When UK Chancellor of the Exchequer Gordon Brown’s budget speech made a one line mention of simplification to company taxation little heed was paid until 105 pages of legislation appeared the following weeks, which caused the blood to drain from many faces in the private equity industry. Although things have since significantly progressed the industry remains for a large part confused about what these changes will mean to future deal structures. Lisa Bushrod reports.
One of the earliest to spring into action was the British Venture Capital Association, which secured two Memorandums of Understanding from the Inland Revenue in July. The memorandum on tax treatment of managers’ equity sets out what it terms a “safe harbour” for managers to adhere to, which should ultimately mean their equity participation in a private equity-backed transaction is treated as capital gains rather than income.
This is the all important distinction given that although capital gains tax in the UK is charged at 40% once those shares have been held for two years full taper relief of 75%, resulting in a capital gains tax charge of just 10%, is due. Ability to defend the current tax status quo was something seen as vitally important by the private equity industry since managers facing a 40% tax bill, instead of a 10% tax bill, on their equity could conceivably be less attracted to get involved with a private equity-backed company in the first place.
(The other memorandum -see evcj last issue – page 51- for the most part exempted limited partnership structures that were operational as carried interest schemes and allowed VCs to invest alongside their institutional investors.)
Unfortunately although the criteria for manager shareholders to get their equity gain treated as capital gain rather than income is clearly laid out, it is simply difficult to agree the value of a private company, and therefore the value of the shares in it. And it is the calculation of this value upon which these carefully laid out criteria rest.
“For investing in private companies with complex structures getting to the bottom of what is an unrestricted value where you haven’t got any investors that are unrestricted, you are back to what would someone else pay and then you are on to valuing the company,” says Maggie Mullen, chairman of Gravitas Partners, the independent valuation specialist.
Starting from first principles of agreeing the value of the company and then splitting the value between the various share classes and the attendant restrictions is one way to approach the issue. An alternative is to look at the price paid and then attempt to work out the market value, or what the Inland Revenue refers to as the initial unrestricted market value, by ascribing a value that each restriction has depressed the share price by.
Michael Weaver, partner at Gravitas Partners, notes there are broadly five categories of restriction. They relate to share transfers, voting rights, leaver provisions, dividends and return on capital. Unfortunately the Inland Revenue has not suggested any scale by which these restrictions can be judged, although there is an expectation that when deals start to filter through (any share capital acquired on April 16, 2003 and after is caught by the new legislation, which is contained within the 2003 Finance Act) some patterns of treatment will begin to emerge.
But as things stand it is up to the company and the manager to determine the value of the shares or call for external advice. The latter option could carry more weight with the Inland Revenue if the value is later queried. At which point the manager can choose either to pay income tax on the restricted value of the shares or pay income tax on the unrestricted value. Opting to pay income tax on the unrestricted value involves carrying out an election Elections
The election process is one that everyone, possibly with the exception of the Inland Revenue filing department, finds a bit odd. Although the memorandum stipulates that an election must be carried out within 14 days of acquiring the shares there is no requirement to submit that documentation to the Inland Revenue. It merely must exist, presumably to be called upon when individual tax returns are completed.
Jessica McMichael, partner share schemes at Lovells, explains the election process. “If the shares, for example, are worth £1 but if you include all the restrictions they are worth 50p and you don’t make an election but pay income tax on the 50p value (or pay 50p for the shares) when you sell the shares that initial discount is applied. So, in this case, half of the value at sale will be subject to income tax. There are two pages of formula to work it out but that is basically what it does,” she says. The half of the value at sale that is not subject to income tax in this scenario is taxed under the capital gains tax regime.
But it’s not just those that are seeking to pay income tax upfront on the unrestricted value of their shares that are being forced down the election route. McMichael explains: “In principal you don’t need to make an election if you pay the initial unrestricted market value but the problem is that you cannot be completely certain that you have paid this, which is why people are making these elections to ensure they will get capital gains tax treatment going forward.”
This is underscored by Mullen’s point about the difficulty of valuing private companies, particularly those where none of the shareholders hold unrestricted capital, which is so often the case in private equity-backed companies.
The election issue appears to be further complicated by the existence of ratchets in a number of private equity-backed companies. “Ratchets have always been, if structured correctly, accepted by the Inland Revenue as genuine commercial arrangements. The Memorandum effectively sets out what can now be treated as a genuine commercial arrangement,” says McMichael.
Ratchets are common practice among private equity firms although a brief poll by EVCJ of private equity and venture capital investors, as well as those operating within the industry in an advisory capacity, found their use varies greatly from firm to firm. Some large buyout firms report not using the structure at all in recent years, others report its use in public-to-private transactions and early stage venture capital and development deals, whereas use among mid-market investors appears almost a matter of house style.
“Broadly speaking ratchets are designed to ensure that when you buy the original shares they are already pregnant with the extra value. Therefore if the ratchet triggers they will be treated as part of your original holding,” says McMichael. In effect those managers in private equity-backed companies that are incentivised by ratchet structures need to assess the likelihood of triggering that ratchet and then, if they wish to be treated under the capital gains tax regime, pay income tax at the time of acquiring the share capital on the maximum value they think the company might achieve, in other words at the maximum value the ratchet might be worth.
As Mullen points out, it would be easy to see due diligence questionnaires starting to include details of the managers’ elections and failure to elect could be construed as lack of commitment or belief in the business plan.
But managers may simply not have the cash to pay the income tax bill on the value of the share capital upfront. This is conceivable in an early stage venture capital company with
a younger than average management team that perhaps pre the age of 30 does not have the capital or the assets to get a cash loan against. Such a scenario is potentially worrying for early stage venture capital investors, which are seeing their managers put in a disadvantageous tax position since this is something that could disincentivise young companies to take outside capital in order to speed up their growth.
Kiki Stannard, associate director of Smith & Williamson, likens the election process to days gone by where punters were allowed to place bets and either pay tax on their bet or their winnings. It’s a solid analogy because if the manager makes an election on the unrestricted value of the shares plus any ratchet upside that income tax cannot be reclaimed. This is something that will no doubt weigh on the minds of managers who will not only face upside ratchets in their share capital agreements but downside ratchets too.
Of the future Stannard says: “It will start to change the way deals are structured once we understand the way the Inland Revenue is going to treat people who have done their elections.” Another concern, fuelled by a belief in some quarters that the Inland Revenue was simply unaware that this legislation would potentially impinge on every private company in the country, is their capacity at the Inland Revenue to assist.
“They have got some really good people at the Inland Revenue Share Valuations division but have they got enough of them?,” says Stannard.
Why the change?
“There are two methods of issuing shares: tax efficient easy route of Inland Revenue approved share schemes; and outside the approved schemes where there is a large amount
of legislation in place to make sure people get taxed. People were making best use of this legislation but the Inland Revenue saw it as blatant abuse,” says Stannard. And McMichael adds: “The Inland Revenue was concerned that people were effectively manipulating things to get themselves into the capital gains tax regime. Rather than
simply buying shares people were effectively deliberately devaluing shares by putting restrictions on them.”