The Enterprise Management Incentive (EMI) Scheme is a tax-advantaged share option scheme in the UK, designed to help small and medium-sized businesses attract and retain key employees.

The EMI Scheme allows companies to grant share options to employees with significant tax advantages (EMI Options) if certain qualifying conditions are met. One of these conditions is known as the "independence test", being one of a number of conditions designed to ensure that the company issuing the options meets the government’s eligibility criteria to utilise the scheme.

In October 2024, HMRC updated its EMI Manual concerning the application of the independence test. This article explains the key elements of the EMI Scheme independence test, its purpose, and the changes made to HMRC’s guidance.

What is the independence test for EMI Options?

The independence test for EMI Options is designed to ensure that the company issuing the options is sufficiently independent from other companies as to its ownership and control to qualify for the EMI scheme.

To pass the independence test, the granting company must not be either:

• ‘majority-owned’ by another company (in other words, it must not have more than 50% of its ordinary share capital directly or indirectly owned by another company); or
• under the control of either (a) another company, or (b) another company and any person connected with it.

If the company is controlled by an employee-ownership trust, however, the independence test will be met under an exception in the EMI Scheme legislation.

What is the purpose of the independence test?

The purpose of the independence test is to ensure that only those companies that the government intends to benefit from the EMI Scheme may grant them, being genuinely independent businesses, and not companies that are part of a larger corporate group or those with corporate investors that enjoy a majority stake in, or influence, over the business.

The independence test often prevents EMI Options being granted over shares in joint venture companies, and over shares in companies that receive venture capital or private equity investment where the investment structure includes a controlling corporate entity or a corporate entity which is a partner in a partnership which has control (as partners are connected persons).

What are the consequences of failing the independence test?

The independence test must be met at the time of the grant of the option under the EMI Scheme for the option to qualify for favourable EMI tax treatment at the outset.  If, at the point of grant, this test is not met, or there are “arrangements” in place for a loss of independence (discussed further below), the option will constitute a fully non tax-advantaged option from the outset, and will be subject to employment income tax and National Insurance contributions on the full gain made by the employee at exercise.

If a company fails to continue to meet the independence test at any point after granting qualifying EMI Options, this failure will constitute a ‘Disqualifying Event’ in relation to those options to the extent they remain outstanding at that point.  In that case, any gain made on the underlying shares from that point will fall into the employment income tax and National Insurance contributions regime at exercise, unless the option is exercised within 90 days of the Disqualifying Event.

Updates to HMRC’s manual guidance in October 2024: Overview

HMRC updated its manual guidance relating to the independence test in October 2024, clarifying the application of the test with respect to:

1. corporate structures that include a limited partnership or a limited liability partnership (LLP); and
2. what HMRC would consider to constitute “arrangements” for the loss of independence, which (if in existence) would mean that the independence test cannot be satisfied with respect to the grant of new options.

The updates aim to provide further guidance to businesses as to how they should assess their compliance with the independence test, and how HMRC will apply the test in practice. 
In particular, uncertainty has always surrounded what might constitute “arrangements” for the loss of independence, as HMRC maintains that the term "arrangements" is broad and includes any scheme, agreement, or understanding, whether legally enforceable or not.  This means that even informal agreements or mutual understandings can be considered to be arrangements, and it can be particularly difficult for companies to determine when “arrangements” for EMI Scheme purposes have come into existence during negotiations in the lead up to a sale of the company, which would prevent the grant of new EMI Options.  

Update 1: Limited Liability Partnerships (LLPs)

The updated guidance at ETASSUM52030 confirms that HMRC does not treat LLPs as companies for the purposes of the EMI Scheme legislation.  As such, if an LLP controls the EMI company but does not have any corporate members, the EMI company will not fail the independence test as a result of the LLP structure.

However, HMRC is clear that a company will fail the independence test if it is controlled by a partnership (of any kind) with a corporate member.

Update 2: “Arrangements” for a loss of independence

The new page at ETASSUM52031 confirms that:

• “Arrangements” for a loss of independence may include:
  
  1. deadlock provisions that could give another company the deciding vote;
  2. when 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
  3. where a company investor (or group of company investors) obtains control of the board in the event of underperformance by the company (known as swamping rights).
• In relation to non-binding understandings for the sale of the EMI company, HMRC confirm that:
  
  • the independence test will not be met if there is a mutual understanding by all relevant parties including the potential purchaser “that each will act in a certain way, and there is an expectation that this will occur”;
  • evidence of a non-binding agreement for the sale of a company includes, but is not limited to, heads of terms, a letter of intent or similar, because even if not legally enforceable there is an expectation among all parties that the sale will proceed on generally agreed core terms; and
  • the mere existence of an offer letter (or similar) from a prospective purchaser will not constitute an arrangement until such time as there is a mutual understanding as referred to above and an expectation that the sale will proceed largely on the terms set out in the offer letter.
• HMRC accept that any genuine requirement for external approval, which is outside of the control of the parties, before a transaction can proceed will prevent the existence of arrangements until the approval is given (or until it is clear that it will be given). The guidance explains that this is because an arrangement must be something that can take effect.
• HMRC additionally confirms that provisions under which an investor may take control in certain circumstances, such as in the event of a breach of banking covenants, a failure to redeem loan notes or a proposed liquidation, do not constitute “arrangements” for these purposes. However, “contrived or artificial provisions”, or provisions that offer protection to an investor if business performance is not as expected (such as a failure to meet profit targets, for example), would breach the independence test. 

Practical Implications for Companies

The guidance updates should not contain any major surprises for well-advised companies, save perhaps HMRC’s apparent lenience in situations where external approval is being sought for a transaction.

It remains the case that when operating an EMI Scheme, companies must be careful to review their ownership and governance structures, and any agreements with shareholders and lenders, to ensure the independence test is satisfied and to check that they do not inadvertently create arrangements that could lead to a loss of independence.

A breach of this requirement may not always be obvious – put and call rights, conversion rights, weighted, restricted or suspended voting rights and powers to determine the composition of – or otherwise influence – the board are all examples of mechanisms that can bar qualifying EMI Option grants, and so the articles of association, any shareholders’ agreement, funding agreements and similar documents must be checked carefully.

Particular care is advised where any investment, ownership or lending arrangements are changed, or during the lead up to the sale of the company when the point at which “arrangements” for a loss of independence may be said to have come into place may be unclear. Connections between shareholders is another risk area; these may go undetected without conscious review.

For businesses that are uncertain about their eligibility to implement an EMI Scheme or how the updated guidance impacts their EMI Options, consulting with tax professionals can help clarify the application of these new rules.  Where uncertainty remains in any specific case, companies may be able to submit an application to HMRC for clearance as to whether the independence test has been met. However, HMRC may not respond to an application for advance assurance if negotiations for a sale are underway.

As always, businesses are advised to keep their eligibility for operating EMI Schemes under review to ensure they remain compliant with the requirements and can take full advantage of the scheme’s benefits. EMI options: Top 10 mistakes uncovered on an exit – and how to avoid them explains more about securing compliance and avoiding common pitfalls.