The Benefits of an Unapproved Share Option Scheme

Most startups utilise the EMI scheme in order to issue options to their employees, because it is HMRC approved and very tax efficient. But EMI options do not work for everyone. For example, contractors or non UK employees do not qualify for the scheme. Also, startups that have breached the EMI thresholds (£250k per employee and/or £3m in total) are unable to issue further options under the scheme, any new options would then default to being unapproved.

An unapproved option scheme does have benefits though. Firstly, start-ups can be far more flexible with the terms and conditions, as the strict HMRC guidelines don't need to be followed - they can be offered to anyone, anywhere, at any time! Vesting criteria can be relaxed or even tightened during the option period, something that can't be done with an EMI. Furthermore, a formal HMRC valuation is not required, and the exercise price can be set as low (or as high) as you like.

• Individuals are not taxed when the options are granted to them, only when they are exercised.
• The tax is calculated by assessing the difference between the market value at the time of exercise and the amount paid for the shares. This difference is treated as 'income' and is taxed as such on the option holder.
• For example, a contractor is granted options over 100 shares at an exercise price of £9 per share. The contractor does not pay any tax when the options are granted. In three years’ time the contractor decides to exercise the options when the market price of the shares are £20 per share.
• The contractor will pay £900 for the shares, but the market value is £2,000. The contractor pays income tax on the difference of £1,100.
• Often, individuals will only exercise their option when there is a liquidity event, i.e. there is an option to sell the shares to a third party immediately. This might be, for example, in a VC takeover of the company.
• If the shares purchased are ‘readily convertible’ (ie during a liquidity event) and the option holder is an employee or director, the company will be obliged to account for the income tax liability through the PAYE system.
• Both employee and employer NIC will also be due on exercise of the option where the shares acquired are readily convertible. However, on occasion the company can request that the individual bears the employer's NIC liability on behalf of the company.
• If the shares are not 'readily convertible', then income tax is due on the individual's self assessment tax return, and NIC's are not due.
• Capital gains tax applies only when the options are converted to shares, i.e. from the date of exercise. If the options are exercised and sold immediately, then the whole increase is subject to income tax.
• However, if the options are exercised and subsequently sold at a later date, then part of the increase will be subject to capital gains tax.

The main difference in terms of tax between an EMI option and an unapproved option is that an EMI options are generally taxed on the option holder as capital whereas unapproved options are typically taxed as income. Capital gains usually have a lower tax rate and can be reduced further by reliefs such as 'business asset disposal relief', meaning that under an EMI scheme individuals could pay a tax rate of only 10%, whereas under an unapproved scheme the tax rate can be up to 45%. However, this tax is paid by the employee, and not the company.

From the company's perspective, the tax effects are broadly similar under both schemes. A corporation tax deduction is received when options are exercised, based on the market value less the exercise price. This applies to both EMI and unapproved schemes. However, under an unapproved scheme, this relief only applies to UK employees, not contractors or workers abroad.

Whilst unapproved option schemes may not be as tax effective for the option holders, they still have their place in high growth companies. They are flexible, easy to implement and can be issued more widely than their EMI counterparts.

Often, from the company's perspective, the tax effects are the same.

 

 

 

 

 

 

 

 

But they are best used strategically, for example, only when the EMI limits have been breached, or if an individual is not on payroll or based in the UK.

If you would like some help with setting up a company option scheme then get in touch with me via LinkedIn or though our website. You can also read more about how unapproved options are taxed here.