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A Fly in the EMI Ointment

13 September 2000
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Michael Wyatt, LLB, ATII, barrister discusses a potential difficulty with the Revenue's latest share option incentive

Hector was an egg, sat upon a wall,
Trying to E-M-I, he had a great fall,
None of the Queen's horses would restore him to his place,
Because all the Queen's men had egg on their face.
 

Like other specialists in employee share schemes, I have for a number of months been considering with interest the provisions of what is now Schedule 14 to the Finance Act 2000. These confer tax reliefs in respect of so-called 'enterprise management incentives', commonly known as EMI share options. Briefly stated, in optimum circumstances the reliefs give exemption from income tax and (if otherwise applicable) employers' National Insurance contributions in respect of the unrealised gain arising upon the exercise of the option; and for capital gains tax taper relief purposes, the shares are treated as having been acquired when the option was originally granted. All along, I have had the feeling that, like version 1.0 of some piece of software, these provisions might include some previously unrecognised defect or bug, which either might render them largely unworkable or might blow up in the face of someone trying to implement these provisions in a particular way. The mind-focusing exercise of actually trying to set up a scheme for granting options within the scheme has now uncovered such a bug.
A case study
Suppose Whizco Limited, has recently started selling a new type of software. The company needs to recruit several more highly skilled employees in order to develop the software sufficiently quickly to get it into a commanding position in the market. As an incentive to join the company and to achieve some substantial goals, in September 2000 several new employees are granted share options entitling them to acquire small holdings of ordinary shares in Whizco Limited. These options are designed to comply with the enterprise management incentive provisions.
The exercise price is set at the market value per share of a small holding of the shares, which has previously been agreed with Shares Valuation Division. This creates the expectation that when/if the options are exercised, no amount will be chargeable to income tax under section 135, Taxes Act 1988 (paragraph 44(2) of Schedule 14 to the Finance Act 2000).
The waiting period before the share options can be exercised is set at three years from the date of grant (that period being a matter for the company's commercial judgment). The shareholders wish the company to continue to have a single class of ordinary shares, so that when options come to be exercised new ordinary shares will be issued by the company to the optionholders, who will then be on an equal footing, in proportion to their shareholdings, with all the other shareholders. The company's articles contain the general type of share transfer pre-emption clause which it is usual (and, in practical terms, essential) for a private company to have, including a power for the board of directors to veto any transfer of shares not bought by other shareholders.
The directors have for some time had at the back of their minds the idea of seeking a quotation for the company's shares. A year or so after the grant of the share options, this idea comes to fruition. At the final stage of the flotation procedure, the company (having re-registered as a public limited company) adopts new articles which are appropriate for a quoted company. As one would expect, the new articles include no restrictions on share transfers. The flotation is successful, with a float price which is way above the exercise price of the still unexercised share options.
By the end of the three-year waiting period under the share options, the company's quoted share price has risen further still. The optionholders exercise their options at the earliest opportunity, and immediately sell a small proportion of their shares to recoup part of the exercise price. The number of shares each employee sells is calculated as the right number to use up his capital gains tax annual exemption for that year, taking into account the fact that, for taper relief purposes, paragraph 57 of Schedule 14 to the Finance Act 2000 deems the shares to have been acquired when the original option was granted; three years' taper relief halves the gain on the shares, which are 'business assets' for this purpose.
Following the submission by the company of the return it is required to make annually under paragraph 65 of Schedule 14, the Revenue starts an enquiry, which culminates in:
(i) claims against the company in respect of unpaid pay-as-you-earn; and
(ii) employers' National Insurance contributions relating to the exercise of the share options; and
(iii) claims against the employees for capital gains tax in respect of their share sales.
At the root of these startling claims is the contention that the flotation of the company gave rise to a 'disqualifying event' under paragraph 47(1)(e) of Schedule 14. That is allegedly because:
(a) under paragraph 49(1) of Schedule 14, the adoption by the company of its new articles immediately prior to the flotation constituted an 'alteration of the share capital of the company' which consisted of or included 'the... removal of a restriction to which any shares [in the company] are subject'; under the old articles, share transfers were subject to restrictions, whereas under the new articles they are not; and
(b) the removal of these restrictions was a sudden event which clearly increased the market value of the shares that were the subject of each share option.
