Private Equity - Good News for Managers!

HM Revenue & Customs (HMRC) has finally admitted that its interpretation of parts of the income tax legislation in relation to ratchets and sweet equity were wrong, removing a large part of the doubt over the tax treatment for managers on private equity transactions.

Soon after the income tax regime for employees owning shares was changed in 2003, HMRC agreed a memorandum of understanding (MOU) with the British Venture Capital Association (BVCA) setting out safe harbours for private equity transactions, whereby deals complying with the conditions set out in the MOU would not result in an income tax charge for managers in respect of their shares. Although the MOU dealt principally with the tax treatment at the time of acquisition of the shares it did provide some comfort in relation to the tax position on a subsequent exit, especially in relation to ratchets.

Since then HMRC had appeared to be trying to undermine the MOU by arguing that, notwithstanding the MOU, the operation of a ratchet could trigger an income tax liability under the provisions of Chapter 4 ITEPA 2003 (commonly known as the special benefits charge). They also began to argue that even though the conditions of the MOU were satisfied, if the managers had invested almost all their investment in shares (so called sweet equity) rather than investing the same proportion in loan capital or preference shares as the institutions and the company was highly geared, they were receiving a benefit and this ‘thin capitalisation’ could give rise to a proportion of any gain realised on an exit being subject to income tax not capital gains tax.

Although practitioners disagreed with HMRC's interpretation of the legislation, this led to a large degree of uncertainty as to the tax treatment of managers' investments in private equity transactions. Since any income tax liabilities would be due from Newco under PAYE and national insurance liabilities could fall on Newco, this was a concern for the institutions as well as the managers.

In a statement on their website, issued this month, HMRC has now confirmed that having taken legal advice, their previous interpretation of the legislation was incorrect and the special benefits charge cannot apply where the benefit to the shareholder arising on the operation of the ratchet, reflected rights inherent in the shares at the time they were acquired. HMRC has also been advised that the thin capitalisation argument was not sustainable.

Whilst this statement gives comfort in relation to current and past transactions, HMRC has announced that they are reviewing the tax treatment of management equity and carried interest funds. It is likely therefore that there will be future changes in legislation which may make the tax treatment of management equity less attractive.

Since the 2005 changes in legislation, transfer pricing remains an issue on private equity transactions, meaning that Newco is unlikely to be able to deduct all the interest it pays on the debt to the institutions. HMRC is also still contesting the pre 2005 position in relation to transfer pricing on private equity transactions so uncertainty remains as to the tax treatment of interest paid on institutional debt prior to this date.