ETASSUM52031 - Enterprise Management Incentives (EMI): Qualifying companies: Arrangements leading to loss of Independence
Paragraph 9, Schedule 5 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA).
In order to be a qualifying company to grant EMI options, a company must not be under the control of another company, nor must they be capable of falling under such control (ETASSUM52030). It is necessary to consider whether any arrangements exist which can lead to a loss of independence. Where such arrangements exist, the company is not considered to be independent for EMI purposes.
Definition of arrangements
The term “arrangements” is very broad, and it includes any scheme, agreement or understanding, whether legally enforceable or not (paragraph 58 Schedule 5 ITEPA 2003).
What constitutes an arrangement?
Potential scenarios which could affect EMI companies include:
deadlock provisions that could give another company the deciding vote
provisions which allow the appointment of a company investor representative director to the board where the decisions of that representative director are deemed as made regardless of votes cast.
swamping rights – where a company investor (or group of company investors) obtains control of the board in the event of underperformance by the company.
when a company investor representative director is appointed chair at a board meeting with a casting vote.
Mutual understanding regarding a sale
A common arrangement for EMI is where there is a mutual understanding regarding a sale (or other event leading to a loss of independence). At the point all relevant parties reach a mutual understanding that each will act in a certain way, and there is an expectation that this will occur, the independence requirement will not be met. However, the relevant parties for this purpose must include the potential purchaser for the mutual understanding to be treated as an arrangement under which control could pass.
During negotiations for a sale of the company, a non-binding agreement can constitute an arrangement. Evidence of this may include, but is not limited to, Heads of Terms, a Letter of Intent or similar. Such evidence will be enough to demonstrate that an arrangement was in place, as even though there is no legally binding commitment from either party, there is still an expectation among all parties that the sale will proceed on generally agreed core terms. However, the mere existence of an offer letter (or similar) from a prospective purchaser will not constitute an arrangement until such time as there is a mutual understanding as referred to in the previous paragraph and an expectation that the sale will proceed largely on the terms set out in the offer letter.
HMRC accept that any genuine requirement for external approval, which is outside of the control of the parties, before a transaction can proceed will prevent the existence of arrangements until the approval is given (or until it is clear that it will be given). This is because an arrangement must be something that can take effect. (Scottish and Universal Newspapers Ltd v Fisher (1996) CTM80196)
Distress Provisions
A distress provision is one in which a corporate investor could gain control in certain situations in order to rescue a company from potential failure. HMRC accept that the existence of certain distress provisions is not sufficient to deny a company from granting EMI options. These distress situations may include:
a company failing to redeem any loan notes;
a company breaching banking covenants; and
a proposed liquidation (other than a voluntary liquidation) of a company.
These scenarios are indicators of financial distress. However, depending on the circumstances they may not always amount to distress provisions and each case will be decided on the individual facts.
It is acceptable for step in rights to apply pre-emptively if the investor reasonably considered that the company was about to fall into genuine financial distress in line with the situations outlined above.
HMRC considers distress provisions such as those above are not arrangements by virtue of which a company could breach the independence requirement for the purpose of granting EMI options. This interpretation concerns the granting of EMI options only and has no bearing on the interpretation of ‘arrangements’ in other legislation.
Whilst the existence of such distress provisions would not result in failing the independence test, should these come into effect and a corporate investor gains control of the company, this will be a disqualifying event (ETASSUM57080).
Any contrived or artificial arrangements whereby any agreement could be breached simply because business performance was not as expected or that offers protection to the investor would not be considered a distress provision and are likely to constitute arrangements that breach the independence requirement. Examples of this could include but are not limited to:
where an investor can act “in their reasonable opinion” if certain business performance measures have not been met
where investors can hire or fire directors under certain circumstances where the company breaches certain financial covenants such as not meeting profitability targets
where the company breaches certain financial covenants such as not meeting profitability targets
where a corporate investor could get the majority of voting rights if a future event occurs that is not linked to distress