ETASSUM54360 - Enterprise Management Incentives (EMI): Requirements relating to options: Examples of unacceptable 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 would be considered by HMRC as causing the release and regrant of the option.
Example 1
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.
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an employee is granted an EMI option over 10,000 shares that is exercisable only once the option is fully vested, and the board has the discretion to amend the vesting schedule.
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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 uses its discretion to amend the vesting schedule so that 50% vests after 12 months and 25% each year thereafter until such time the option is fully vested. The option is now exercisable, to the point fully vested, after 36 months rather than 48 months.
As the amendment to the vesting schedule has changed ‘when’ the options can be exercised this is considered a change to the fundamental terms which would cause a release and regrant of the option.
Example 2
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 option over 10,000 shares that is exercisable on an exit event that is described as a takeover/change of control or listing.
- the board has the discretion to permit all or any part of an option to be exercised at an earlier time, on such terms as may be determined by the board.
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there is a vesting schedule appended to the option that says:
- 25% vests after 12 months and 25% each year thereafter until such time as the option is fully vested (48 months after grant).
- there are no good leaver provisions within the EMI option agreement.
The option holder leaves employment, in month 40, before an exit event has occurred. The board decides to use its discretion to allow the employee to be considered a ‘good leaver’ and permits the employee to exercise their option, outside of the exit, and to accelerate vesting so all options are exercisable.
Because the good leaver provisions were not provided for from the outset, using the discretion clause to allow exercise outside of an exit event changes the fundamental terms of the option as it changes when the option can be exercised. This would cause a release and re-grant of the option.
If there were specific good leaver provisions sufficiently stating, from the outset, when an option could be exercised, other than upon an exit, then this would not cause a release and re-grant of the option. In these circumstances, it would be acceptable for the board to use the discretion to allow for accelerated vesting which would not cause a release and regrant.
In contrast, the exercise of a discretion allowing early exercise otherwise than on a specified event would not be acceptable even where that discretion is provided for in the option terms from the outset.
Example 3
The following example also 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 option over 10,000 shares that is exercisable on an exit event that is described as a takeover/change of control or listing.
- the board has the discretion to permit all or any part of an option to be exercised at an earlier time, on such terms as may be determined by the board.
The company receives an investment from a third party that results in the third party acquiring 25% of the company’s share capital.
This transaction did not meet the definition of a change of control, but the board decided it was commercially important that the EMI option holders be able to participate in the transaction. The board, using the discretion clause within the terms of the option, permitted all EMI options holders to exercise outside of the permitted exit terms.
As the board used the discretion to change ‘when’ the option can be exercised this has resulted in a change of the fundamental terms, causing a release and regrant.
Example 4
The following example relates to circumstances where the interaction between the vesting schedule and performance conditions will lead to a change to the fundamental terms.
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an employee is granted an option over 10,000 shares that is exercisable only once the option has fully vested an only to the extent that certain performance conditions are met.
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there is a vesting schedule appended to the option that states
| VESTING AMOUNT (CUMULATIVE AMOUNT VESTED) | WHEN AFTER GRANT | TARGET |
|---|---|---|
| 25% | 12 months | EBITDA more than £1 million |
| 25% (50%) | 24 months | EBITDA more than £1.3 million |
| 25% (75%) | 36 months | EBITDA more than £1.6 million |
| 25% (100%) | 48 months | EBITDA more than £2 million |
- the board has discretion to amend the vesting schedule and performance conditions if it considers it fair and reasonable to do so.
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 £1 million |
| 30% (70%) | 24 months | EBITDA more than £1.2 million |
| 30% (100%) | 36 months | EBITDA more than £1.5 million |
Alternative 2
| VESTING AMOUNT (CUMULATIVE AMOUNT VESTED) | WHEN AFTER GRANT | TARGET |
|---|---|---|
| 50% | 12 months | EBITDA more than £500,000 |
| 15% (65%) | 24 months | EBITDA more than £750,000 |
| 15% (80%) | 36 months | EBITDA more than £1.2 million |
| 20% (100%) | 48 months | EBITDA more than £1.5 million |
The amendments under Alternative 1 change ‘when’ the option can be exercised, shortening this from 48 months to 36 months. HMRC consider this a change to the fundamental terms that would cause a release and re-grant.
The amendments under Alternative 2 change the percentage at which share vest and the EBITDA target. Since the amount of shares under option and when the option can be exercised remain the same, these amendments would not change the fundamental terms of the option, because it can still only be exercised 48 months after grant, and there would be no release and re-grant.