Disqualifying events
What the Chancellor giveth with one hand, he might take away with the other; and in a situation like this, with interest as well. A 'disqualifying event' is the ominous term used to describe the situations where that taking away will occur. A disqualifying event is something which happens after an enterprise management incentive scheme share option has been granted and before the option is exercised. Paragraph 47 of Schedule 14 specifies nine categories of disqualifying event. If a disqualifying event occurs and the share option is exercised more than 40 days after that event, the normal rule is that any amount by which the market value of the shares when the option is exercised exceeds their market value immediately before the disqualifying event is chargeable under section 135, Taxes Act 1988 as income of the optionholder (paragraph 53(2) of Schedule 14). Exceptionally, if the amount chargeable under section 135 on the exercise of the option in the absence of the enterprise management incentive provisions would be less, the charge under paragraph 53(2) is restricted to that lesser sum. A 'disqualifying event' under paragraph 47(1)(e) of Schedule 14 is specified as an alteration of the company's share capital which is made without the prior approval of the Inland Revenue and which:
(a) affects (or but for the occurrence of some other event would affect) the value of the shares which are the subject of the share option, and
(b) consists of or includes:
(i) the creation, variation or removal of a right relating to any shares in the company;
(ii) the imposition of a restriction relating to any such shares; or
(iii) the variation or removal of a restriction to which any such shares are subject.
For this purpose references to restrictions relating to shares or to which shares are subject, or to rights relating to shares, include restrictions imposed or rights conferred by any contract or arrangement or in any other way.
The bug
Paragraph 49(1) is very unhappily drafted, because it does not define the expression an 'alteration of share capital'. Paragraph 49(1) adopts the following structure:
'An alteration of the share capital of the relevant company is within this paragraph if... (a)... and (b) it consists of or includes (i)... (ii)... or (iii).'
This pre-supposes that one knows what an 'alteration of share capital' actually is. The expression 'alteration of share capital' is not defined anywhere in the Finance Act 2000, or in the Taxes Act 1988. Nor is it actually defined, as such, in the Companies Act 1985. But it does appear in the heading to section 121,Companies Act 1985; and, by reference to the content of that section, it is generally taken to mean any of the following:
(a) an increase in share capital;
(b) a sub-division of shares into shares of a smaller nominal value;
(c) a consolidation of shares into shares of a larger nominal value;
(d) a cancellation of shares forming part of the authorised but unissued share capital; and
(e) a conversion of shares into stock, and vice versa.
I would also maintain that, as a matter of literal interpretation, an 'alteration of share capita' includes a conversion of shares of one class into shares of another class. However, in Schedule 14, a conversion of shares is specifically dealt with by paragraphs 47(1)(f) and 50, so it cannot be included within paragraph 49.
So, what does paragraph 49 apply to? If a company passes a resolution altering its articles in such a way as to remove restrictions on the transfer of its shares, is that an 'alteration of share capital' as a matter of ordinary usage in company law? Surely not; an alteration of the rights attaching to a class of shares consisting of 100 ordinary £1 shares cannot be an 'alteration of share capital' if, immediately afterwards, there are still just 100 ordinary £1 shares. Going further, is there any situation at all in which an alteration of share capital can consist solely of anything falling within (i), (ii) or (iii) of paragraph 49(1)(b)? I can think of none. What about the 'includes' alternative? Again, as one has to rule out the instance of a conversion of shares from one class into another, I cannot think of any other alteration of share capital which could include any of (i), (ii) or (iii). If that is correct, then paragraph 49(1) is a fundamentally misconceived provision, which achieves nothing. It is like saying:
'An egg is within this paragraph if it is either:
(i) a cucumber,
(ii) a cabbage, or
(iii) a carrot.'
So, if we find a cabbage, does that mean we have an egg for the purposes of that particular paragraph? Of course not.
One may compare the only other main instance in the direct tax legislation where the word 'alteration' is used in relation to share capital, this being section 98, Inheritance Tax Act 1984. Here, the draftsman got the structure right. The first part of section 98(1) reads:
'Where there is at any time
(a) an alteration in so much of a close company's share or loan capital as does not consist of quoted shares or quoted securities; or
(b) an alteration in any rights attaching to unquoted shares in or unquoted debentures of a close company, the alteration shall be treated as...'
Section 98(2) also defines 'alteration' to include extinguishment.
If my above-stated analysis of paragraph 49(1) is correct, there can never be a disqualifying event under paragraph 47(1)(e) – a conclusion which, I suspect, the Revenue would find entirely unpalatable.
What alternative argument is there?
