Shares held by management in private equity companies

The Revenue have published revised guidance on the taxation of geared and ratcheted returns for private equity management shareholdings. This withdraws some of their previous arguments which sought to subject gains as income rather than under the more favourable capital gains regime.

The revised guidance says that:

• the Revenue will no longer challenge geared arrangements merely on the basis that management contributed only a very small proportion of the initial funding in comparison with any large percentage of sale gains which they receive (so-called “thin capitalisation” arguments); and
• most ratchets (where the value of management shareholdings in a company increases on a particular event or on reaching a particular goal) will not give rise to income tax, providing the ratchet rights are inherent in the management shares when management acquired those shares as part of the initial buy-out arrangements.

The position now seems to be that so long as managers pay the upfront market value for their shares (taking account of the hope value in the ratchet), there should be no tax charge at the time of acquisition of the shares, or at the time of their sale, providing that other anti-avoidance measures are not triggered. However, the revised guidance is very brief and so it may be that further details will emerge.

Management have a particular incentive to receive rewards in a private equity situation from gains on shares rather than as salary or bonus. This is because gains on shares will usually be capital in nature and often taxable at 10%. By contrast, salary or bonus will almost invariably be taxed at 40%, with an additional national insurance charge which can take the overall tax costs closer to 55%.

Understandably, the Revenue have introduced a number of anti-avoidance provisions over the years which sought to block arrangements whereby companies set up remuneration schemes taking advantage of the special rules for management shareholding. A particularly determined attack by the Revenue took place in 2003, and resulted in a memorandum of understanding (the “MOU”) between the then Inland Revenue (now HM Revenue & Customs) and the British Venture Capital Association in July 2003. However, uncertainties still remained and in 2004 the Revenue started using a previously little known section (which taxes “special benefits” received on employee shares (as income) to try to tax certain management returns which the MOU had appeared to leave subject to capital gains tax.

In particular, the Revenue were combating the following two arrangements:

• Thin capitalisation - this term (which is taken from another area of tax law) reflected a concern that in a private equity situation, management could receive a reasonably large percentage of the upside (by virtue of their holding of equity). However, they would have had to pay relatively little for this and would certainly not have had to contribute to the debt funding for the buy-out, which constitutes by far the largest proportion of funding. Accordingly, the Revenue argued that managers received favourable treatment over other contributors of capital and that an element of their return could be classed as a “special benefit”.
• Deferred share scheme - in this arrangement, when a target was met (e.g. a sale at or above a particular price) a percentage of the non-management shares would be “deferred” (i.e. become worthless) meaning that the remaining management shares would become worth more. Again, the Revenue argued that this was a special benefit for managers as not all shares were being equally affected.

Advisers generally disagreed with the Revenue’s interpretation. However, uncertainty in this area has caused concern and costs on deals over the last couple of years with specific advice having to be taken each time, and the allocation of risks, indemnities and escrow arrangements among the parties having to be negotiated on each deal.

The announcement made on 21 August 2006 says that the Revenue have received legal advice that the special benefit regime does not catch “thin capitalisation” or “deferred share scheme” arrangements.

The Revenue had privately announced that they were taking several cases on these points before the Special Commissioners (the lowest level of tax tribunal), but it is rumoured that the Revenue have now conceded on these cases and the revised guidance reflects the legal advice it received in the course of the proceedings.

The position now seems to be that so long as managers pay the upfront market value for their shares (taking account of the hope value in the ratchet), there should be no tax charge at the time of acquisition of the shares, or at the time of their sale, providing that other anti-avoidance measures are not triggered. However, the revised guidance is very brief and so it may be that further details will emerge. In particular, the revised guidance does not expressly deal with “flowering” or “blooming” arrangements where the number of management shares does not increase, just the share of sale proceeds, but the implication of the revised and earlier guidance is that the Revenue may not be imposing an income tax charge on these arrangements either if various steps are taken. We are trying to seek further clarification on this.

To view the Revenue's guidance, please click here.