Enterprise Management Incentive Archives - London Chartered Accountants Blog

The report on employee ownership, “The Ownership Dividend” has been published. It has been compiled following over a year of independent review and having heard evidence from more than 100 employee-owned businesses and advisers. A copy can be found at www.theownershipeffect.co.uk.

Benefits of employee ownership

The conclusion is that employee-owned businesses have advantages to both the employee and their employer; including higher employee engagement, motivation and wellbeing. The employer experiences increased productivity and efficiency. At a time when employee engagement levels are dropping, morale is felt to be low and UK productivity is lagging behind our global competitors, the benefits of employee ownership are more pronounced.

There are well known examples of employee ownership, with probably the best known being the John Lewis partnership, Arup and PA Consulting. Despite this there are relatively few employee owned businesses compared to the numbers of businesses in which employees have equity participation, but not overall control.

Tax reliefs of employee ownership

It is acknowledged that the numbers of entrepreneurs who gift ownership of their business to employees is limited. To promote employee ownership there is an exemption from capital gains tax for an entrepreneur who transfers a controlling interest to employees and exemptions for the employee on receipt of benefit connected with the shares. Despite these tax reliefs, far greater numbers of entrepreneurs retain control of their business and allow staff some equity interest in it. I believe that the 10% rate of capital gains tax makes it more attractive for the entrepreneur to retain control of the business and have the business grow to a point where it can then be sold. This exit becomes the fruits of the entrepreneurs’ labour and can represent life changing amounts.

Tax legislation provides incentives when offering shares (but not control) to employees. Tax advantaged share schemes can be categorised as either those which are “all-employee” or those which can benefit specific employees, or groups of employees. Typically, the latter schemes are only offered to directors and senior managers. There are other niche schemes for specific circumstances, such as university spin outs.

Share incentive plans and share option schemes

Share incentive plans and savings related share option schemes are all-employee schemes which, if operated correctly, provide tax breaks to the employees who receive shares. These schemes have limits on the tax advantages and generally result in large numbers of employees owning small numbers of shares.

Company Share Ownership Plans and Enterprise Management Incentives

Company Share Ownership Plans (CSOP) and Enterprise Management Incentives (EMI) can be issued on a selective basis to key employees. CSOP has tax advantages but subject to a ceiling of £30,000 of shares per employee. The limit of £30,000 is sometimes felt to be an impediment to use of CSOP for incentivising senior executives.

EMI is by far the most popular approved share incentive plan in the UK. Smaller trading companies can issue options worth up to £250,000 per employee with the scheme being selective and therefore able to restrict ownership to senior executives. There are no costs to the employee of receiving options and growth in the company during the ownership of the option can be tax free for the employee. This is on top of generous tax reliefs for the employer. EMI can be structured to make it highly beneficial for the employee to grow the value of the business, especially if the option can be exercised immediately prior to a company sale. The tax reliefs available on company sale mean it is possible for the senior executives to receive a percentage of the sales value at a 10% rate of tax. For many this is a compelling reason to use EMI to incentivise senior people to grow the business and participate, together with the controlling entrepreneur, on its sale.

In conclusion

In summary, the benefits of share ownership as set out in The Ownership Dividend are valid. However, employee ownership is relatively rare, especially when compared to the numbers of businesses in which employees have a non-controlling interest. I believe that the tax breaks associated with approved share schemes are a factor in this differential. EMI has generous tax breaks for both the employee and employer. Statistics suggest that it is by far the most common share scheme and my considerable experience of share scheme structuring makes me feel that the statistics are accurate.

Conditions of EMI schemes

EMI have conditions which must be satisfied by the company whose shares are being offered and have conditions which need to be satisfied by the employee who is being granted the options.

There are company conditions attached to the size of the company and its numbers of employees. These conditions are broadly designed to ensure that the company is within the SME sector. The company must have a connection with the UK and it is only the top company of a group which can issue the options. This does not prevent options being issued to employees of a subsidiary. The company must be a trading company and cannot undertake certain prohibited trades. The restriction on acceptable trades is to ensure that there is an element of risk associated with share ownership.

The purpose of the options must be to incentivise employees and there are conditions which ensure that the employee has reasonable employment duties and cannot have a connection with the company which allows more than a 30% ownership interest in it.

Benefit of EMI

The benefit of EMI is that capital growth can be subject to capital gains at a 10% rate of tax.

Ultimately this is the fiscal incentivisation for the option holder to exercise options. Assuming that the employee pays full market value for the shares (with that value being determined at the day the options are granted) then any growth between grant and exercise of the option is not taxed until the shares are sold. That growth, together with any further growth from holding the shares after exercise of the option, is subject to capital gains tax.

Share growth would be subject to a 10% rate of tax as shares arising from EMI options attract Bussines Asset Disposal Relief. This applies even if the options are not exercised until a time immediately prior to a company sale with many EMI plans are structured as being “exit only” to provide employees the ability to participate in a share sale.

Tailored solution

The terms of EMI options must be recorded in writing and this is an opportunity to provide conditionality on their exercise. Options can be tailored for individual employees and therefore provide targets which are under the control of the employee. For example a sales director may be able to exercise options if X leads are converted into customers within a timeframe or a member of the HR team might have the ability to exercise options once the head count exceeds Y employees.
Whatever the conditions attached for options they need to be able to be satisfied within ten years of grant of the option.

The Admin

Once options are granted there are administrative requirements to notify HMRC of their existence, both after their grant and annually thereafter. From an accounting perspective EMI options are included within the cost of employee rewards and there is annual accounting to determine how much reward should be charged to company accounts. As this accounting entry does not lead to tax relief until exercise of the option there are consequential deferred tax considerations.

In summary EMI options are often the first choice for incentivisation but they come with conditions, administration and accounting obligations.