Don’t look back in anger at your tax mistakes!
One of the UK’s biggest bands gave us the instantly recognisable “but don’t look back in anger, I heard you say” almost 29 years ago, as well as some other great songs. While Oasis are almost as famous for their fallings out as their music, are there ways we can apply this philosophy to equity reward tax transactions to make sure you end up with a champagne supernova rather than needing to stop crying your heart out?
Business sales or value transactions are emotional events and are often the culmination of business owners’ careers or significant parts thereof, where they are selling that which they have grown. While the best result would mean vendors are taxed on a capital disposal, with minimal/ nil amounts held back, there are situations where foreseeable tax issues could have been avoided.
As Head of Equity Reward at Claritas, I come across many cases where taking advice at the appropriate time would have prevented significant problems arising on the transaction, such that these adverse implications cast no shadow over what should ultimately be a celebratory event.
The following are the top of the charts for me in terms of avoidable transaction issues where equity reward is in play:
- Employees not jointly completing a Section 431 election with their employer when acquiring shares;
- Failure to complete/ evidence tax valuation work when acquiring shares;
- Enterprise Management Incentive (“EMI”) plans.
The first two points are often picked up as part of a due diligence exercise, and the risk of not doing them relate to the unrestricted market value (“UMV”) of the shares at the point of employees’ acquisition, to the extent they have paid less than UMV. The benefit of a s431 election is that it removes a potentially uncapped income tax liability for the company on disposal. If not in place, there could be significant withholdings on the transaction to indemnify buyers against a potential liability that could live forever.
Of course, it is much easier for interested parties to roll with it and accept a lower risk where a full tax valuation has been prepared, as otherwise it can be very difficult to demonstrate the value applied to shares at any given point.
Some might say that EMI plans are hugely popular and rightly so. Where there is a clear event in the future that the company would like to incentivise employees towards, i.e. an exit transaction, and the company qualifies for EMI, then EMI is normally the rock n roll star.
There are a few reasons for this:
- It is an HMRC tax-advantaged plan, designed to help entrepreneurial businesses recruit and retain the best employee talent.
- There are generous tax benefits for both the participants and the company.
- It is one of the few occasions where it is possible to agree the tax market value of the underlying shares with HMRC.
- Furthermore, it also allows for the company to seek advance assurance from HMRC that it qualifies for EMI purposes.
Unfortunately, EMI plans regularly cause people to ask where did it all go wrong, making it definitely maybe even more painful when on reaching a transaction it is found that the EMI plan does not work as envisaged or does not qualify.
This could be because the EMI plan as drafted does not work in the particular circumstances of the transaction now being undertaken and particularly where discretion is exercised. Following a recent tightening of HMRC’s interpretation on the extent of permissible discretion, this could lead to the cancellation and re-grant of the EMI options, creating a variety of (unwelcome) tax issues.
Alternatively, the company may not have obtained Advance Assurance from HMRC to confirm it is qualifying for EMI purposes, and in my experience, purchasers are now becoming more unwilling to accept a company qualifies without this in place, even though it is not strictly required (but makes the due diligence process far more straightforward if it is).
The risk here is that the EMI plan is not considered to be qualifying. In such cases, this significantly changes the tax position for participants – from capital gains tax on disposal (potentially with Business Asset Disposal Relief (“BADR”) applying a 10% rate) to income tax, potentially via PAYE with NIC applying to the market value on exercise. The result is a smaller net return for participants and additional costs for the company that impact proceeds for existing shareholders.
These are just the top issues I come across on transactions but there are many other ways in which the EMI tax advantages could slide away; the ‘arrangements’ test (new HMRC guidance is expected on this), failing to notify grants, valuation minority discounts to name but a few.
Ultimately, the moral of this story is that preparation is crucial, and should be a key part of the masterplan. If you are considering a transaction, I thoroughly recommend you get advice ahead of time, so that you can get everything in order, d’you know what I mean?
