Management incentivisation and the tax treatment of any management return and/or re-investment remains a key part of a successful M&A transaction. This article sets out a summary of the recent UK tax changes relevant to management incentives and investments.
Many management incentive or investment structures remain focussed on seeking to ensure that any growth in value is not taxed as employment income (at rates of up to 47%), but instead taxed as investment income (for debt or debt-like returns) or capital gains (for equity returns). This is particularly true since the April 2016 reduction in the maximum rate of capital gains tax (“CGT”) from 28% to 20%. However, CGT also gives access to some potentially valuable Government sponsored employee tax reliefs which can further reduce, or even eliminate, an employee’s tax bill on their shares.
It therefore remains important to balance the commercial, legal, tax and administrative considerations when developing an incentive plan in order to seek to ensure it is affordable to employees and administratively workable, as well as meeting its primary objective of providing an appropriate incentive to drive the development of the business.
ESS is a Government initiative that was introduced for UK based employees in autumn 2013 pursuant to which employees could agree to assume ESS and surrender certain employment rights, in consideration for an issue of shares. The benefit to UK employees of assuming this status was that, provided certain conditions were met, any gains on the disposal of the shares acquired should be exempt from CGT. This applied to ESS shares worth up to £50,000 at the date of award.
Since its introduction, ESS has been popular as a feature of management incentive plans implemented either immediately following a change of control, or subsequently.
Budget 2016 announced that, for shares issued pursuant to an ESS arrangement entered into on or after 27 March 2016, the CGT exemption that applies on a disposal of ESS shares is limited to £100,000 of lifetime gains. This limitation does not apply to ESS shares issued prior to this date.
Whilst ESS does still offer a tax saving on gains to UK employees, given the formalities required to issue shares in accordance with the ESS legislation, we have noticed a change in focus in the use of ESS as part of management incentive plans introduced since Budget 2016, as businesses have evaluated the tax benefits against the complexities and legal formalities of using ESS. This type of arrangement can still offer significant tax benefits to employees, but in our experience is now more typically used on broader based incentive plans, rather than those which just involve a handful of participants.
However, one advantage of ESS (particularly considering the withdrawal of the Post Transaction Valuation Check (“PTVC”) service – considered further below) is that it is possible to agree the tax market value of ESS shares with HMRC in advance of issuing the shares, which provides both the employee and the employer with certainty of the tax value of the shares in advance of their issue.
HMRC have historically allowed companies to agree the tax market value of shares acquired by employees via the PTVC facility. This facility allowed employers to obtain certainty of the valuation of shares, to protect against (or quantify) potential PAYE and NIC liabilities.
With effect from 31 March 2016 the PTVC facility has been withdrawn by HMRC, such that employers now no longer have the ability to agree the tax market value of shares, other than in specific circumstances (i.e. issuing ESS shares or granting awards under HMRC tax advantaged share plans).
Whilst this means that certainty is no longer available, provided an employer seeks independent tax valuation advice in relation to each relevant transaction, HMRC should accept that the employer has fulfilled its PAYE ‘best estimate’ obligations so any challenge to the tax market value should be a matter for the employee rather than assessable under PAYE and NIC. This can also help protect against any uncertainty as to tax treatment on a future exit.
ER remains a popular Government sponsored tax relief for key members of UK management which reduces the rate of CGT payable on capital gains from 20% to 10% (subject to a lifetime allowance of £10 million of gains).
In order to qualify for ER, UK managers broadly need to hold shares which represent at least 5% of the voting rights and ‘ordinary share capital’ of: (i) a trading company; or (ii) the holding company of a trading group, for a period of 12 months immediately prior to the relevant disposal upon which ER is to be claimed.
Historically some businesses have used ‘ManCo’ structures pursuant to which employees have acquired their incentive / investment interests in the relevant trading company / holding company via a special purpose vehicle (a “ManCo”). These ManCos were generally used to not only provide a pooling vehicle for the employee investment but also on some occasions allow employees to gain access to ER in circumstances where they may not otherwise have been able to access ER.
Finance Act 2015 introduced provisions which sought to prevent employees gaining access to ER via a ManCo by amending the ‘joint venture’ (“JV”) elements of the ER legislation. However, these changes meant that even if an employee would have had an effective 5% interest in the relevant trading company / holding company via their ManCo interests, the employee was prevented from claiming ER by virtue of holding their interest via a ManCo. The amended rules also created problems for groups with JVs further down the group structure.
Finance Act 2016 will relax these changes to allow those employees who would have an effective 5% interest in the relevant trading company / holding company to be able to claim ER provided certain conditions are met (and also to deal with some of the problems created for groups with JVs below the holding company).
Therefore whilst it should now be possible to use a ManCo without disadvantaging any employee who would have naturally qualified for ER, care should still be taken when seeking to include ManCos in any incentive structure, as there are various other tax implications of ManCos to consider.
In February 2016, HMRC expanded the scope of the Disclosure of Tax Avoidance Scheme (“DOTAS”) regime to include a new ‘financial products’ hallmark which applies to shares, loan notes, and other securities. Amongst other factors, this considers whether “arrangements contains at least one term which is unlikely to have been entered into by the persons concerned were it not for the tax advantage”.
To the extent arrangements put in place post-February 2016 are considered to fall within this expanded DOTAS regime, those arrangements must be disclosed to HMRC under the DOTAS regime, which could increase the likelihood of HMRC challenging the expected tax treatment of the arrangements. This area should be covered by tax advice you receive..
Although not such a recent development, those undertaking transactions are also now grappling in certain cases with the disguised interest rules. Finance Act 2013 introduced new income tax rules which provided that, in relation to arrangements entered into on or after 6 April 2013, the extent to which a return not otherwise considered as ‘interest’ but is economically equivalent to interest, that amount should be subject to income tax (as investment income at rates of up to 45%, rather than employment income) at the point of payment.
Where employees hold existing interests in a business, often a proportion of the value of those interests is re-invested in the business in connection with a change of control.
For these purposes, it is important for employees to calculate their after tax returns available for re-investment so the potential application of the disguised interest rules should be considered in relation to existing interests held by employees (such as, for instance, on the disposal of preference shares ‘cum-div’), as well as in relation to any new interests to be acquired by employees.