UK: Enhanced Gains On Shares For Managers In Private Companies – How Not To Do It

A recent case (Company A v Commissioners of HM Revenue & Customs) has demonstrated the importance, if arrangements are intended to avoid an income tax and National Insurance contributions charge, of managers’ enhanced equity returns in private companies coming from rights contained in articles of association rather than in any subsequent or other agreements.

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A recent Special Commissioner’s case (Company A v Commissioners of HM Revenue & Customs) has demonstrated the importance, if arrangements are intended to avoid an income tax and National Insurance contributions charge, of managers’ enhanced equity returns in private companies coming from rights contained in articles of association rather than in any subsequent or other agreements.

In this case, a manager had subscribed for shares in the parent company of his employing company. The articles of association provided that each share was to receive a pro rata amount on a sale of the company. However, shortly after the acquisition of the shares, the shareholders entered into a shareholders’ agreement under which it was agreed that if the company was sold at or above a certain price, the manager would receive a higher proportion of the sale proceeds than he was entitled to receive under the articles. In effect, this was a ratchet arrangement.

In due course, the company was sold at or above that price and the manager received the disproportionate return he was entitled to.

The manager expected to pay capital gains tax on his proceeds. However, it has long been the position that wherever an employee receives more than the "market value" of his shares, that excess is chargeable to income tax and NICs as employment income. The Schedule 22 changes in 2003 reinforced this yet further. What was the shares’ "market value"?

It was held in this case that the market value of the manager’s shares should be determined by reference to the company’s articles. The shareholders’ agreement did not override this and so when the manager received more than his entitlement under the articles (which was only to receive an amount pro rata to the number of shares he held), the excess was taxable as employment income with PAYE and NIC consequences. The taxpayer failed in his arguments that the intention all along to have a shareholders’ agreement and other factors should mean that the articles and shareholders’ agreement should together form the basis of working out the shares’ market value.

It is therefore crucial that the possibility of any ratcheted returns for managers is contained in the articles of association and is moreover included before the shares are acquired. For tax purposes, only articles of association give shares their intrinsic rights and contribute to the market value of the shares – any side agreements (such as shareholders’ agreements) will normally have no bearing on the market value of the shares.

The good news here, however, is the very clear suggestion by the Special Commissioner (and this has also, more importantly, been separately suggested by the Revenue in their unpublished commentary on the case) that had the ratchet been contained in the articles, then what the manager received would indeed have been market value as that is what the articles prescribed. This would mean that the whole of the return would have been taxed as capital i.e. normally at 10%, rather than the excess being taxed at 40% as employment income with additional NIC costs.

Most ratchets have for some time been structured in this way anyway. This case, combined with the Revenue’s withdrawal of attacks on ratchets for other reasons last year (which is referred to in the case report) and the fact that this year’s Finance Bill currently going through Parliament leaves them unscathed, therefore means that managers and private equity investors can still be reasonably sure that most ratchets should still give the expected capital gains treatment on sale. That is, at least until any changes which may result from the general private equity review currently underway.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 17/04/2007.