EMI Schemes and the Independence Test: What Businesses Need to Know

For small and medium-sized businesses using Enterprise Management Incentive (EMI) Schemes to attract and retain key employees, maintaining independence from other companies is crucial to preserving the scheme's tax advantages. Recent guidance from HMRC (October 2024) has clarified what may constitute 'arrangements' that could result in a loss of independence, ultimately affecting the tax benefits for employees.

Key risk areas include situations where another company has voting control, influence over the board, or a mutual understanding for a sale, even if not legally binding. Businesses should regularly review their ownership structures, shareholder agreements, and governance arrangements to ensure they do not inadvertently breach the independence test and risk losing the tax-efficient benefits of their EMI scheme.

In this article, Corporate and Commercial Solicitor and Director Nick Mayles sets out the implications of the HMRC Guidance Update that was released in October 2024 provides context for companies that have adopted an EMI Scheme and granted EMI options.

What are EMI Schemes?

Enterprise Management Incentive (EMI) Schemes are a tax-advantaged share option schemes designed to help small and medium-sized businesses attract and retain key employees. They offer significant tax advantages if certain qualifying conditions are met. One of those conditions is that the company must meet the ‘independence test’. In October 2024, HMRC updated its guidance concerning the independence test.

What is the independence test?

The independence test seeks to ensure that a company granting EMI options is independent from other companies as to ownership and control. To meet the test, the company must not be either (and for these purposes, employee ownership trusts are an exception):

• majority-owned by another company; or
• under the control of either another company, or another company and any person connected with it.

When must the independence test be met?

The company must:

• meet the independence test at the time of grant of the EMI option; and if it does not, or there are ‘arrangements’ in place that could lead to a loss of independence, the option will not benefit from the EMI tax advantages, and will be subject to employment income tax and National Insurance contributions on the full gain made by the employee on exercise of the option;
• continue to meet the independence test after the grant of the option to avoid triggering a ‘Disqualifying Event’ in relation to those options that remain outstanding at that point; and if it does not, any gain made on the underlying shares from that point will be subject to employment income tax and National Insurance contributions on exercise, unless the option is exercised within 90 days of the Disqualifying Event.

What was the HMRC Guidance Update (October 2024)?

HMRC have provided clarification as to what constitutes ‘arrangements’ for the loss of independence. It is worth saying that it has always been understood that ‘arrangements’ would be construed widely to include any scheme, agreement, or understanding, whether legally enforceable or not. But it was not always when those arrangements might arise, especially in relation to a potential sale of a company (for example, during negotiations in the lead up to a sale of the company).

HMRC have confirmed that:

“Arrangements” for a loss of independence may include:

• • deadlock provisions that could give another company the deciding vote;
  • where a company investor representative director is appointed chair at a board meeting with a casting vote, or can make decisions regardless of votes cast; and
  • where a company investor (or group of company investors) obtain control of the board in the event of underperformance by the company.

In relation to non-binding understandings for the sale of a company:

• • if there is a mutual understanding by the parties (including the potential purchaser) “that each will act in a certain way, and there is an expectation that this will occur”, the company will not meet the ‘independence’ test;
  • evidence of a non-binding agreement for the sale of a company includes heads of terms, or a letter of intent, because even if not legally enforceable there is an expectation that a sale of the company will take place on generally agreed core terms;
  • an offer letter (alone) from a prospective purchaser will not constitute an ‘arrangement’ until there is a mutual understanding and an expectation that the sale will proceed largely on the terms set out in the offer letter; and
  • any genuine requirement for external approval, which is outside of the control of the parties, as a condition to a transaction will prevent the existence of ‘arrangements’ until the approval is given (or it is clear that it will be given).

Takeaways

Companies that have adopted an EMI Scheme and granted EMI options should keep under constant review their ownership and governance structures, and any agreements with shareholders and lenders, to ensure the independence test is satisfied, and continues to be satisfied, to ensure they do not inadvertently create arrangements that could lead to a loss of independence. This may not always be obvious (for example, put and call rights, conversion rights, weighted, restricted or suspended voting rights, and powers to determine the composition of, or otherwise influence, the board of directors (whether set out in a company’s articles of association or a shareholders’ agreement) could lead to a loss of independence).

For further information about anything covered in the above article, please contact Corporate and Commercial Solicitor Nick Mayles. Nick is a highly experienced transactional corporate and commercial lawyer. For assistance with any questions you may have in relation to your business, please get in touch by emailing nick.mayles@tsplegal.com or calling us 01206 574431.