Incentivising UK employees: salary top up vs EMI share option allocation

Employing staff in a politically-volatile[1], low growth environment can be challenging.  More so following the UK’s autumn ’24 budget (and the resulting increase in employer’s National Insurance contributions) and the changes proposed by the Employment Rights Bill currently making its way through Parliament and which if passed will among other things provide rights of unfair dismissal for employees from day one of employment.  Many employers are currently in an unenviable position of trying to retain and incentivise their best staff and yet wanting to reduce or avoid increasing costs.

For those that qualify, EMI (enterprise management incentive) options can be one way of bridging the gap, with resulting tax efficiencies for both sides.

A worked example

Consider the following:

• Employer A is a private limited company incorporated in the UK.
• Employee B is a UK taxpayer and is employed full time by A.
• B’s salary is currently set at £90,000 per annum.
• A is considering awarding B with a pay rise of £25,000 per annum.
• A has a qualifying EMI share option scheme in place; and A’s directors have authority to grant options in place from A’s shareholders and a window of time in which to grant them at a market value agreed in advance with HM Revenue & Customs.

Tax free personal allowance

We pause here to note that in the UK there is an amount of income that a person can earn tax free every year, what is called the personal allowance.  For the 2024/5 tax year this is set at £12,570[2].  Individuals earning over £100,000 per annum see their personal allowance reduced by £1 for every £2 of income above that salary threshold.  Individuals earning £125,140 or more will have lost their entire personal allowance.

• On her current salary, B enjoys her full personal allowance.
• If she is awarded the pay rise, she now earns £15,000 more than the £100,000 threshold and her personal allowance is reduced (by £7,500) to just £5,070.

£12,570 – (((£90,000 + £25,000) – £100,000) / 2)

The zone of 60% effective tax

What this means is that the effective rate of tax for the income band between £100,000 and £125,140 is – an eye watering – 60%.

How so?

The income in this band is taxed at 40%.  But – in addition – for every £2 added to one’s income in this range, £1 is added to one’s taxable income by way of reduction of the personal allowance.

That’s effectively an extra 20% in tax between £100,000 and the point at which the personal allowance is reduced to zero on that £2 for £1 ratio, which is £125,140.

• In B’s case, she has lost £7,500 of the personal allowance and as a result her taxable income increases to £109,930. She is paying 60% in effective income tax on the £9,930 (and any further pay rises) within the £100,000 and £125,140 band.

(£115,000 (new salary) – £5,070 (reduced personal allowance)) = £109,930 (taxable income)

£109,930 – £100,000 (threshold at which personal allowance reduces) = £9,930

£9,930 * 40% (higher rate income tax) = £3,972

(£9,930 / 2 (tapering of tax free personal allowance)) * 40% = £1,986

(£3,972 + £1,986) / £9,930 = 60%

• The effective income tax rate for B against all her income is as follows:

Gross income: £115,000

Taxable income: £109,930 (after reducing personal allowance, per the above)

Basic rate tax between £12,570 and £50,270 at 20%: £7,540

Higher rate tax between £50,270 and £125,140 at 40%:  £23,864

Additional rate tax above £125,140 at 45%: £0.

Aggregate income tax across all bands: £31,404

£31,404 / £115,000 = 27.3% 

£31,404 / £109,930 = 28.6% 

• There will also be employee’s National Insurance Contributions to be deducted through payroll for B, calculated as follows:

Earnings between the primary threshold (£12,570) and the upper earnings limit (£50,270) taxed at 12%: £4,524

Earnings above the upper earnings limit taxed at 2%: £1,294.60

Aggregate employee’s NICs: £5,818.60

• Factor those in, and B’s effective rate of tax increases.

(£31,404 + £5,818.60)  / £115,000 = 32.37% 

(£31,404 + £5,818.60)  / £109,930 = 33.86% 

•  After the pay rise, B’s take home net salary is then £77,777.40.

£115,000 – £37,222.60 (income tax and her NICs) 

Employer’s NICs

We pause again to note that employers pay a separate class of National Insurance Contributions above what is called the secondary threshold, which is currently set at £9,100 per annum (but which reduces to £5,000 per annum from 6 April 2025 per the changes announced in the autumn budget).

