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Employment related securities and the private equity market

In May 2003, the UK government delivered a shock to the private equity industry by unveiling an entirely new system for taxing 'employment related securities', says SJ Berwin. This was itself a new term, encompassing any share or security, or interest in a share or security, obtained by reason of employment, with the exception of Inland Revenue approved share schemes.

The regime also applies to carried interest and co-investments, as well as manager shares acquired on an MBO. This means that the old conditional shares regime no longer applies to acquisitions of shares or carry, and it is no longer possible to escape a charge to income tax and national insurance by relying on the “safe harbours” in the old legislation. The major disadvantage of the change is that capital gains tax treatment, with the benefit of taper relief (which can reduce the effective tax rate from 40% to 10%), can no longer be guaranteed on a sale of such securities, unless it can be shown that an executive or manager paid full market value when acquiring them.

This gives rise to difficult questions of valuation, especially where any restrictions attach to the securities, and creates a trap: in some cases, managers or executives expecting to pay capital gains tax at 10% on the sale of their shares or securities, could end up with an income tax and national insurance liability of around 48%. Urgent discussions followed the publication of the legislation, led by the BVCA, which resulted in some helpful clarifications (in the form of “memoranda of understanding”) on the impact of the new rules as they affected both carried interest structures and manager shares.

These memoranda (“MOUs”) had the effect of providing new “safe harbours”, so that if the structure of a transaction fitted the “models” contained in the MOUs by having particular features, then it would provide the assurance that what had been paid for the securities or interest on acquisition would be treated as full market value, so that capital gains tax treatment for the future was assured.

However, in many cases, there are practical difficulties in structuring a transaction in such a way that it falls within the “safe harbours”.

Should I elect?

Where the securities or interests acquired by the executive or manager are “restricted”, for example by having any conditions attached to them which restrict the ability to dispose of them at market value (including good or bad leaver provisions, pre-emption or “drag-along” obligations), the executive has the opportunity to make an election, within 14 days of the acquisition, to disapply the tax treatment set out in the new rules. This election guarantees capital gains tax treatment on disposal, at the price of a potential up-front income tax and national insurance charge, based on the difference between what has actually been paid and the unrestricted market value.

On any transaction, a decision will need to be taken as to whether or not the safe harbours in the MOU apply, and whether it will be worthwhile to make an election, at the possible cost of an up-front tax charge. There is the added compliance burden of the employer company having to complete a form 42 in respect of the acquisition by executives, directors or managers of any employment related security, whether or not any restrictions or other features attach to it. This requirement appears to extend even to subscriber shares acquired on a company formation or off the shelf acquisition, although the Revenue have now published a simplified version for use in such cases where only ordinary shares with no restrictions or special rights attaching to them are issued.

Effect on private equity transactions

It is true that the new regime has created difficulties in structuring many private equity transactions where previously these did not exist. It is also unsatisfactory to be faced with pages of difficult legislation which can only be navigated by recourse to non-statutory materials such as the MOUs or the Inland Revenue’s Frequently Asked Questions page on its website. On the other hand, the new rules have brought with them certain advantages, such as a reduction in the amount liable to income tax and national insurance on eventual disposal where an executive has paid a proportion of the market value on acquisition, compared with the potential liabilities and uncertainties which could arise under the old conditional shares regime. The employment related securities regime has been with us for over a year now, and clarifications are still emerging from the Revenue.

These are welcome, but an atmosphere of uncertainty remains and will continue while the private equity community gets to grips with the complexities of the rules. And the result cannot be a good one. It leaves entrepreneurs – a breed which the Government says it wants to encourage – paying up to 48% tax on value they have created, unless they comply with detailed rules issued – not by the elected Government – but by the Revenue.

For more information on the material in this feature please email the authors, Michael Trask (michael.trask@sjberwin.com) or Jill Hallpike (jill.hallpike@sjberwin.com).

SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on its services to the private equity industry please contact Jonathan Blake or Simon Witney in its London office +44 (0)20 7533 2222 or visit our website at www.sjberwin.com