gain that would be subject to income tax at your highest marginal rate into a capital gain. This could save you vast amounts of money.
For D: If your shares doubled in value in four years, then you could exercise your option, make a £100,000 profit and pay only tax on the tapered gain of £10,000. If you got these shares under any other arrangements, you would pay approximately £52,000.
For T: If your shares doubled in value in four years, then you could exercise your option, make a £5,000 profit and pay tax on the gain of £nil. This assumes that you have not used up your annual exemption.
Q. Are these schemes being used by a lot of companies?
A. They are almost too good to be true in most cases, and are proving unbelievably popular with many of the companies that are allowed to use them.
Philip Fisher is the employee benefits partner at Chantrey Vellacott DFK. The company has recently launched a new website CVDFK.COM. A full archive of Philip's articles on employee share schemes is available on the site. Philip Fisher can be contacted on 020 7509 9453 or by e-mail at pfisher@cvdfk.com.
 

Issue: 3792 / Categories: Comment & Analysis , Income Tax