Types of shares that may be acquired
The option must be a right to acquire shares that are part of the ordinary share capital of the company, and:
- are fully paid up, and
- not redeemable.
Ordinary share capital is defined in section 989 Income Tax Act 2007 and in relation to a company, means all the company’s issued share capital (however described) other than capital the holders of which have a right to a dividend at a fixed rate but have no other right to share in the company’s profits.
It does not matter whether the shares in question are called “ordinary”.
A company’s articles of association should make it clear whether the shares are fully paid up and not redeemable. Shares are not fully paid up if there is any arrangement to pay cash for them at a future date. Shares are redeemable if they are to be redeemed for cash. Some shares are redeemed at pre-determined dates or events. There may also be conditions that allow shares to be redeemed at the request of the company or the shareholder.
Options capable of exercise within 10 years
It must be possible for a qualifying option to be exercised within ten years of the date of grant, but it does not have to be exercised within that period. For example, if the exercise of the option depends on the fulfillment of performance conditions, it must be possible to fulfill those conditions within ten years.
However, the option agreement does not have to prevent the employee from exercising the option after that time. If the employee does exercise the option more than ten years after the date of grant, there will be no tax relief under Schedule 5 on the exercise. The tax relief on grant of the option will be unchanged.
Terms of option to be agreed in writing
The option must be in the form of a written agreement between the person granting the option and the employee. The agreement must be retained by the company so that it can be inspected by HMRC if an enquiry is opened into the option.
The agreement must state:
- the date the option is granted,
- that it is granted under the provisions of Schedule 5,
- the number, or maximum number, of shares that may be acquired or the formula that will be used for calculating this,
- the price (if any) the employee will pay to acquire the shares, or the method by which that price will be determined,
- when and how the option may be exercised,
- details of any restrictions on the shares,
- any conditions such as performance conditions affecting the employee’s entitlement, and
- whether there is a risk of forfeiture (shares are subject to risk of forfeiture if the interest in shares that may be acquired is only conditional within the meaning of S423 ITEPA, (Paragraph 37)).
The option agreement can either set out details of the restrictions on the shares, performance conditions or forfeiture conditions in the text of the option agreement itself or alternatively, the details may be contained in another document attached to the agreement and incorporated into the agreement by reference to the document (this means that the restrictions must be identified for participants and it is not sufficient for the company to refer generally to its articles of association or shareholder agreement for example). Examples of other documents include:
- the Articles of Association,
- the share scheme rules (where a formal scheme exists), or
- a shareholders’ agreement which an option holder is required to enter into as a condition of exercising his option (if this exists).
Where the details are included by reference to a separate document, the option agreement will need to specify the title of the document, when it was dated or adopted and the dates of any amendments.
In the case that restrictions are omitted from grant documentation, HMRC will take into consideration for compliance purposes any evidence that the restrictions have been otherwise brought to a Participant’s attention in a meaningful way at or near the date of option grant.
Failure to state a trivial restriction will not be a compliance issue.
There are no requirements in Schedule 5 about the type of performance conditions that can be imposed or whether such conditions must be objective.
Grant of option by deed
The option may be granted under deed or seal if a company so wishes. In this case a separate written agreement to the terms of the option will need to be signed by the optionholder. This document must state the conditions set out above.
If an option is granted by deed, the date of grant of the option is the date on which the deed is executed. The option is not a qualifying EMI option, however, until the agreement has been signed. A company can, for its own administrative purposes, get its employees to sign agreements in advance of the deed being executed, but the options will not be legally granted until the deed has been executed.
Options not transferable
The terms of the option must prohibit the option holder from transferring any of their rights under it. The only exception is that, following the death of the option holder, the agreement can allow personal representatives to exercise the option.
If the terms of an option allow its exercise after the option holder’s death, they must state that the personal representatives must exercise the option within 12 months of the date of death.
Amendments to options
Whether any changes amount to a new option is a question of fact and degree. Minor alterations that do not affect the terms of the option and do not increase the market value of the shares that may be acquired and are not contrary to the requirements of Schedule 5 will generally be acceptable. The date of grant of the option will remain unchanged.
However it will be a disqualifying event if the changes are a variation in the terms of the option and they increase the value of the shares that may be acquired under the option, or result in the conditions of Schedule 5 no longer being met, (Section 536 ITEPA).
If there is a change to any of the fundamental terms of an option to improve the rights of the option holder and the change is more than “de minimis”, the change will amount to the grant of a new option. The fundamental terms of an option are:
- the number of shares to be acquired,
- the price at which they are to be acquired, and
- when they can be acquired.
A “de minimis” alteration to the fundamental terms of an option is one which results in only a very minor improvement to the existing rights and the advice of ESSU should be obtained before accepting that an alteration to the fundamental terms of an option is a “de minimis” alteration.
If the change amounts to the grant of a new option, the existing EMI option is released. Any consideration received for the release will be chargeable to income tax under Section 477 ITEPA.
Amendments to performance conditions
The case of CIR v Burton Group plc (63 TC 191) concerned the Board of Inland Revenue’s refusal to approve an amendment to an existing approved executive share option scheme, relating to the setting and varying of additional (performance) conditions to which options would be subject. The case concerned an approved executive share option plan but the principle also applies to EMI options.
Burton Group’s approved executive share option scheme already included provision for the exercise of options to be subject to meeting performance conditions set at the date of grant. But the amendment to the scheme, which the Board refused to approve, provided scope for the right to exercise the options, and the number of shares over which the options could be exercised, to be subject to meeting additional performance conditions which could be set after the option had been granted, and amended after they had been set.
The Revenue’s practical concern was to ensure that “rights” could not be taken away from the employee other than in circumstances which were clearly defined when the option was granted and within the control of the employee concerned, and to an extent which was objective, quantifiable and reasonable.
The judge found in favour of the Burton Group because:
- additional conditions could only be imposed by the directors in circumstances which were clearly stated (at the date of grant of the option, or before the beginning of the financial year to which the performance target related, or at the time when the option- holder first held the relevant job),
- additional conditions which could be set were limited to specified matters, and to “being reasonably considered… to be a fair measure of the performance of the holder of the relevant job”, and
- the subsequent variation of such conditions was only permitted if the directors considered that different conditions in relation to the job would be a fairer measure of the performance of the holder of the job and would, reasonably, be less difficult to satisfy than they would have been without the amendment.
In the judge’s view, the directors did not have unlimited discretion on when and to what extent they could set or vary performance conditions. They had to act fairly and reasonably in the specified circumstances.