ETASSUM54340 - Enterprise Management Incentives (EMI): Requirements relating to options: Discretion and types of EMI scheme

Paragraph 37, Schedule 5 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA)

There are broadly two common types of EMI option schemes - those that permit exercise only upon the occurrence of a specified event, and those that permit exercise after a defined period of time. There are many different variants but these can mostly, if not all, be placed in one of these categories or a combination of the two.

Specified event

A common example is an ‘exit-only’ scheme. These allow the option to be exercised once the business is sold or when a significant change in the ownership or control of the EMI company occurs. An example of a discretion clause in specified event EMI schemes would be one which allows, subject to the discretion of the board, for the shares subject to the option to vest at an accelerated rate upon the occurrence of an exit.

Another example of a specified event could be cessation of employment.

Time-based

These allow options to be exercised after a specified period of time has elapsed, and they may require completion of a vesting schedule and/or the achievement of performance milestones. A common example of a discretion clause in time-based EMI schemes would be one which allows for the acceleration of vesting subject to the discretion of the board; however, whether a use of discretion in this specific way would be permissible in accordance with the principles from the Eurocopy and Reed International cases would depend on when the option is exercisable.

When discretion may be used

The relationship between vesting and exercise is different for ‘specified event’ and ‘time-based’ options – this, in turn, influences the circumstances under which a change to the schedule for the vesting of the EMI option will amount to a change to its fundamental terms and when it will not:

  • in respect of specified event options, changes to the timetable for vesting will typically not amount to a change to the fundamental terms of the option and lead to the grant of a new option. This is because ‘when’ the option may be exercised, for the purposes of paragraph 37(2)(e) Schedule 5, ITEPA, does not change as even though the timetable for vesting has been altered, exercise will still only be possible upon the occurrence of the specified event

  • in respect of time-based options, changes to the timetable for vesting will typically amount to a change to the fundamental terms of the option. In particular, if exercise is contingent upon the option fully vesting, any change to when this happens is tantamount to changing when the option may be exercised.

    • if changes are made to the timetable for vesting which do not change the date on which the last of the shares subject to the option may vest, this will be permissible provided that exercise is contingent upon the option having vested in full; when the option may be exercised will not have been altered as a result of changes of this nature.
    • in instances where the option can be immediately exercised to the extent that it has vested, any change to when the option vests is equivalent to a change to when the option can be exercised – thus, it will amount to a change to the fundamental terms of the option. Even if the option holder could be said to possess the right to exercise the option from the outset, they can only exercise it in practice ‘when’ it vests.
    • in practice, the terms of time-based options may also contain provisions allowing exercise of the option on the occurrence of certain specified events, for example an exit, cessation of the option holder’s employment or a disqualifying event. Exercise of the option is often allowed in those circumstances to the extent the option is vested at the relevant time or sometimes the board is given the discretion to allow exercise to a greater extent than vested, including by varying or waiving any performance conditions. HMRC will generally treat the exercise of a board discretion to allow exercise of an option on the occurrence of a specified event or the exercise of a board discretion to allow exercise of an option to a greater extent than vested as not being a change to the fundamental terms of the option, provided that the discretion was provided for from the outset.

This is linked to the distinction between fundamental terms and performance conditions which is referenced in ETASSUM54310.

Cessation of Employment

Both time-based and specified event EMI schemes may contain clauses with provisions allowing employees who leave the company under specified circumstances to exercise their options, at the board’s discretion, to the extent vested up to that point. Such clauses will often refer to ‘good’ leavers, which will be defined in the agreement.

In these circumstances, meeting the required criteria to be considered a ‘good’ leaver will be a performance condition, whilst the ‘when’ for the purposes of paragraph 37(2)(e) Schedule 5, ITEPA will be when the employee actually leaves the company in the capacity of a ‘good’ leaver.

It is acceptable for the definition of ‘good’ leaver to fall to the discretion of the board and for the board to be given a complete discretion as to whether an option holder ceasing to be employed should be treated as a ‘good’ leaver.

This approach allows the board to exercise discretion over who may fall within the category of a ‘good’ leaver without causing the surrender and re-grant of the option. Such a change would not affect ‘when’ the option may be exercised, meaning that, so long as such an exercise of the discretion was made in good faith for the purpose of ensuring the fair and/or effective operation of the option in accordance with the principle from the Burton Group case, it would be permissible.