Capital Gains Tax Treatment For Management/Employee Shares

The Pre-Budget Report announced that with effect from 6 April 2008, capital gains tax for individuals will be payable at a flat rate of 18%. Reductions in the effective rate of tax caused by taper relief and indexation allowance will cease to apply.

This Law-Now looks at the implications of this change for private equity managers and deals, and for employee share schemes generally, although it is important to remember that the Chancellor of the Exchequer has himself said that he is considering the impact on certain types of investment he wishes to favour and lobbying on these changes has only just begun.

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The Pre-Budget Report announced that with effect from 6 April 2008, capital gains tax for individuals will be payable at a flat rate of 18%.  Reductions in the effective rate of tax caused by taper relief and indexation allowance will cease to apply.

This Law-Now looks at the implications of this change for private equity managers and private equity deals, and for employee share schemes generally although it is important to remember that the Chancellor of the Exchequer has himself said that he is considering the impact on certain types of investment he wishes to favour and lobbying on these changes has only just begun.

Background

Capital gains have since 1988 been taxed at the same rate as income, but since 1998 a system of taper relief has operated, which reduces the capital gain the longer the asset has been held. 

Assets are divided into business and non-business assets, with shares in trading companies and shares owned by employees normally being business assets.  For business assets, any capital gain is reduced by 50% once the asset has been held for 1 year (an effective rate of 20% for a higher rate taxpayer) and by 75% once the asset has been held for 2 years (an effective rate of tax of 10% for a higher rate taxpayer).  Non-business asset taper relief is less generous.  It only begins to reduce a gain after the asset has been held for 3 years and maximum relief is only given after 10 years, when the effective rate of tax for a higher rate taxpayer falls to 24%.

All the above is swept away by the proposals.  Capital gains will be taxed at a flat rate of 18%, whatever the type of asset, however long it has been held, and regardless of whether the individual is a higher or basic rate taxpayer.  An annual exemption for (in the 07/08 tax year) the first £9,200 of capital gains and the ability to use capital losses will still remain, however.

Impact of changes

The changes produce some interesting planning points for private equity and management shares:

Timing of deals

Currently, management sometimes want to delay a deal until they have held their shares for one, or preferably two whole years.  Equally, the fact that maximum taper relief only comes after two years is a powerful incentive for management to stay in employment with a company so as to receive a 10% rate of tax.  Both are now removed as relevant factors influencing management retention and the optimal timing of deals as far as management are concerned.  Quick exits will be just as favourable in tax terms for management as late exits.

There may be pressure though to time deals either side of 6 April 2008.  Management teams with gains now taxable at 10% will see an increase in rates after that date; those currently facing 20% or 40% tax rates will be better off waiting until the rate falls to 18%.  There will no doubt be interesting tensions in deals being negotiated close to the end of the tax year, as no credit will be given for taper that had already accrued, the benefit of which will be wholly lost.

Loan note

Management interest in loan notes being offered in exchange for shares may fall. Loan notes have largely been used as opportunities to reduce their tax rate to 10% by means of deferring receipt of cash until the combined holding period of the shares and the loan notes is 2 years or more.  Purchasers have been happy to delay payment of cash also for cash flow reasons. There will now no longer be any benefit in this for managers – the rate will be 18% whenever capital gains disposals are made.

Can any action be taken now to save tax?

Some management teams may also be interested in crystallising gains in some way before 6 April 2008 so that they are taxed at 10% and that only subsequent gain, not the whole ultimate gain, is taxed at 18%.  Trusts could be used to achieve this.  Any pre-emptive action would, however, need to be taken before 6 April 2008.

EMI options

Enterprise Management Incentive (“EMI”) options effectively allow management to use a 10% rate of tax just by holding the option for two years, regardless of how long they had held shares, because business asset taper relief starts from the option grant date.  With taper relief irrelevant after 6 April 2008, this will no longer be an advantage for EMI options (although other income tax benefits remain).

Employee share schemes

Schemes such as the Sharesave and Company Share Option Plan may also be adversely affected where options are granted to basic rate taxpayers.  Any taxable capital gains are currently taxed at an effective rate of tax of 5% if the shares are held for two or more years (as only 25% of the gain is taxed and they only pay tax on that gain at 20%).  Going forward, they will pay tax at 18% - although many will continue to pay no tax at all as gains are often sheltered by the annual exemption of £9,200. However, an optionholder who sells right away and has a taxable gain will be better off, as he under the current system faces a tax charge of 20% or 40% - now he will always just pay 18% as basic and higher rate tax payers will have the same rate of tax.

Carry

There has been some debate on when taper relief starts applying to gains realised under carry arrangements.  Is it when the carry is awarded on day one (the industry’s argument) or when the hurdle kicks in (known to be a Revenue argument)?  If there is a sale of a portfolio company just after the hurdle is reached, which is the correct treatment can lead to dramatic differences.  If taper relief has only started running, the tax rate will be 40% - if it started running at the outset, the gain would be taxed at 10%.  This has still not been concluded, but these arguments will however be academic after 6 April 2008. It will be 18% either way.

Continuing developments

The Chancellor has said he will be open to suggestions as to how to tax small-scale, start-up investment activity and so exceptions may emerge.  Also, the Pre-Budget Report only covered capital gains treatment and some unfavourable changes for non-UK domiciliaries: it is known the Revenue is looking at extending income tax treatment to ratchet and other geared growth arrangements as well as reviewing the EMI scheme and other approved schemes generally. The various 2003 Memoranda of Understanding agreed with the British Venture Capital Association in this area and which provide a safe harbour for many arrangements in this area may still be reviewed. 

The Budget itself may therefore have concessions on the one hand, yet further surprises on the other.

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 12/10/2007.