Tax changes introduced in the Finance Act 1998 have forced venture capitalists and their advisers to re-appraise the tax structuring of many private equity transactions including management buy outs. New legislation has been introduced to prevent perceived "tax leakage" through share incentive arrangements which have aimed to provide employees with valuable shares but without all the value of those shares being within the charge to Schedule E income tax. However, the new legislation, affecting conditional and convertible shares, is widely drafted and could create difficulties for "innocent" commercial transactions unless appropriate steps are taken.
Conditional Shares
The legislation applies where an employee or director acquires an interest in shares on or after 17 March 1998 on terms which are "conditional". Broadly speaking, an interest in shares will be "conditional" if it is subject to the possibility of compulsory transfer or forfeiture for a consideration less than the market value of that interest at the date of transfer. Provided that the shares cannot remain conditional for more than five years, no income tax charge will arise at the date of acquisition of the shares. However, an income tax charge will crystallise on the earlier of the disposal of the interest in the shares or the removal of the conditions attaching to the shares The income tax charge will be collected under PAYE where the shares are "readily convertible assets" - broadly shares where arrangements are in existence, or likely to come into existence, to allow the shareholder to turn the shares into cash.
National insurance contributions will also be payable if the conditional shares are readily convertible assets. Where, under long term incentive schemes, an employee has been granted an interest in shares dependent on the satisfaction of performance targets, the employee will be taxed on the value of the shares received (less any amount paid for the shares or previously taxed on receipt of the shares) at the date the performance targets are met and the conditions removed, or when the employee's interest in the shares is forfeited on the performance targets not being met. The widely drafted legislation raises concerns that the operation of "bad leaver" provisions regarding forfeiture and enforced disposals in many management buy out companies could lead to routine and innocent commercial arrangements being subject to adverse tax charges.
Convertible Shares
Where shares acquired by employees and directors through their employment on or after 17 March 1998 are capable of being converted into shares of a different class, an income tax charge under Schedule E will arise at the date of conversion or earlier disposal of the shares. The legislation aims to counter structures whereby employees receive valuable shares as remuneration without the full value of those shares being within the charge to income tax. For example, an employee could be awarded low value 'A' shares which could convert to higher value 'B' shares on the achievement of performance conditions or prior to an exit event (such as a trade sale or flotation). While a relatively low income tax charge would have arisen on the acquisition of the 'A' shares, no income tax would have crystallised on the conversion to 'B' shares (although the chargeable gain on the 'B' shares would have been higher on their ultimate sale).
The Finance Act 1998 introduced an income tax charge at the point of conversion of the original shares into the converted shares of a different class. The tax charge is based on the value of the shares acquired through the conversion, less any amount paid to acquire the original shares and any income tax charged on the acquisition of those shares. Where the converted shares meet the definition of "readily convertible assets", the income tax charge will be collected under PAYE and national insurance contributions will also be payable.
The legislation will effectively crystallises an income tax charge on employees and directors equal to the increase in value of their shares realised through conversion. If the shares are disposed of immediately after their conversion, such as where conversion precedes an exit under a trade sale, the employee shareholders will not benefit from CGT taper relief or the CGT annual exemption. By contrast, if the converted shares are retained, employees could face a tax liability derived from the conversion of the shares without funds to meet the resulting tax liability.
Impact of New Rules
These new provisions can jeopardise the tax effectiveness of the often complex share capital structures which characterise many management buy outs. Directors of MBO companies face a potentical income tax charge at the time an equity ratchet converts their existing shares to a new, more valuable, class of shares. If the conversion takes place some time before the ultimate sale of the MBO company, an income tax charge could be crystallised before any profit is realised from the sale of the shares held by the employee. Similary the operation of bad leaver provisions could trigger an income tax charge. However, with care, these adverse tax charges on convertible shares can be avoided although this may result in changes to traditional structures.
For further information please contact Adam Blakemore, e-mail: Click Contact Link , 2 Park Lane, Leeds LS3 1ES, UK, Tel: + 44 113 284 7000
This article was first published in the Spring 1999 Hammond Suddards Tax Newsletter Update
The information and opinions contained in this article are provided by Hammond Suddards. They should not be applied to any particular set of facts without appropriate legal or other professional advice.
UK: Finance Act Changes Force Re-Appraisal of Tax Structuring for Private Equity Tra
Last Updated: 22 March 1999
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