With a truly astonishing lack of consultation, the Inland Revenue revealed on 16 April in its Finance Bill that it wants to move immediately to a US-style treatment of employee shareholdings. This involves employee shareholders, including management, making an early election – within 14 days according to the bill – as to whether to be treated inside the provisions of the bill or outside it.
Electing to be outside the bill could trigger an immediate PAYE 40% tax charge, plus NI on any difference in value between the market value of the shares and what the employee paid for them. Being inside the bill could trigger tax at 40% any time any condition attached to the shares is changed, even if no actual sale of the shares takes place.
The move has far-reaching implications for the way management buyout and buy-in deals are structured in future, and has been attacked by many corporate finance specialists as a serious stumbling block to MBO and MBI deals. John Hodgson, a tax partner at Grant Thornton, is currently advising on an MBO that is nearing conclusion. He believes the bill creates uncertainty for management and that it is standing in the way of completion.
David Tuck, a tax partner at KPMG, agrees. “We are supposed to be heading for tax simplification and now have legislation thrust upon us that leaves tax specialists struggling to understand how this is going to work. We have deals in process right now and simply do not know how this is supposed to play between now and July when the draft legislation becomes law. The problem is the lack of certainty in knowing if the legislation bites in specific circumstances. It is incredibly unhelpful for MBO activity at this crucial juncture in the market,” he says.
The shift to a US-style system is not made explicit in the bill. Nowhere in the bill does the Inland Revenue come right out and say, ‘We think the US system is a great idea, so we’re going to throw caution to the wind and adopt it here.’ Instead, to the surprise of the profession, the Inland Revenue has simply slotted a 76-page section (Schedule 22) into the bill that is incredibly dense in changes and refinements to established practice.
Tim Hughes, tax partner at PricewaterhouseCoopers, has worked on a number of MBOs in the US and knows the US system quite well. Within a few minutes of perusing Schedule 22, it was clear to him that he was looking at a US-style system indeed. Perhaps because of his understanding of the US system, he takes a different line from Hodgson and Tuck. He sees the bill as “quite sensible”, and says, “The old legislation was very Draconian.
If you fell foul of various parts of it as an employee, you ended up being charged large amounts of tax on things that should not have incurred tax at all. The new legislation is much better targeted in that regard.”
Neville Bramwell, tax partner at Deloitte and Touche, agrees. “I certainly would not put myself in the camp of those who claim this is a horrendously bad piece of drafting and a terrible mistake by the Inland Revenue. My view is that the bill is actually rather well drafted and has been carefully put together. There may be some unintended consequences there, particularly for the venture capital community and for MBOs, but that is not the point of the bill,” he says.
In Bramwell’s view, the bill aims to bring more flexibility into some areas of the law relating to employee shareholdings that the industry has long been saying were too inflexible. It has also brought in a great deal of anti-avoidance legislation, aimed at the way in which big financial institutions have been paying staff bonuses to avoid tax. There is a risk, however, that this could have unintended consequences for MBOs, and the profession will clearly be arguing that MBO deals have many commercial characteristics and should not be lumped in with artificial avoidance, he explains.
The point Bramwell wants to stress is that the bill is rather helpful to share ownership. Hodgson, on the other hand, disagrees and says: “We all understood what the rules were under the old legislation, and we knew how to avoid the bad bits and maximise the good bits.”
Bramwell argues, too, that there should be little difficulty for MBO managers to elect immediately to be outside the Finance Act since MBO shares are generally pretty low in value anyway. “The Inland Revenue has shown itself in the past as willing to take whatever the institution involved paid for the shares as constituting fair market value, so that removes uncertainty,” he says.
Again, Hodgson disagrees. “We must not be na’ve about this. Venture capitalists will issue preferential shares and ordinary shares, and there is a switch in value between the two. The point is that valuing MBO shares is difficult, even for experts. I can’t say with confidence to managers who are not necessarily men of great wealth that they will not incur a significant tax charge if they make an election, as the bill suggests.”
The thought that they might pay £10,000 for their shares and then finish up incurring an additional tax charge of £20,000 or £30,000 is a significant deterrent to an MBO in the first place. I cannot believe the Inland Revenue intended to catch MBOs in this way. Nor am I particularly confident that having caught MBOs it will all be sorted out and put right in a reasonable time frame,” says Hodgson.
Tuck agrees and says: “The Inland Revenue has had a real attempt at closing down all bonus planning that the banks and financial institutions, in particular, have been entering into to avoid NI. As such, the Revenue has used the bill to take a shotgun to the whole thing and have, in effect, said they are going to catch anything that moves.”
In the process, he says, it has caught all bona fide employee shareholders in unlisted companies and these companies will find it difficult to understand how the legislation affects them.
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