Vermilion Holdings Ltd v HMRC – When are options employment related?

In summary, an option over 2.5% of the company was originally granted for consultancy work performed, where no employment/directorship existed. Had no further changes occurred, this presumably would have been outside the scope of Pay As You Earn (PAYE)/National Insurance Contributions (NICs).

However, a refinancing round resulted in the original option being replaced, with the new option now being over 1.5% of the equity issued. Additionally (and crucially), the consultant in question was also appointed as executive chairman.

On eventual exercise of the option, Vermilion sought non-statutory clearance from HMRC that the exercise was outside of the scope of PAYE/NIC. This was on the basis that the original option was granted pre-employment and that the directorship taken up on grant of the new option was not relevant. Whilst this was not an unreasonable argument (and Vermilion won their case on this up to the Court of Session, the highest court in Scotland), the Supreme Court ruled that the ‘deeming provision’ below applies and the option exercise is subject to PAYE/NIC. This appears to apply a more literal interpretation of the deeming provision, even in the case where the new option replaces a non-employment related option as part of a refinancing round.

The law and interpretation of the deeming provision

In addition to factually assessing whether an option is granted by reason of employment (or holding an office such as a directorship), provisions also exist to deem the option to be employment related. Specifically, the law states ‘a right or opportunity to acquire a securities option made available by a person’s employer, is to be regarded as available by reason of an employment of that person unless:

  1. The person by whom the right or opportunity is made available is an individual; and
  2. The right or opportunity is made available in the normal course of the domestic, family or personal relationships of that person’.

In summary, where an employment or directorship exists at the time of grant, the deeming provision makes it very difficult to argue that an option exercise is outside the scope of employment taxes.

Why is this case important?

It is sometimes unclear if an option has been granted by reason of an individual’s employment. Where an option is granted by reason of employment, the exercise of the option will result in Income Tax, and in many cases NICs. It is therefore tempting to argue that options may have been granted for non-employment reasons, such as pursuant to a consultancy contract or acquired in an individual’s capacity as an investor. The recent ruling in Vermilion v HMRC confirms just how difficult it is to make this argument.

Wider ramifications

The deeming provision for employment related options has an equivalent for employment related securities, which deems shares, loan notes and other securities as within the scope of employment taxes. Advice should be sought where shares, options, convertible loans or other instruments are issued as part of a financing round, especially where the recipient holds employment/directorship as it appears they will be within the scope of PAYE/NIC, even if they finance on the same terms as pure investors.

This case also demonstrates the importance of having robust tax indemnities drafted into the legal documents. Where PAYE/NICs are due, it is primarily the responsibility of the employer to withhold these amounts and pay them to HMRC. Having appropriate indemnities should ensure that the company can recover such amounts from the employee.

To discuss your existing options schemes and how this case may affect you, contact David Bareham, Share Schemes Director, or Mark Allwood, Partner.

Employee options in M&A transactions

Employee options often play a key role in M&A transactions and need to be considered by all parties. We consider some key issues to be aware of:

  • Which options will be exercised as part of the deal?
  • How will the exercise price be funded?
  • Tax pitfalls and opportunities
Which options will be exercised?

When a company merges with or is acquired by another company, employees with share options usually get to exercise all their options, otherwise known as ‘full vesting’. However, there are some exceptions to this. For example, if employees have not worked for the required time or if certain performance targets have not been met by the time of the deal, they might not be able to exercise their options in full.

Before the deal, it’s essential to review if any unexercised options will become fully vested.  Some options contain ‘accelerated vesting’ clauses, whereby any outstanding performance or time-based vesting targets are automatically waived if an exit occurs.

If the decision to waive these targets depends on the directors’ discretion, care must be taken.  This can have adverse implications for tax-advantaged options, such as Enterprise Management Incentives (EMI) and Company Share Option Plans (CSOP), where applying director discretion to accelerate vesting can cause a loss of tax-advantaged status, resulting in PAYE and National Insurance contribution (NIC) charges.

How will the exercise price be funded?

Where the exercise price represents a material cost to the option holders, thought needs to be given to its funding. If the payment is pure cash, the exercise price, along with any PAYE/NIC, can typically be withheld from sale proceeds.

However, if the payment includes non-cash elements, such as shares, loan notes or earn-out rights, it can become complicated when withholding such amounts from the gross sales proceeds. In some cases, the cash consideration is not sufficient to cover the exercise price and PAYE/NIC liabilities. Therefore, it is often necessary to adjust the split of cash to non-cash consideration, for option holders to receive more cash. Where a deal includes substantial non-cash consideration, an early analysis of the net cash impact on option holders is recommended – especially for those holding unapproved options – to identify those cases where there is a cash ‘gap’.

