Incentivising and Handcuffing Key Employees: The EMI Scheme

Written by Gavin Stebbing on 14 July 2014

Most companies want to motivate their staff to perform to the best of their abilities, and generally speaking, nothing motivates employees better than feeling they own part of the company that employs them. Unfortunately, simply giving employees shares in their employer's company is usually fraught with tax issues, but there are some tax advantaged schemes that are well worth looking at closely.

One of the best schemes available is the Enterprise Management Incentive (EMI), which is available to most unquoted companies carrying on a qualifying trade. The company must meet certain criteria in order to qualify; it must be independent, it must not be a subsidiary of or controlled by another company, it must have gross assets of less than £30 million, it must have less than 250 employees and it must be carrying on a trade that is not an excluded activity (excluded activities include such things as property development, legal and accountancy services, hotel management, operating nursing homes etc). Most employees will qualify to be included in the scheme, as long as they work at least 25 hours per week and do not own more than 30% of the shares in the company.

Under an EMI Scheme, an employer grants an employee an option to acquire a certain number of its shares at a fixed price (usually the current market value but a lower or higher value can be used) over a specified period, usually up to 10 years. Each employee can be granted options over shares up to a maximum value of £250,000, calculated by reference to the value at the date the options are granted. The options can be granted with considerable flexibility; for example the employer can include performance hurdles that must be achieved before the options can be exercised.

Alternatively, if the employer is looking to handcuff a key employee (let's call him John), he could offer John an option over £250,000 worth of shares at a nominal exercise price of say £1 in total, but the option could state that it cannot be exercised for at least 5 years and that John must still be in employment at the date of exercise. So John has a guaranteed profit of £250,000, which may well increase if the share price increases, but he is effectively locked into employment with the company for 5 years before he can realise his good fortune.

The scheme has been popular with many companies, big and small alike. It clearly suits companies that are growing fast and are planning to sell to a third party or perhaps float on the stock market within a 2 to 5 year period. The employees will exercise their option immediately prior to sale or flotation and then sell their shareholding, hopefully at a big profit. However, the scheme can also be used effectively even where the company is unquoted and has no plans to sell or float; in these circumstances the employees may wonder how they will realise the value in their shares as there is rarely a secondary trading market in unquoted companies. Usually, this is resolved by the company agreeing to buy back the shares from the employee immediately after exercise at the then market value so that the employees can cash in their profit straight away.

So how is the employee taxed on this type of scheme?

Firstly, there is no tax charge on the initial grant of the option, regardless of whether the exercise price is at market value or lower or higher. So there is no tax charge on John being granted his option over £250,000 of options at an exercise price of £1. When the share options are exercised, there is also no tax charge on the condition that the exercise price is at or above the market value at the date the options were granted. 

However, where the exercise price is below the market value at the date of grant, as in John's case, then a charge to income tax and national insurance arises at the date of exercise equal to the difference between the exercise price and the market value at the date of grant. In John's case, he will be taxed on the sum of £249,999 when he exercises his options, and will be liable to both income tax and national insurance on that amount.

When the employee sells his shares, he will be taxed on the profit as a capital gain, and in most cases the gain will be eligible for Entrepreneur's Relief and taxable at the rate of 10%, up to the lifetime limit of £10 million. If John qualifies for Entrepreneur's Relief and sells his shares for £2 million immediately after exercise, he will pay capital gains tax at 10% on his gain of £1.75 million – note that the gain is calculated as the sale proceeds less the sum of the exercise price and the value on which income tax has been paid (in John's case these add up to £250,000).

John has cashed in £2 million and paid income tax on £250,000 and 10% tax on £1.75mn. Meanwhile the company has been able to handcuff him by giving him a £250,000 carrot that he could not realise for at least 5 years. Both employer and employee are very happy.

For more advice on this topic please contact Gavin on 020 8545 7600.