Above that threshold, the rate of tax for the employer to pay is 13.8% (increasing to 15% on 6 April 2025 per that same budget).

• A must then pay employer’s NICs on B’s gross income of £115,000.

2024/5 tax year (secondary threshold at £9,100 and rate above that at 13.8%): £14,614.20

 2025/6 tax year (£5,000 and 15%): £16,500.00

• Leaving aside pension contributions any other payroll deductions as well as employment allowance and corporation tax deductions, after the pay rise B’s aggregate cost to A (gross salary plus employer’s NICs) is £129,614.20 for the 2024/5 tax year and £131,500.00 for 2025/6.
• We can now calculate the benefit to cost percentage for A (i.e. the net sum that B receives after tax and the gross cost to A needed to get B there).

2024/5 tax year: 60.01% (£77,777.40 / £129,614.20)

 2025/6 tax year: 59.15% (£77,777.40 / £131,500.00)

That then is the position if B is awarded that £25,000 as an increase to her base salary.

Award of EMI options as an alternative

What if, instead, B was granted an EMI option over shares in A at market value which resulted in an eventual gain of £25,000?  The tax treatment is much better because the gain made on the EMI option would be subject to capital gains tax rather than income tax and there are no NIC charges for both B or A.

Let us assume further:

• B is not in a position to insist on (and effectively force through) the increase to salary.
• A and B both think that A is on a path to exit one day and that there is a good chance of B being in a position to exercise the option at that time for a gain.
• Conservatively, that gain would be at least £25,000 (although of course it could be a lot more (perhaps a multiple of that sum) or a lot less, perhaps nothing).

The difference in the tax treatment can be dramatic because:

• There would be no reduction to B’s personal allowance at all and so no taxable income for B in that band between £100,000 and £125,140 that is effectively taxed at 60%.
• That gain would be taxed as capital rather than income.
• The taxation of that gain would be deferred into the future after the point of exit (see further below on that point).

Re-running those numbers on existing salary of £90k

Let us now re-run B’s numbers for the taxation as income of her current salary set at £90,000 per annum:

Gross income: £90,000

Taxable income: £77,430 (gross income less personal allowance)

Basic rate tax between £12,570 and £50,270 at 20%: £7,540

Higher rate tax between £50,270 and £125,140 at 40%: £15,892

Additional rate tax above £125,140 at 45%: £0

Aggregate income tax across all bands: £23,432

• B’s gross salary remains at £90,000 and so her NICs and A’s NICs are lower (but – crucially – not proportionately lower, as to which see further below).

For B, 12% on £12,570 – £50,270 (£4,524) and 2% above £50,270 (£794.60): £5,318.60

 For A, 2024/5 tax year: (£90,000 – £9,100 (secondary threshold)) * 13.8% = £11,164.20

 For A, 2025/6 tax year: (£90,000 – £4,992 (secondary threshold)) * 15% = £12,750.00

• Factor in B’s NICs to her effective rate of tax on gross income and taxable income and you get:

£23,432 + £5,318.60 / £90,000 = 31.95%

 £23,432 + £5,318.60 / £77,430 = 37.13%

• The benefit to cost percentage for A is:

2024/5 tax year: 60.54% (£61,249.40 (gross salary – income tax + employee NICs) / £101,164.20 (gross salary + employer NICs))

2025/6 tax year: 59.61% (£61,249.40 (gross salary – income tax + employee NICs) / £102,750.00 (gross salary + employer NICs))

…now wait a second!

Why do the benefit to cost percentages for income look so similar on £115k and £90k?

We pause at this point – noting that we have not yet turned to address the £25k capital gain, although will do so further below – to address the point that the benefit to cost percentage for A looks very similar for £90,000 as it did for £115,000 further above.

NICs as a proportional tax

What the above also shows is the NICs regime having a proportionately greater effect on the lower salary than the higher one.  This is because the 12% band between £12,570 and £50,270 is proportionately larger for the £90,000 salary than the £115,000 salary (with just the 2% applying beyond £50,270).

