FA 2013 has introduced two ways in which employee shareholders can mitigate or avoid capital gains tax when selling their shares. First, the conditions to be satisfied in order to qualify for the 10% CGT rate under entrepreneurs’ relief have been significantly eased for shares acquired on the exercise of an enterprise management incentive (EMI) option. Most EMI participants should now pay only 10% but there are pitfalls to be avoided and elections which may need to be made. Second, up to £50,000 worth of shares will be CGT-free if acquired in consideration for an employee surrendering certain statutory employment rights.
Tax planning for employee share schemes used to be – and largely still is – about avoiding income tax and paying only capital gains tax. However, two recent developments, both activated by FA 2013, will give a significant number of employees the opportunity to be more ambitious. Most holders of enterprise management incentive (EMI) options should in future pay CGT at a rate of only 10%, whereas the gains made by employees who embrace the new ‘employee shareholder’ status – which came into force on 1 September 2013 – will mostly be CGT-exempt. Although this suggests that the latter is more attractive, the reality is that whereas EMI is the most popular kid in the class, employee shareholder status appears to have only one friend in the whole wide world, admittedly one who has more influence than anyone else over UK tax legislation.
When EMI was introduced by FA 2000, its most attractive feature was that shares acquired on the exercise of an EMI option qualified for business asset taper relief with effect from the date on which the option was granted. However, from the abolition of taper relief on 5 April 2008 until 5 April 2013, EMI option holders were subject to the same CGT rules as all other taxpayers.
The closest thing to a successor to business asset taper relief on a share sale is entrepreneurs’ relief which also delivers a reduced CGT rate of 10%, subject to an individual lifetime allowance of £10m of gains. Until FA 2013, two stumbling blocks prevented virtually all EMI holders from taking advantage of entrepreneurs’ relief. The first was the requirement that the individual owned at least 5% of the ordinary voting shares of the relevant company (TCGA 1992 s 169I(6)). The second was the minimum ownership period of one year (TCGA 1992 s 169I(6)), because EMI options tend to be exercised on a company sale when all shares have to be transferred immediately to the acquiring company.
There was therefore great rejoicing when FA 2013 Sch 24 largely removed both these conditions for shares acquired on the exercise of an EMI option (the special access of EMI option holders to entrepreneurs’ relief is referred to in this article as EMI/ER). There is a quite urgent timing point which companies operating EMI and their advisers need to be aware of.
The new relief applies to shares acquired following the exercise of an EMI option on or after 6 April 2013. However, there is transitional relief for shares acquired between 6 April 2012 and 5 April 2013 and not disposed of until after 5 April 2013 (FA 2013 Sch 24 para 6), provided either that the employee sold no shares in the relevant company during the 2012/13 tax year or that he makes an election for the new relief to apply to the shares which he still owned on 6 April 2013 (see example 1 below). Such an election must be made by 31 January 2014 and, once made, cannot be revoked after 31 January 2014.
There will no doubt be a client expectation that, whenever an employee sells shares acquired by exercising an EMI option, CGT will be charged at only 10%. This is dangerous. Though in most cases EMI/ER will be available, this is by no means guaranteed in practice.
Most embarrassing for an adviser will be if the option turns out not to be a valid EMI option from the outset or was not notified to HMRC within 92 days of grant. It is assumed that readers are aware of the initial EMI qualifying conditions. There is insufficient room to describe them in this article.
A qualifying EMI option will forfeit the 10% CGT rate in the unlikely event that it is exercised after the 10th anniversary of grant (TCGA 1992 s 169(7D)(b)) or if it fails to meet any of the following conditions:
There are several circumstances where an adviser needs to be particularly vigilant to ensure that his client or his client’s employees fully benefit from the FA 2013 improvements to EMI. This article will consider two such situations.
The first scenario is that an employee has exercised his EMI option and is then compelled, as a result of a share-for-share takeover, to exchange his shares for shares in the acquiring company. The problem here is that he is most unlikely to qualify for EMI/ER in relation to the shares in the acquiring company. He needs to dispose of his EMI shares in order to crystallise his gain while he still qualifies for EMI/ER. However, a share for share exchange is not normally treated as a disposal for CGT purposes.
The solution is that he can elect, under the entrepreneurs’ relief legislation, for the share exchange to be treated as a disposal (TCGA 1992 s 169Q). An election must be made on or before the first anniversary of 31 January following the tax year in which the share exchange takes place (TCGA 1992 s169Q(4)) and may only be made in respect of all an individual’s shares in the acquiring company (see HMRC’s Capital Gains Manual CG64155). An election will not always prove to be advantageous. The individual may need to pay CGT before he has received any cash for his shares and a fall in share price may mean that some or all of the gain on which he has paid tax evaporates. His adviser will obviously need to sum up the pros and cons.
The second scenario takes us down the well-trodden tax planning path whereby an acquirer of shares under an approved scheme transfers some of the shares to her spouse, in order to utilise the spouse’s annual CGT exemption. The fact that the receiving spouse will usually not be an employee of the relevant company will not matter because, once the shares have been acquired, the employment status of the shareholder becomes irrelevant. Clearly, EMI/ER creates an exception to this. Only the individual who exercised an EMI option can qualify for EMI/ER. A spousal transfer will mean that ER is only available if, when the recipient sells the shares, he has held at least 5% of the voting ordinary shares for at least 12 months.
This does not mean that it is never worthwhile to transfer EMI shares to a spouse. However, unless the receiving spouse has unutilised capital losses, the transfer will only be beneficial if the tax saved by being able to use another annual exemption is not outweighed by the extra liability incurred on the rest of the gain. See example 3 above.
The essence of employee shareholder (ES) status is that an employee receives free shares in his employer in consideration for entering into an employee shareholder agreement. Under such an agreement, the employee agrees to waive certain of his statutory employment rights, most notably the right to sue for unfair dismissal (unless discrimination is alleged) or redundancy (The Employment Rights Act 1996 s 205A inserted by The Growth and Infrastructure Act 2013 s 31). The free shares, to the extent they were not worth more than £50,000 on acquisition, will be exempt from capital gains tax on disposal (FA 2013 Sch 23).
This advantage of ES over EMI is to some extent counterbalanced by the income tax treatment. If an EMI option is granted at a discount, the amount of the discount will generally be subject to income tax on exercise (ITEPA 2003 s 531); however if the exercise price is not less than the market price at the date of grant, and the charge on a disqualifying event is avoided, an EMI participant can avoid income tax altogether. By contrast, although £2,000 is deemed to be paid up on an individual’s ES, any value in excess of that will be subject to upfront income tax.
For a tax-relieving measure, ES has received a remarkably, perhaps uniquely, hostile reception. It would clearly be iniquitous if large numbers of relatively unsophisticated employees were cajoled into giving up basic employment protections in return for the nebulousness of a tax advantage on a share gain which may never materialise.
However, for senior executives in private companies, particularly those controlled by venture capitalists, the potential CGT exemption may hugely outweigh the value to them of their statutory employment rights (and in a ‘cosy’ set up, of course, there is nothing to stop them being given equivalent or even superior contractual rights). Venture capital-backed companies will frequently fail to qualify for EMI (by failing the independence requirement in ITEPA 2003 Sch 5 para 9, and they are therefore likely to be prime candidates for ES.
Amid all the opprobrium being heaped on the new arrangements, some companies may decide to adopt the bon mot of the emperor Vespasian: ‘Pecunia non olet’.
