Tax issues for managers in private equity transactions

Out-Law Guide | 03 Aug 2011 | 11:49 am | 6 min. read

This guide was last updated in March 2018.

This guide outlines some of the main tax issues arising for management teams on a private equity transaction. It is not comprehensive. Private equity transactions take a wide variety of forms and other issues can arise in specific cases.

For the purposes of this Guide, it is assumed that the private equity transaction will take the form of a classic management buy-out (MBO). The structure will involve:

  • the management team acquiring shares in a new company (Newco);
  • Newco receiving further equity funding from venture capital (VC) institutions. It will also receive funding by way of debt from those institutions, their affiliates or from third parties;
  • Newco acquiring the target company or target business from the vendor;
  • the VC investors and management team aiming for an exit in the medium term, usually three to five years;

Although a proportion of equity may be retained for other employees, there would not be significant employee equity participation.

The issues outlined for management teams will also generally be relevant for management buy-in (MBI) teams, where the management investors will usually have no previous connection with the target company or business.

Income tax issues

Acquiring shares as employees/directors: It will be extremely important to the management team that no personal tax liability arises as a result of their acquisition of shares in Newco, and that the hoped-for gain the management team make on exit from the arrangement is subject to capital gains tax (CGT) rather than income tax. CGT treatment is important because this will be payable at 20% (for higher rate tax payers) or, if entrepreneurs' relief is available, 10%. If the shares are instead subject to income tax the rate of tax will be 40% (for higher rate tax payers) or 45% for those managers with taxable income of more than £150,000.

In almost all cases where a person acquires shares in a private company which employs that individual, the shares will be obtained by reason of employment. In a buy-out context HM Revenue & Customs (HMRC) have always taken the view that where employees buy out the company for which they work, they do so under an opportunity offered to them as employees of that company or of a new company formed in the course of that buy-out to take over the business.

Acquiring shares at an undervalue: An income tax charge arises if shares are acquired by reason of employment at less than their actual market value. It is therefore important that the price paid by the management team is considered carefully, particularly in comparison with the price paid by the VC investors for their shares.

An income tax liability could also potentially arise for management investors in a private equity transaction if HMRC are able to determine that Newco acquired the target business or company at an undervalue.

Restricted securities: If the shares acquired by reason of employment constitute 'restricted securities' an income tax charge can arise under the restricted securities regime even if the shares are acquired for their market value, taking into account any restrictions on the shares or their transferability.

The shares will be 'restricted' if restrictions have been imposed directly or indirectly by any contract, agreement, arrangement or condition and the restrictions have an effect on the market value of the security.

In general terms, any restriction that reduces the value of a security will be covered by the restricted securities regime but the legislation splits the restrictions into three broad categories:

  • risk of forfeiture, where the disposal will be for less than the full market value;
  • restriction on freedom to retain or dispose of the shares, or to exercise rights;
  • the disposal or retention or the exercise of a right conferred by the shares may result in a disadvantage to the shareholder or to a person connected with the shareholder

In the context of a private equity transaction, the shares acquired by managers will normally be restricted in the sense that there will probably be a 'bad leaver' provision, requiring the manager to sell the shares at less than market value if that person leaves the company. There are also likely to be restrictions on transfers.

If the shares are restricted securities in this sense, a charge to income tax will arise upon the occurrence of a chargeable event such as:

  • the shares ceasing to be restricted securities;
  • the removal or variation of any restriction;
  • the shares being sold.

Typically such a chargeable event will occur upon an exit or, if earlier, when the manager leaves the company.

The taxable amount charged upon one of these chargeable events is determined in accordance with a formula, which involves comparing the market value of the shares when acquired ignoring any restrictions on the shares - the initial unrestricted market value (IUMV) - with the price paid for the shares. The principle behind the formula is that, on an exit, income tax is charged on such proportion of the unrestricted market value of the shares at the time of the chargeable event as has not already been paid for in full or charged to income tax.

There will not be a tax charge if the manager pays at least the IUMV for the shares.

Electing out of the restricted securities regime: The manager and his employer may, within 14 days after the shares are acquired, jointly elect to opt out of the restricted securities regime. If such an election (referred to as a 's431(1) election' after the relevant provision in the Income Tax (Earnings and Pensions) Act 2003 is made, the manager will be charged to income tax when the shares are originally acquired on the difference between the price paid and the IUMV of the shares. The VC will normally insist on a s431(1) election being made.

The British Venture Capital Association (BVCA) Memorandum of Understanding (MOU): This was issued in 2003 following discussions between the BVCA and HMRC. It provides a safe harbour for managers on the acquisition of their shares in a typical MBO situation.

If all conditions mentioned in the MOU are satisfied, HMRC will normally accept that the price paid for the managers' shares is market value (if they are not restricted securities) or IUMV (if they are restricted securities). The MOU will not however apply if there is a tax avoidance motive or if there are any material deviations from the normal structure of such a deal. Where the MOU applies, this means that there will be no charge to income tax on acquisition of the shares nor on any subsequent exit or other chargeable event.

PAYE and NIC: If, as will normally be the case, the managers' shares fall within the restricted securities regime, then unless a s431(1) election is made to opt out of that regime a proportion of the growth in value of the shares will be subject to income tax and both employer and employee NICs under PAYE on an exit.

If a s431(1) election is made to opt out of the regime, managers will be charged to income tax at the time of acquisition of the shares on any difference between the price paid and the IUMV.

Tax reliefs for private equity team

Interest relief for management teams: Interest relief should be available in respect of interest paid on loans taken out by the management team to acquire ordinary share capital in Newco if certain conditions are met. The main condition is that Newco must be a 'close company' for tax purposes at the time the shares are obtained. The definition of close company is a complicated one, but broadly a company is considered to be close if it is controlled by five or fewer 'participators' (ie any person having a share or interest in the capital or income of the company).

EIS relief: Income tax relief (at 30%) is available under the enterprise investment scheme (EIS) in respect of subscriptions of ordinary shares in qualifying unquoted trading companies. The maximum annual investment which will qualify for this relief is £1 million. Gains made on shares in respect of which EIS relief is given and not withdrawn are exempt from CGT. There is also an unlimited CGT deferral for individuals rolling over capital gains into 'eligible shares' in qualifying companies for the purposes of the EIS.

EIS relief is not available in most MBO situations because the detailed conditions prevent this relief being available for individuals who have previously been involved in the trade carried on by the EIS company or its subsidiaries.

The conditions for EIS relief are complex, and include restrictions on the size of company whose shares can qualify.

Loss relief: A manager may be able to obtain relief for income tax purposes in respect of allowable losses on the disposal of shares subscribed in a qualifying trading company. The definition of 'trading company' is that the shares qualify for EIS purposes.

Share plans

Managers may be granted options to subscribe for shares in Newco. Some types of tax advantaged share schemes,such as Enterprise Management Incentives, are more attractive than schemes which carry no tax advantages for participants.