What is a share option?
A share option is the right to buy a certain number of shares in a company, at a fixed price, sometime in the future. Options can be granted to anyone, however EMI options (see below) can only be granted to employees.
This is because options can be a good way to remunerate, retain and motivate key employees long-term. The potential value of the shares encourages greater interest in the performance of the business and can help to keep offers from head-hunters at bay.
It’s common for options to have vested conditions attached, which need to be satisfied for the option holder (normally the employee) to become entitled to receive the asset under the share option agreement. The conditions typically divide into:
- Market conditions – ie attaining a specified share price of a share option, or achieving a specified target price based on the market price of an entity’s equity instrument.
- Non-market conditions – such as remaining in employment for a specified time or achieving individual performance targets.
Share options are an increasingly popular strategy to keep employment packages attractive in start-up and small fast-growth companies – particularly in the technology, SAAS and video games industries.
Share options vs shares
It is important to stress though that options are about a right to buy shares in the future. This is very different to letting someone buy shares right now, as that purchase means they become a shareholder with certain rights (for example voting rights and dividends).
Having a share option doesn’t mean you’re a shareholder, and so you don’t have any of the rights that come with having shares. These come in the future, if you exercise your option to buy the shares at the agreed fixed price.
How do you issue and gain share options?
There are various schemes for small and medium-sized businesses available and the main ones include:
- Enterprise Management Incentives (EMI)
- Save As You Earn (SAYE)
- Company Share Option Plan (CSOP)
When working with fast-growth businesses, we find that the EMI tends to be the most popular. It provides greater certainty over the likely tax treatment of the options granted, as it is a scheme approved by HMRC. That said, you should get advanced approval from HMRC for your share valuations when the options are issued.
No money changes hands when options are granted. An option-holder only pays the pre-agreed fixed price (usually known as the strike price) when they choose to convert their option into shares.
The strike price is usually a discount on the fair market value at the time the options were granted. To assess market value of the shares, HMRC typically uses the most recent share valuation. This is commonly depicted by the price paid per share by investors in the last funding round, or the earning per share according to the company’s trading history.
So what’s the tax position on share options?
No tax is charged when the share options are initially granted.
Tax is however charged on the option holder (typically the employee) when the options are exercised, and shares are bought at the pre-agreed price.
For non-EMI related schemes, the employee will pay Income Tax and NICS on the difference in price between the strike price and actual market value of the shares when they exercise their option. If they then go on to sell their shares, they’ll be liable for Capital Gains Tax on any profits. For employers, there should be no tax cost (subject to certain conditions).
Tax savings with EMI Schemes
EMI schemes are popular because they are backed by HMRC and come with tax savings. If the market value of the shares has been agreed by HMRC when the options were granted, the option holder doesn’t pay the Income Tax or NICS, as long as the shares are bought for at least the market value when the options were granted.
Capital Gains Tax on the sale of the share also reduces to 10% (based on Business Asset Disposal Relief being available, previously known as Entrepreneur’s Relief). The company pays no capital gains tax on the options either.
Another bonus is that Corporation Tax relief is available on EMI share schemes where the qualifying shares are acquired upon exercise of the option. The relief available is on the difference between the market value of the shares at point of exercise and the option price paid.
Don’t fall foul of HMRC
It’s important to remember that failure to agree a fair market value with HMRC can inevitably lead to questions about historic market values. This runs the risk that options were granted at a discount or EMI limits were broken at the grant date which could result in tax implications later down the line.
A conflict example here would be if a funding round took place, and the shares were sold at £5 per share. If it was later decided to grant EMI options at £2 per share, HMRC would argue the market value at the time of granting the options was at a discount (what with the recent allotment made at the higher £5 value). It would then be difficult to prove to HMRC the £2 valuation.
Timing is everything
Timing is vital in all of this and particularly for fast growth start-ups facing imminent or multiple funding rounds. Do be sure that share options and advance approval of valuations are undertaken at the right time for your business.
If the company is not able to qualify for HMRC-approved option schemes like EMI, there are still ways to use shares to incentivise employees. See this article – How unapproved share options are taxed and note there is a 6 July deadline for reporting unapproved share option plans to HMRC.
Can we help?
We regularly advise and help start-ups and fast-growth small businesses set up share option schemes as part of their growth plans. We guide them through the tax implications and costs to the option holders and companies alike, so they can find the most tax efficient and effective way to fuel their growth.
Please do get in touch with one of our specialists on this page to find out more.
Specific advice should be obtained before taking action, or refraining from taking action, in relation to this summary. If you would like advice or further information, please speak to your usual Shipleys contact.
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