Tax pitfalls

The immediate tax issue to consider is whether the exercise of an option creates PAYE/NIC charges. Whilst tax-advantaged options, such as EMI and CSOP, can potentially remove these liabilities, they can still be subject to PAYE/NIC in certain scenarios, such as:

  • EMI options granted at undervalue
  • EMI options subject to a disqualifying event (such as for a leaver who retains their options)
  • CSOP options exercised within three years of grant

A penal tax regime applies where PAYE is not correctly accounted for or recovered from the employee within the required time limits.

A review of employee options will typically be the focus of legal and tax due diligence, with appropriate warranties and indemnities then provided by the sellers.

Tax opportunities

Where conditions for Income Tax relief are met, EMI and CSOP options can provide employees with exit proceeds at Capital Gains Tax rates at 20%, or even 10%, in the case of EMI options held for two years or more.

Additionally, the exercise of employee options typically results in a Corporation Tax deduction for the employer company. This deduction is based on the market value of the shares when the options are exercised, less the exercise price paid, and is due even where the employees’ gains are not subject to Income Tax.

Where sizeable Corporation Tax deductions are due, the sellers may seek to negotiate with the buyer so that any resulting tax saving leads to additional sale proceeds being paid to them. In other words, the sellers may seek to benefit from the tax advantages by increasing the amount they receive from the sale. This negotiation would be a way for the sellers to capture some of the financial benefits that arise from the favourable tax treatment of the transaction.

How haysmacintyre can help

Our Share Schemes team has extensive experience advising from a buyer or seller’s perspective and can help with:

  • Sale readiness and vendor due diligence
  • Buyer financial and tax due diligence
  • Financial modelling
  • Tax planning for individual and corporate sellers
  • Post-deal tax compliance for employers and sellers

Get in touch with David Bareham, Share Schemes Director, for further advice.

Employee option schemes – recent changes

As of 6 April 2023, changes have been made to HMRC tax-advantaged option schemes. These changes are summarised here:

  • Company Share Option Plan (CSOP) value limit – increased from £30k to £60k per employee.
  • CSOP removal of restrictions on share class to be used.
  • Employee Management Incentive (EMI) removal of requirement to sign a working time declaration.
  • EMI removal of requirement to itemise restrictions over shares.
CSOP changes

The increase in the value of shares that can be subject to CSOP options has increased to £60k. Whilst this is still significantly lower than the equivalent £250k limit for EMI, it is a welcome and long overdue increase. Considering that it is usually possible to negotiate discounted share values with HMRC, the £60k limit may prove enough incentive for second tier, and in some cases, first tier management.

The removal of restrictions on share class for CSOP is also a welcome change. The historic rules made it difficult for companies with multiple share classes to operate a CSOP or prevented them from granting options over minority share classes. The changes now allow for CSOP options to be granted over growth shares or other bespoke share classes. The use of CSOP options over growth shares allows for more shares to fit within the £60k limit, allowing for a viable incentive for first tier management.

EMI changes

The EMI changes are also welcome. The removal of the requirement to sign a working time declaration is retrospective, applying to EMI options exercised post 6 April 2023, even if granted earlier. It must be noted, it is still a requirement that the option holder meets the working time requirements (working 25 hours per week or spends 75% of their time working for the employer or group company).

Similarly, the removal of the requirement to itemise restrictions over EMI shares is also retrospective, applying to options exercised post 6 April 2023, even if granted earlier.

The lack of signed working time declarations and/or the itemisation of share restrictions had often been omitted in EMI scheme documentation, only to then be picked up on a due diligence exercise, creating concern and uncertainty to the tax status of the ‘defective’ option agreements. Removing these requirements should significantly help facilitate a smoother due diligence process where EMI options are involved.

Further EMI changes due

There are further changes due from 6 April 2024, whereby the notification of EMI options to HMRC will change from being an ‘in-year’ requirement reportable within 92 days of grant to being reportable by 6 July, following the end of the tax year of grant.

Whilst the extra time to notify may prove useful, it may present greater risk for employers. For example, if the person responsible for filing the notification leaves the business before the end of the tax year, it is possible that their successor will not be aware of the requirement. Missing the notification deadline can be a serious issue for employers, as it removes the EMI status of the option, meaning the exercise is likely subject to PAYE/NIC instead of favourable rates of Capital Gains Tax (CGT).

Employers and their advisors will need to ensure they have procedures in place to minimise the risk of EMI notification falling through the cracks.

Get in touch

If you wish to discuss how the above changes will affect you, please get in touch with David Bareham, Share Schemes Director, or our Share Schemes team.

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