HMRC has recently updated its guidance on qualifying conditions for Enterprise Management Incentive (EMI) share options, specifically regarding the ‘independence’ test.

The updated guidance is particularly relevant for private equity-backed companies, though businesses with any form of corporate investment should consider it and whether their plans are impacted.

This includes investors that are partnerships with at least one corporate member.

EMI independence test: what you need to know

EMI is a form of tax-advantaged share option plan that offers a number of benefits to both employee participants and the companies that operate them.

To qualify for EMI, companies and participants must satisfy a number of statutory requirements, including (but not limited to) an independence test for the company whose shares are under option.

There are two parts to the independence test:

1. Ownership structure

• The company whose shares are under option must not be a 51% subsidiary of another company (by virtue of owning more than 50% of its ordinary share capital).
• The company must not be controlled by another company or by a combination of another company and any person connected to it.

One exception is that a company controlled by an Employee Ownership Trust (EOT), a specific form of employee-controlled business, may still satisfy the independence test.

2. Potential changes in ownership or control

• There must not be any ‘arrangements’ in existence by virtue of which the company could become a subsidiary or fall under control of another company.

‘Arrangements’ is a broad term, and includes any scheme, agreement or understanding, whether legally enforceable or not. It can be relatively easy to fall foul of this requirement, including when any corporate shareholder only holds a minority interest.

Common examples of arrangements that HMRC guidance confirms would fail the independence test include:

• Deadlock provisions that could give another company the deciding vote.
• A company investor representative director appointed chair at a board meeting with a casting vote.
• A company investor representative director whose decisions are deemed to be made regardless of votes passed.
• Swamping rights – where a company investor (or group of company investors) obtains control of the board if the company underperforms.
• Existence of a mutual understanding regarding a potential sale of the EMI company – this would likely prevent the granting of qualifying options if such an understanding applied at the grant date, even if that mutual understanding is non-binding (for example, if Heads of Terms for a sale have been agreed).

The latest HMRC guidance confirms its view that ‘distress provisions’ in investor contractual arrangements, which allow a corporate investor to obtain control of a company that is in financial distress, do not necessarily breach the independence condition. However, any contrived or artificial arrangements that could give control simply from business performance not meeting expectations, or that offer protection to investors, would not be considered acceptable distress provisions and are likely to breach the independence requirement. Examples of this could include, but are not limited to:

• Where an investor can act if, “in their reasonable opinion”, certain business performance measures have not been met.
• Where investors can hire or fire directors under certain circumstances where the company breaches certain financial covenants, such as not meeting profitability targets.
• Where a corporate investor could gain the majority of voting rights if a future event occurs that is not linked to distress.

While many investor protections will therefore cause a company to fall foul of the independence requirement, certain provisions may not. This would primarily apply to distress provisions, in which a corporate investor could obtain control in certain situations to rescue a company from potential failure.

HMRC guidance outlines some situations indicating financial distress that would not necessarily result in a breach of the independence requirement, including:

• A company failing to redeem loan notes.
• A company breaching banking covenants.
• A proposed liquidation (other than a voluntary liquidation) of a company.

Whilst these examples are reflected in HMRC’s guidance, each case must be considered on its own facts and merits.

It is worth noting that, even if the existence of a distress provision would not result in a failure to satisfy the independence test, such a provision actually coming into force may constitute a disqualifying event for any existing EMI options, impacting the availability of tax relief under the plan.

My business has a corporate investor – can I still operate an EMI plan?

Businesses backed by corporate investors can still operate EMI plans, provided they meet the eligibility criteria and comply with the relevant regulations.

The updated HMRC guidance does, however, underscore the importance of diligent compliance and proactive management to maintain the benefits of the scheme. If EMI is not available, an alternative approach may be possible that delivers similar outcomes for participants and the employer company (for example, a Company Share Option Plan, an alternative form of HMRC tax-advantaged option scheme that offers similar, though less generous, treatment compared with EMI).

While the legislation has not changed, the latest guidance provides greater clarity on HMRC’s application of the independence requirement for EMI, and sheds further light on certain scenarios where HMRC would consider this test not to be satisfied.

Although HMRC maintains that its application of the independence condition has not changed, we are aware that the interpretation set out in the new guidance is, in some circumstances, contrary to the position previously agreed by HMRC via its advance assurance process for EMI. RSM is in discussions with HMRC to confirm what this means for EMI options that have already been granted. If your business has already received an advance assurance from HMRC, you should consider approaching HMRC for an additional assurance for any new option grants.

If you would like more information or have any questions about the topics mentioned above, please contact Martin Cooper, Kerrie Willis, or Anna Haworth.