The Government has made possible a startling possibility for employers: give your employees high value incentives and rewards on which they pay tax at less than 28%, while at the same time increasing your after-tax profits, and all without incurring any expense other than set up costs (which are themselves generally tax deductible).

Tax legislation is now extremely favourable for employers and employees who take advantage of EMI share options. These can enhance the recruitment and retention of key employees for most small and medium trading companies (with less than 250 employees) through:

• greater employee incentivisation and reward
• employee gains taxed at 28% or less, and with the tax payable up to 22 months after the employee receives the cash
• if the employee owns at least 5% of the company's shares for 12 months before the sale, Entrepreneurs Relief may reduce the tax rate to 10%
• no PAYE or employee or employer national insurance contribution liability
• no loss of control for existing shareholders
• the possibility of equity release for existing shareholders, with tax at 10%/28% or less
• a corporation tax deduction for the employer company equal to employees’ gains, whether or not any costs have been incurred.

Example

Employee is granted option to purchase shares for market value at grant date, of £50,000. Employee exercises option after two years, and company issues new shares for £50,000. Employee sells shares to a third party for then market value of £250,000 (this is a fundamental assumption. The value of an investment can of course fall as well as rise!). Employee immediately realises a gain of £200,000, tax of £53,032 (at 2011/12 tax rates), i.e. a net gain of £146,968. Company receives £50,000 for share subscription and corporation tax relief (assuming a 27% tax rate) of £54,000, making a net gain of £104,000. If instead the company had provided a net cash bonus of £146,968, rather than making a gain it would have incurred a total cost (after corporation tax relief) of £254,358 (assuming the employee is liable to income tax at 50% on the bonus).

If instead of selling to an unrelated third party, the employee sells to an employee benefit trust funded by the employer, the employer would still save around £108,000 compared with the cost of providing an equivalent cash bonus.

The main features of the EMI rules are summarised below, but specific advice should be sought in every instance. An option plan is flexible and simple to administer, and should be considered by every qualifying company as part of its remuneration strategy.

• Options can only be granted to full time employees or directors, but not those who already own over 30% of the company
• Options must be over fully paid up, non-redeemable shares, and must be exerciseable within ten years of grant, but otherwise the employer may use shares with a variety of rights and restrictions as commercial needs dictate (although restrictions may give rise to additional tax complications, this is unlikely to cause any real difficulty in most cases)
• Options may be subject to continued employment conditions, exercisable only after a specified period, or subject to achievement of performance targets, all at the discretion of the employer company
• Each employee may have unexercised options over shares worth no more than £120,000, by reference to their market value (to be agreed with HM Revenue & Customs) as at the date of grant
• The total value of unexercised options must not exceed £3 million per company and the company or group must have less than 250 employees
• The gross assets of the employer company must not exceed £30 million as at the date options are granted
• The employer company must carry on a trade wholly or mainly in the UK, but certain trades, e.g. leasing, financial services, farming and property development, are non-qualifying
• The shares must be in a company that is not under the control of another company
• The exercise price for options can be market value at grant, or at a discount, or at a premium, to market value
• On grant of the option, no tax nor NIC arises
• On exercise of the option, no tax nor NIC arises, unless the option was granted at a discount, or there has been a ‘disqualifying event’
• If the option was granted at a discount to market value, that discount is charged to income tax (and possibly subject to PAYE and NIC) when the option is exercised
• Disqualifying events include the employee ceasing full time employment, and the company ceasing to carry on a qualifying trade, and will result in income tax and possibly NIC becoming due on growth in value thereafter
• On sale of the shares acquired through option exercise, normally only capital gains tax is charged on the gain, at a tax rate of 28% (possibly reduced by entrepreneurs' relief, the annual exemption, losses, etc).

Careful attention must be paid to the risk factors set out below.

• The tax legislation, rates and reliefs referred to herein are those for 2011/12. Tax rules change and the value of a relief from taxation depends on the circumstances of the taxpayer
• The value of an investment and the income from it can fall as well as rise as a result of market and currency fluctuations and changes in tax legislation and you may not get back the amount originally invested
• If there is no recognised market for the shares involved it may be difficult to deal in the investment or to obtain reliable information about the value of the investment or the risks that may be involved.

For further information on share schemes, please visit www.bakertilly.co.uk/ecg