The canine approach

MARC ABRAMS considers the enterprise management incentive scheme and asks whether the tax tail wags the commercial dog.

A PHRASE ENCOMPASSING 'tax tail', 'wag' and 'commercial dog' normally springs to mind when one is being an effective tax adviser to a small or medium-sized enterprise (SME). In other words, it is not merely enough to understand the tax consequences of events and transactions going on within a business, but it is vital to have at least one eye on the wider thought processes of the client, together with being alert to the all important 'what-if' questions that will inevitably arise.
One of the areas where commerciality and tax advice heavily collide on SMEs is in relation to share incentive arrangements. In providing such advice, the possibility of using enterprise management incentive (EMI) share options (ITEPA 2003, ss 527 to 541 and Sch 5) as a 'tool' will typically rank high on the agenda.
Given my thoughts on commerciality in the context of tax advice, I was interested to learn of two publications by HMRC in recent weeks, considering the reaction of companies to the introduction of EMIs. As someone who regularly has discussions with SMEs on equity incentive mechanisms, I thought it useful to take a closer look at these publications and see what conclusions could be drawn for the future application of EMIs in this popular SME tax advisory area.

Background

Whilst this article is not intended to provide a detailed explanation of EMIs, just to recap, it is a form of tax-favoured share option scheme, introduced by the Chancellor in his 2000 Budget.
When first introduced, the Government's stated purpose of the scheme was to assist 'small, higher risk' companies recruit and retain 'key' individuals to help their businesses succeed and grow. Subsequent amendments were made, with the intention of improving the scheme and increasing its appeal to smaller companies.
A number of parameters exist surrounding the scheme, including the requirement that the maximum market value of unexercised EMI options at the date of grant is £100,000 per employee, with a total cap of unexercised EMI options over the company's shares of £3 million.
In terms of the taxation treatment, no income tax or NIC charges arise when an EMI option is granted. No income tax or NIC charges arise upon exercise, providing the employee purchases the shares for a price equivalent to their market value at grant. The employee is not taxed on any growth in the value of the company's shares between grant and exercise of the option, with tax charges possibly arising where the exercise price is less than market value at grant. For taper relief purposes, TCGA 1992, Sch 7D paras 14 to 16 provide that the taper relief clock for 'qualifying' shares acquired on the exercise of 'qualifying' options should commence at the grant of the option, rather than exercise.

A surprising story?

Take a look at Table 1 on page 167, which sets out the take-up figures of EMIs since inception, published on the HMRC website in the summer (www.hmrc.gov.uk/stats/emp_share_schemes/table6-6-jul05.pdf).
An historic upward trend in the number of companies implementing EMI schemes is perhaps to have been expected, as both familiarity with the régime grows and as a result of various legislative changes (including abolition of the rule that only 15 employees could benefit from an EMI and increasing the limit on the gross assets of companies that could qualify from £15 milion to £30 million). However, I was still surprised to note that, in total, just less than 6,000 companies have granted EMI options.
Whilst I do not confess to closely monitoring all strategic developments in relation to EMIs over the last five years, or to being party to any policy discussions with HMRC, my personal reaction was that this figure seemed low, particularly given the taxation opportunities available. Putting this in context, the rate of incorporations is running at 300,000 annually. Was I missing something?

Becoming clearer?

In the context of the detail at Table 1, it was interesting to note the publication on 30 September 2005 by HMRC of a survey on EMIs, prepared by FDS International Limited (www.hmrc.gov.uk/research/research-report11.pdf).
The survey was carried out during autumn 2003, and whilst we appear a little behind in receiving the results, the sentiments emerging are certainly worth considering. They do enable us to further understand some of the thought processes that a company may go through in considering an EMI — and their subsequent reactions post implementation. Ultimately, they shed some further light on the HMRC's 'take-up' statistics and provide a commercial view on the topic.
Ninety-one interviews took place with organisations that adopted an EMI. The survey attempted to consider why EMI schemes were adopted, how they are used, what features were liked and disliked and the perceived impacts on recruitment, retention and the companies' performances.
Of course, the weakness here is that the survey does not consider companies who considered EMIs and decided not to implement. If it were possible, this would perhaps be a more interesting survey.

Overall strategy

HMRC will be pleased to learn that the key theme emerging was that the companies' reasons for adopting EMIs were broadly in line with original aim — to promote the retention and recruitment of key staff in senior or core capacities, with the intention of helping the organisation thrive productively.
Indeed, a wide range of reasons were noted for the introduction of EMIs — motivation, reward for staff, to develop a sense of shared purpose, a fairer distribution of the fruits of success, as security for individuals against a takeover, to allow for the continuity of key people, to ultimately provide for management succession, and to allow for an immediate saving on salary costs. Of course, this is all good stuff, but how does the tax angle fit in, and where are the thoughts on the take-up of EMIs?

Taxation considerations

The survey does comment that the tax-advantaged status enjoyed under an EMI is a powerful means to an end, but that it is rarely viewed as the end in itself. Whilst a company appears to have other objectives for implementing an EMI, the survey does comment that saving tax is part of the mechanism within an EMI that makes it a more effective and attractive tool for achieving these aims compared to other enquiry incentive arrangements.
On reflection, I am probably relieved by the conclusions of the survey in relation to the tax motive. ITEPA 2003, Sch 5 para 4 does state that the options 'must be granted for commercial reasons in order to recruit or retain an employee in a company, and not as part of a scheme or arrangement the main purpose (or one of the main purposes) of which is the avoidance of tax'.
Whilst I have occasionally considered this point with other advisers, on a day to day level I have practically had very little cause for concern in this area, and have little knowledge of the point being taken by HMRC. This, of course, is no defence should the point emerge in the future! The typical starting point in even contemplating an EMI, appears to be that the company requires some form of equity incentive. It may only be when it is pointed out that tax costs could emerge from a direct award of shares (with associated commercial points) or the granting of an unapproved option, does the client tend to become more conducive to an EMI. Getting a more effective tax treatment is in many cases restoring the employee and company to the position which the client would otherwise have assumed it to be — perhaps with the exception of the taper relief benefits.
The implementation of an EMI does appear to occur as a result of the commercial circumstance that the client has already identified.

Table 1: EMIs implemented since inception.

Issue: 4034 / Categories: Comment & Analysis