UK: Clarity and confusion - HMRC speak out on EMI tax status during sale negotiations and equity funding rounds

Companies that offer Enterprise Management Incentive (EMI) options should confirm the tax status of those options following updated guidance from HMRC: practical solutions may be available if swift action is taken. Going forwards, care will be needed on funding rounds to ensure swamping rights held by corporate investors do not disqualify existing EMI options or future grants.  On a share sale exit, the timing of any pre-sale grants is critical to obtaining EMI tax status and HMRC has opened the door to option grants qualifying even after an offer letter has been tabled. 

What does HMRC’s new guidance say?

On 14 October 2024, HMRC published new guidance on what constitutes “arrangements” for EMI tax purposes and when HMRC considers such arrangements to exist in the context of sale negotiations and funding rounds.

HMRC’s guidance is welcome because the definition of “arrangements” in the EMI tax legislation is so broad, covering any scheme, arrangement or understanding, whether legally enforceable or not.

What are “arrangements”?

The following are given as specific examples of arrangements:

• deadlock provisions that could give another company the deciding vote;
• provisions which allow a corporate investor to appoint a representative director to the board where the decisions of that representative director could not be voted down; 
• swamping rights (that is, where a corporate investor, or group of corporate investors, could obtain control of the board in the event of underperformance by the company);
• when a corporate investor representative director is appointed chair at a board meeting with a casting vote; and
• a mutual understanding on a sale.

Why does it matter if “arrangements” are in place?

Tax-advantaged EMI options must meet strict qualifying criteria. In particular, it is crucial that “arrangements” are not in place for a company to come under the control of another company when EMI options are granted. If such arrangements are in place, the company will fail the “independence test” and be prohibited from granting further tax-advantaged EMI options. 

For EMI options that have already been granted, the existence of arrangements will not be a disqualifying event in itself. However, if the company later comes under the control of another company as a consequence of such arrangements (typically on a share sale exit), that event will be an EMI disqualifying event and EMI tax status for any further gain in the value of the underlying shares will be lost unless the EMI options are exercised within 90 days.

Swamping rights and distress provisions

HMRC have now confirmed that “distress” provisions will not be arrangements for EMI tax purposes, while all other categories of swamping rights held by corporate investors will be arrangements for EMI tax purposes.

HMRC have explained that they would usually treat the following categories of swamping rights as distress provisions (and therefore, not arrangements for the purposes of EMI):

• a company failing to redeem any loan notes; 
• a company breaching banking covenants; and  
• a proposed liquidation of a company (other than a voluntary liquidation),

and helpfully note that it is acceptable for step in rights to apply pre-emptively if an investor reasonably considered that the company was about to fall into genuine financial distress in such situations. Less helpfully, HMRC caveat their clarifications by noting that “depending on the circumstances they may not always amount to distress provisions and each case will be decided on the individual facts”.

In line with this position, if a swamping right held by a corporate investor is contrived or consists of artificial arrangements so that an agreement could be breached simply because business performance was not as expected, HMRC considers that this would constitute an arrangement and so breach the EMI independence requirement. Examples include where:

• a corporate investor can intervene if certain business performance measures have not been met “in their reasonable opinion”; 
• the company breaches certain financial covenants, such as not meeting profitability targets; 
• a corporate investor can hire or fire directors if the company breaches such financial covenants; 
• a corporate investor could obtain the majority of voting rights on a future event that is not linked to a distress situation.

Sadly, HMRC do not address the position of negative control rights and so such provisions remain open to debate.

IMPORTANT NOTE: HMRC limit their new guidance on distress provisions to the EMI tax legislation only. As such, clients should be aware that there may be differing acceptability criteria for other tax-efficient arrangements, such as S/EIS, and so we strongly advise seeking professional input on any drafting proposed.

Sale negotiations

If there is a mutual understanding between all relevant parties that they will act in a certain way on the sale of a company, HMRC considers an arrangement to be in place and so the target company could not grant further tax-advantaged EMI options. 

This means that a non-binding agreement relating to the sale of a company (such as an offer letter, letter of intent, term sheet, etc.) can constitute an arrangement for EMI tax purposes, whether it has been signed or not. Not great news! Fortunately, HMRC continues to explain that the mere existence of an offer letter (or similar) 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. As such, it seems that letters of intent should not cause issues, and heads of terms will only be considered an arrangement for EMI tax purposes once they have been signed by both parties. However, the position for heads of terms before signing remains uncertain.

Confusingly, HMRC have also stated that if a sale can genuinely not proceed without external approval that is outside the control of the parties, an arrangement will not exist until such approval is given (or it is clear that it will be given) on the basis that an arrangement must be something that can take effect. Presumably, this “clarification” is intended to cover situations where, for example, competition clearance or National Security and Investment Act (NISA) approval is required. But the breadth of the concession leaves the position in some common circumstances uncertain still; for example, could investor consent or the provision of validly executed notices of option exercise prevent the existence of an arrangement for EMI tax purposes if they are genuinely required as a completion deliverable? Such an interpretation could inadvertently frustrate the arrangements provisions in the EMI tax legislation and so sadly the point on a share sale exit when tax-advantaged EMI options can no longer be granted remains open to differing views.

Your trusted adviser 

If you operate an EMI option plan and your constitutional documents contain swamping rights and/or you are preparing for sale, please contact Sarah Ferguson, Samuel Marriott or another member of the EIB team at Bird & Bird LLP via: sarah.ferguson@twobirds.com, samuel.marriott@twobirds.com or LDNEIB@twobirds.com and we will help you navigate any issues in light of HMRC’s new guidance.