HMRC has recently published long awaited guidance on the use of discretions in the operation of Enterprise Management Incentive (EMI) options.
This is the first time that HMRC has published guidance on the use of discretion in relation to EMI options (although HMRC has stated that the guidance is not a change in its position). Previously the position had developed through caselaw and practice, rather than being set out in legislation, so it is helpful that we now have more clarity. In addition, HMRC has flagged that it is aware it has given some incorrect advice in this area in a limited number of cases.
Why has HMRC published guidance?
It is common for EMI plans and option agreements to contain provisions which allow for various discretions to be exercised in the operation of the arrangements. The exercise of discretion involves the decision maker using their judgement to come to a decision and, in the context of a share plan, the decision maker would usually be the board of directors (or anyone with delegated authority). Examples include deciding to treat a departing employee as a 'good leaver' or deciding to increase the number of vested shares on an exit (known as acceleration).
In certain circumstances, HMRC view the use of a discretion as making an amendment to the rights the option holder has under the option, which is a change to the fundamental terms of that option. Where there is a fundamental change to its terms, this would then be deemed a release and regrant of that option, which may result in the loss of beneficial EMI tax treatment. HMRC was aware that confusion had arisen following discussions in a number of cases where a company wished to use a discretion in relation to existing EMI options.
What issues do you need to consider when using a discretion?
The published guidance sets out the key principles HMRC considers when assessing the facts of a specific case and includes some practical examples.
One of the qualifying requirements for an EMI option is for the following fundamental terms to be set out on grant:
- number of shares under option
- exercise price
- timing for exercise/acquiring the shares.
Certain discretions may allow for a change to these fundamental terms, and other terms of the option, and are commonly included in the option plan/agreements governing the option at grant.
As set out in the guidance, the key principles HMRC considers when assessing the use of discretions in the context of EMI options are:
- Exercise conditions, discretions and other relevant terms must be included in the option documentation on grant.
- Use of discretion on a fair and reasonable basis to increase extent of vesting or waive performance conditions is acceptable.
- It is acceptable to use a discretion to determine who is a 'good leaver' and to allow additional vesting for a departing employee. Decisions must be made in good faith and for the purpose of ensuring the fair and/or effective operation of the option plan.
- It is not acceptable to use discretion to bring forward when the option would otherwise have been exercisable (including as a result of making a change to vesting conditions).
- The use of a general discretion to allow exercise of an option at any time not previously specified is not acceptable. This commonly arises where there is a secondary funding round and a company wishes to allow employees to exercise their options early. If the circumstances of this exercise are not provided for in the terms at the outset, it would be a fundamental change to the timing of exercise.
- An amendment after grant of an option to allow for discretion or variation of vesting/performance conditions is not acceptable (unless this were considered a minimal change, for example for administrative purposes).
HMRC draw a distinction between discretions which impact on the extent of vesting and those impacting the timing of exercise. Where the use of a discretion could impact on both aspects, careful consideration should be given as to whether this is a fundamental change to the option (eg acceleration of a time-based vesting schedule where options are exercisable from the point of vesting).
Next steps
Although the HMRC guidance is helpful, there are some nuances and advice should be taken when there is a proposed use of a discretion or amendments to terms to ensure any beneficial EMI tax treatment of the option is not impacted.
Where previous HMRC advice was not in line with their current guidance, the Share Schemes unit at HMRC should be contacted to assess whether any income tax and national insurance contributions paid on the exercise of an EMI option should be refunded. There is ordinarily a 4-year statutory limit to claim a refund of overpaid tax, however, this may be extended if this was due to an error by HMRC.
The above is a summary based on the guidance as currently drafted and may be subject to change by HMRC.
If you would like to discuss the impact of the HMRC guidance on your EMI options, please get in touch with a member of the Incentives team or your usual Taylor Wessing contact.