One might argue to the effect that paragraph 49(1) must mean something and that it must, therefore, also be a defining provision (a highly strained process of reasoning, I suggest), with the result that the straightforward removal of a restriction in a private company's articles is an 'alteration of share capital'. I then see no escape from the conclusion that the removal of the restrictions on transfer by a company (e.g. for the purpose of obtaining a quotation) constitutes a 'disqualifying event' under paragraph 47(1)(e), unless the Revenue were to give its prior approval to the making of this 'alteration of share capital', in accordance with paragraph 47(1)(e).
However, on the wording of paragraph 49(2), it is doubtful whether the Revenue actually has power to give its approval to an alteration which increases the market value of the shares – and, in the Whizco example above, an increase in market value would clearly be involved, because the shares without the restriction must, on ordinary valuation principles, be worth more than the same shares subject to the restriction. But even if the Revenue does have that power, the wording of paragraph 49(2) suggests that it is unlikely to exercise it favourably in a situation involving an increase in market value. All this leads to the conclusion that the removal by a company of restrictions on share transfers (e.g. for the purpose of obtaining a quotation) constitutes a 'disqualifying event'.
If that conclusion (based on the alternative argument) is correct, one of the main purposes of the enterprise management incentive legislation is undermined. Although flotation is a common objective for the types of company at which these provisions are aimed, it would be difficult for a company to contemplate a flotation while there existed substantial unexercised share options within the legislation in respect of shares in the company. A company is unlikely to agree to a share option contract containing a provision which allows an 'early' right of exercise to arise upon the occurrence of a disqualifying event, except where that event is the take-over of the company. A company may be equally unlikely to permit an optionholder to exercise his option early within 40 days after a flotation, because the optionholder might need to sell some of his shares in the market in order to recover the exercise price, at a time when sales of shares by key individuals in the company would normally be very unwelcome commercially. Alternatively, if the option is exercised later than the 40 day period, that would create additional tax charges for both the company and the employee. Of course, the existence of this alleged disqualifying event might not even be recognised when it arose.
From a couple of telephone discussions with the Revenue, I am left with the impression that it was not intended that the flotation of a company should give rise to a disqualifying event. Yet two weeks after first raising the matter, I have yet to receive any formal view from the Revenue regarding paragraph 49. Nor (unsurprisingly) have I received any definitive response to my suggestion that the legislation be appropriately amended.
Without some other solution to this problem, the result is that an unquoted company should think twice before granting enterprise management share options if the company thinks that it might, in the short or medium term future, get a quotation for its shares.
A practical solution
All is not lost, however. Like some bugs in computer programs, this 'legislation bug' has a work-around solution. Proceeding on the worst-case assumption that paragraph 49 can be said to have some meaning and practical application (i.e. the alternative argument), let us return to the example at the beginning of this article.
The private company in question has a single class of ordinary shares. At the time when the enterprise management incentive share option scheme is established, alterations to the articles are likely to be required. One could add to these alterations the creation of a second class of shares, called (say) 'B' shares and carrying the same rights and obligations as the existing class of shares, except that the shares of this second class would be freely transferable. A provision would also be inserted to enable all the issued ordinary shares to be converted into 'B' shares upon the passing of a special resolution to that effect.
No 'B' shares would in fact ever be issued as such. There matters would rest until the eve of the flotation (which might, of course, never happen), when the ordinary shareholders would pass their special resolution converting the entire class of shares into 'B' shares. This act of conversion would be prevented from being a disqualifying event by paragraph 50 of Schedule 14. The following day, the articles would be replaced with ones suitable for a quoted company, again without triggering any disqualifying event. Thereafter, the enterprise management share options would be exercisable with the tax consequences originally envisaged. However, this procedure involving an otherwise unwanted second class of shares would, to say the least, be somewhat inconvenient. Some might call it just plain ridiculous. Yet I have received tentative confirmation from the Revenue that it can see no problem with this work-around solution. For the time being, therefore, this appears to be the only prudent way to proceed.
Why was this problem not spotted in the period between the publication of the draft legislation last November and the publication of the Finance Bill in April? – because the original draft of the legislation did not include the provisions which are now paragraphs 49 and 50 of Schedule 14. And why was it not spotted between the Bill's publication and Royal Assent? Hmmm. The huge, distracting size of the Bill, coupled with enterprise management incentive fatigue, may form the basis for a plea in mitigation going on for several pages.

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