Although income tax is to an extent progressive, NICs are proportional.

CGT on the gain

Turning back to B and her £25,000 capital gain on the sale of her shares in A:

• We assume the disposal came some time in the tax year 2025/6.
• There is no income tax or NICs charged (assuming that the option was granted at market value and the qualifying conditions for A, B and generally were met).
• The gain is subject to capital gains tax (CGT). Following the autumn budget, CGT is charged on the sale of shares at 18% for basic rate tax payers and 24% for higher rate tax payers.
• Business asset disposal relief (BADR) (what was called entrepreneurs’ relief) currently reduces CGT down to 10% but from 6 April 2025 – per the autumn budget – that changes to 14% and from 6 April 2026 to 18%.
• Let us assume B has all of her annual exempt (from CGT) amount (AEA) available, £3,000 following the autumn budget. Let us assume that B qualifies for BADR.

£25,000 (gain) – £3,000 (AEA) = £22,000

£22,000 * 14% (BADR for 2025/6) = £3,080

 £25,000 – £3,080 = £21,920 (net gain)

• We pause then to remind ourselves that, on her salary of £90,000, B has already paid £23,432 in income tax and £5,318.60 in employee NICs.
• Let us now factor in the capital gain and the taxation of it:

Gross income and capital gain: £115,000 (£90,000 salary + £25,000 capital gain)

 Tax: £31,830.60 (£23,432 (income tax) + £5,318.60 (employee NICS) + £3,080 (CGT))

• B’s effective rate of tax across all that is then only 27.68% and effective net take home is £83,169.40.
• You will remember that on a salary of £115,000, those figures were 32.37% and £77,777.40 respectively.
• So it’s a bit better for B as employee. If the value of the gain ends up being a lot larger than the £25k, it will be a lot better.
• And at the point of awarding the EMI options, there was no tax to pay and the eventual CGT to pay is not due until 31 January following the end of the tax year in which the disposal occurred.

There is though a much more dramatic benefit to A as employer.

A’s benefit to cost percentage

Turning back to A and its benefit to cost percentage:

• The cost to A is the gross salary (£90,000) plus the employer’s NICs (£11,164.20 in this tax year).
• B’s take home is, per the above, £83,169.
• The benefit cost percentage is then 82.21%. That is a significant improvement for A!
• You will remember from the above that – on a £115,000 salary following the pay rise – it’s 60.54% for this tax year and a bit less come 6 April 2025.

And it can get more advantageous still.

The corporation tax deduction for employee options

Further to A’s benefit, the exercise of the EMI options can be tax deductible.

When B exercises her options, A can claim a corporation tax deduction – from A’s profits otherwise subject to corporation tax – based on the market value of B’s underlying shares at the point in time of exercise by B (which will be the exit most likely and is assumed to be for what follows).

The deduction is an amount equal to the difference between the exercise price for the options and the market value of B’s shares at time of exercise.

In our scenario above, that would be the £25,000 gain.

That value is then taken off A’s taxable profits for the accounting period in which the exercise took place.  If there were no profits, it can be carried forward to future periods as a loss.

The main rate of corporation tax is 25% for the current year and 2025/6, giving a tax saving of £6,250.

Deduct that from the cost side of A’s benefit to cost percentage applied to be, and we get to 87.63%.

£83,169 (that same take home for B) / £90,000 (gross salary) + £11,164.20 (employer’s NICs for 2024/5) – £6,250 (tax deduction) = 87.63%  

If you have got this far then well done, and you will remember that the benefit to cost percentage for A on a salary for B of £115,000 was a mere 60% for 2024/5.

This Insight piece was written by Jeremy Glover and Henry Humphreys with input from Amanda Solomon.  If you have questions about EMI option schemes, management incentives generally, or matters of employment law, please reach out to Jeremy, Henry or another member of the HLaw team.  If you think we got the numbers wrong, let us know please!

All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice and is not to be relied upon.  Much of the above will no doubt fall out of date and conflict with future law and practice one day.  None of the above should be relied upon.  Always seek your own independent professional advice.

Humphreys Law

[1] Relatively, of course!

[2] We assume in what follows that it won’t change from here.