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NOTE: This document does not provide legal advice – it is only intended as a discussion draft to be updated and modified to fit the circumstances. The publishers and authors shall not be liable to any person with respect to any loss or damages caused or alleged to be caused directly or indirectly by the information or any mistake in this document. In particular, all statutory references should be checked and users are reminded that changes are continually being made to the law and the document will not be up to date. [24 August 2011] LEGAL GUIDE SHARE OPTIONS (NOT EMI) This note contains a summary of the difference between approved and unapproved share options. It does not deal with Enterprise Management Incentives options which are dealt with in a separate briefing note. The note is directed particularly at start-ups and early stage companies. 1. Introduction Share options may either be “approved” by the Inland Revenue, “unapproved” or Enterprise Management Incentive (“EMI”) options. This note deals with approved and unapproved options only. One difference between these options is the tax treatment of the option on exercise. If approved, there is no tax charge on exercise (and instead it is delayed until the shares are sold). If unapproved, income tax is payable on exercise. This tax problem for the option holder is largely overcome if shares are sold at time of exercise (which is often the case) as income tax at the higher rate of 40% is same as capital gains tax (“CGT”) at 40% (although the CGT annual exemption currently £9,600 is not available for the unapproved option). There are additional problems for the employer with an unapproved scheme as NIC will be payable on the exercise of the unapproved option and income tax will require to be collected through the PAYE system if on exercise the shares are readily realisable. There is no NIC or income tax payable on the exercise of approved options. 2. Approved share option schemes SHARE OPTIONS NOT EMI (GUIDE) Very broadly, to qualify for relief from income tax on exercise an approved share option must:- 3. (a) be granted under a scheme which is approved by the Inland Revenue; (b) be granted only to an employee or a full-time director of the company; (c) be exercised at least three years after the date of grant; (d) have an exercise price which is not less than the market value of the shares as at the time of grant; (e) ensure no individual is granted an option if the aggregate market value of his shares exceeds £30,000. Unapproved schemes If the option scheme is unapproved: (a) there is no statutory limit on the percentage or value of share capital over which options may be granted to an individual (compare with the £30,000 limit for the approved scheme); (b) there is no minimum period before exercise (compare the 3 year wait for the approved scheme); (c) there is no restriction on exercise price. For approved options, the exercise price must not be less than the market value and in the case of unlisted shares, their market value has to be agreed with the Inland Revenue before an approved share option can be granted; (d) provided the option is not exercisable more than seven years after grant, no liability to tax arises at the time of grant. However, a liability to NI contributions will arise at the time of grant if the exercise price is at a discount to market value; (e) assuming that the shares will be sold as soon as the option is exercised, capital gains tax due on the exercise of an approved option (within the statutory time limits) will be due and payable on 31 January in the following tax year. For unapproved schemes, income tax would 2 SHARE OPTIONS NOT EMI (GUIDE) normally be due and payable shortly after the end of the tax year in which the option is exercised; 4. (f) if the shares acquired are not immediately sold, the amount on which income tax is charged on unapproved options is then added to their base cost for capital gains tax purposes. This means that the amount by reference to which the indexation allowance is calculated is greater than it would have been if the shares had been acquired on the exercise of an approved option within the statutory time limits; (g) income tax due on the exercise of an unapproved share option is collected from the employer under PAYE if the shares are readily realisable. This imposes an administrative burden and cash flow disadvantage for both the employer and the option holder. Procedures As regards procedure: (a) for all schemes Articles of Association and any Shareholders Agreements will have to be checked to see if the Directors have authority to grant options; (b) the adoption of an unapproved scheme is very straightforward. It is simply approved by the Board and then you decide which employees should be invited to participate. Please be warned though that start-up and early stage companies are often poor regarding administration of their option schemes. Sometimes they mention at recruitment that options will be granted. There is then subsequent contradictory correspondence relating to their employment about options. Even when options are properly granted sometimes copy letters are not kept and the whole thing turns into a nightmare. Companies need a good internal administrator to keep a tight grip on any options granted. 5. Conclusions Options granted under the new Enterprise Management Incentives must be the first choice (if the company is eligible). Please see the separate briefing note entitled EMI Share Options. If further options are required then the board needs 3 SHARE OPTIONS NOT EMI (GUIDE) to consider the respective merits/disadvantages of approved and unapproved option schemes. The tax advantages of an approved scheme are compelling but many start-up and early stage companies are not impressed by the hurdles the Revenue imposes to have an option scheme approved. There is the £30k limit but more importantly there is the 3 year wait before the option can be exercised. For many involved in young, high-growth companies, a wait of 3 years is like an eternity. An approved scheme is a poor motivational tool compared to an unapproved scheme where you vest say 20% after say 9 months and 2% a month thereafter. For further information please contact: Tom Mackay or Jennifer Carter Shaw, Solicitors, Mackay Carter Shaw LLP Tel: 0207 193 1009 or 1016 Email: [email protected] or [email protected] Website: www.mackaycartershaw.com This note is only a general review of the subjects covered and does not constitute legal advice which will vary depending on the circumstances of each case. No legal or business decision should be based on the contents of this note. 4 SHARE OPTIONS NOT EMI (GUIDE)