ETASSUM54350 - Enterprise Management Incentives (EMI): Requirements relating to options: Discretion: Examples of acceptable use of discretion
Paragraph 37, Schedule 5 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA)
Below are some examples of circumstances where discretion to change the terms of the option can be applied that HMRC would generally not consider as causing the release and re-grant of the option.
These examples are merely illustrative and what follows is in no way an exhaustive list of the circumstances where discretion may be exercised in relation to an EMI option or of the ways in which such an exercise of discretion may take place.
Example 1
The following example relates to an EMI scheme that has been established to allow for option exercise on a sale, listing or change of control of the company – otherwise commonly referred to as an ‘exit only’ scheme.
- an employee is granted an EMI option that is exercisable on an exit event which is described as a takeover/change of control or listing.
- the option is exercisable on an exit event to the extent vested unless the board determines otherwise.
- the terms of the option include the following provisions:
- upon cessation of employment unless the board determines, at its discretion, that the employee is a good leaver the option will lapse in its entirety.
- the board, having determined that the employee is a good leaver, at its discretion, can permit exercise of the option within X days (or not as the case may be) to the extent vested or as the board otherwise determines .
The option holder leaves employment before an exit has happened and the board has determined that he is a good leaver and permits exercise of the option (outside of the exit) upon leaving to the extent vested.
Before the individual exercises their option the board makes a further decision that exercise can be permitted over all of the shares irrespective of the extent to which the option has vested.
The exercise of the EMI option by the individual qualifies for tax advantages because the ability of the board to utilise discretion, both on an employee leaving and acceleration of vesting, is provided for at the outset.
It is perfectly acceptable for an exit-only option to also allow for exercise in accordance with the kind of good leaver provisions provided in this example; so long as such provisions are included from the outset. The legislative provisions at paragraph 37(2)(e) Schedule 5, ITEPA will be satisfied and the utilisation of these provisions will not result in a loss of entitlement to the tax benefits of the EMI scheme.
The position would be the same if the option terms provided, instead of the option becoming exercisable on the cessation of employment, that the option remains exercisable only on an exit but that the option holder is entitled to retain the option upon leaving employment as a good leaver to the extent vested at that time, or such greater extent determined by the board. The tax advantaged status of the option would be retained although, of course, if the subsequent exercise were more than 90 days after the cessation of employment, the tax benefits would be limited by virtue of there having been a disqualifying event.
If the provisions at bullet 3 in the example were not provided for at the outset and a company sought to introduce those provisions after the option had been granted, then HMRC would view this as a change to the fundamental terms of the option which would cause the original option to be released and re-granted.
Example 2
The following example relates to an EMI scheme that has been established to allow for option exercise after a period of time – otherwise commonly referred to as a ‘time-based’ scheme.
- an employee is granted an option over 10,000 shares that is exercisable only once the option is fully vested.
- there is a vesting schedule appended to the option that says:
- 25% vests after 12 months and 25% each year thereafter until such time the time the option is fully vested (48 months after grant).
- the board has discretion to amend the vesting schedule if it considers it fair and reasonable to do so
- the terms of the option include the following provisions:
- upon cessation of employment unless the board determines, at its discretion, that the employee is a good leaver the option will lapse in its entirety.
- the board, having determined that the employee is a good leaver, at its discretion, can permit exercise of the option within X days of cessation of employment (or not as the case may be) to the extent vested or as the board otherwise determines.
The option holder leaves employment in month 40. The option is therefore only partially vested. The board, using its discretion, determines the employee to be a good leaver and decides to accelerate vesting permitting exercise to take place over all of the 10,000 shares.
Because good leaver provisions sufficiently specifying ‘when’ the option may be exercised are provided for from the outset, the employee will benefit from tax advantaged treatment.
Note the discretion clause in bullet 2.2 does not permit the alteration of the vesting schedule to allow the option to be exercised earlier than determined at the outset, in this case being effectively 48 months after grant. A more detailed example of the exercise of this type of discretion clause is set out in Example 4 of ETASSUM54360.
Example 3
The following example tries to demonstrate the impact from any changes made to the terms of an option that are subject to both a vesting schedule and linked performance conditions.
- an employee is granted an option over 10,000 shares that is exercisable only once the option is fully vested, and only to the extent that certain performance conditions have been met.
- there is a vesting schedule appended to the option that says
| VESTING AMOUNT | ||
|---|---|---|
| (CUMULATIVE AMOUNT VESTED) | WHEN AFTER GRANT | TARGET |
| 25% | 12 months | EBITDA more than £1m |
| 25% (50%) | 24 months | EBITDA more than £1.3m |
| 25% (75%) | 36 months | EBITDA more than £1.6m |
| 25% (100%) | 48 months | EBITDA more than £2m |
- the board has discretion to amend either or both of the vesting schedule and performance conditions if it considers it fair and reasonable to do so.
- the terms of the option include the following provisions:
- upon cessation of employment unless the board determines, at its discretion, that the employee is a good leaver, the option will lapse in its entirety.
- the board, having determined the employee is a good leaver, at its discretion, can permit exercise of the option within X days of cessation of employment (or not as the case may be) to the extent vested or as the board otherwise determines.
The board considers the following changes to the vesting/performance conditions.
Alternative 1
| VESTING AMOUNT | ||
|---|---|---|
| (CUMULATIVE AMOUNT VESTED) | WHEN AFTER GRANT | TARGET |
| 40% | 12 months | EBITDA more than £1m |
| 30% (70%) | 24 months | EBITDA more than £1.2m |
| 30% (100%) | 36 months | EBITDA more than £1.5m |
Alternative 2
| VESTING AMOUNT | ||
|---|---|---|
| (CUMULATIVE AMOUNT VESTED) | WHEN AFTER GRANT | TARGET |
| 40% | 12 months | EBITDA more than£1m |
| 20% (60%) | 24 months | EBITDA more than £1.2m |
| 20% (80%) | 36 months | EBITDA more than £1.4m |
| 20% (100%) | 48 months | EBITDA more than £1.6m |
Changes under Alternative 1 would, in HMRC’s view, be a change to the fundamental terms since, due to the amendment to the vesting terms, the option now becomes exercisable after 36 months, rather than 48 months.
Changes under Alternative 2 would be acceptable because it is only the rate at which the option vests and the performance conditions which have been changed; ‘when’ the holder may exercise the option has not changed, meaning there would be no change to the fundamental terms of the option.
A further scenario could be the case of an employee leaving in month 26 with the vesting schedule remaining unchanged.
At this point only two years worth of options could have vested but the EBITDA target wasn’t met in year two, falling short by £50,000.
The board, using its discretion, firstly decides to reduce the EBITDA target for year two to £1.15 million. Having taken into account circumstances of why the target wasn’t met it considers this reduction is a more fair and reasonable measure of performance.
The board then also determines the employee to be a good leaver and decides to permit exercise of the option over all of the shares.
HMRC take the view that this is acceptable as the alteration of EBITDA is an alteration to the performance condition that the board, in its discretion, decides is a more fair and reasonable measure.
Although the application of discretion upon the employee leaving has led to the board concluding that exercise can be permitted over all of the option shares, that discretion is provided for in the option terms from the outset and does not change. It is not relevant in these circumstances that the number of shares over which the option vests and over which the holder is allowed to exercise their option is altered due to the exercise of the discretion relating to the performance conditions.