Share Incentives in Companies under the Control of Private Equity: Some Blue-Sky Thinking?

Employees of companies under the control of another body corporate – in particular, those controlled by ‘private equity’ funds –  are excluded from participating in EMI share option and other tax-favoured employee share plans (SIPs, SAYE schemes and CSOPs). Given the substantial increase in the number of such employees in the UK now that so many British companies have fallen into the partial or entire ownership of such funds, it is suggested that the Government examine how such companies may allow their employees to share in the growth in value to which they contribute through share ownership in a manner which does not put them at a fiscal disadvantage compared with non-employee investors.

It is understood that, if the Government were to afford such a mechanism enabling such employees to participate in a type of share plan which is both relatively straightforward to establish and (crucially) has certainty as to the tax treatment for both employer and employees, members of the BVCA (for example) would be keen to direct or encourage investee companies to establish such plans, given that providing effective incentives to employees is just as much in the interests of the private equity fund as it is in the financial interests of the employees.

The idea of employees benefitting from being joint owners of shares in a company, under a ‘joint share ownership plan’ (or JSOP), was first developed in 2001 and has since been widely adopted by independent companies for allowing selected senior employees to benefit in excess of the limits under tax-favoured plans. The tax treatment of JSOPs has long been settled and accepted by HMRC. A JSOP has the benefit of allowing participants to benefit from growth in value of a share without the need for them to first acquire, and later sell, ownership of the whole of the share. However, at present a company has no certainty as to what is the taxable value of an interest acquired by an employee as joint owner, and the financial risks of discovering some time later that HMRC disagrees with the original estimate of the taxable value of an interest as joint owner of shares is perceived by private equity funds as commercially unacceptable.  Leaving all consideration of tax aside, and all other things being equal, the JSOP is, or would be, the mechanism most favoured by private equity funds (when compared with non-tax-favoured share options, ‘growth shares’ or ‘phantom’ share schemes’).

Accordingly, it is suggested that HM Treasury consider consulting upon (with a view to including in the Finance Act 2019) provisions which will allow and encourage wider use of JSOPs in private equity-owned companies, but with strict rules on valuation and subject to a minimum proportion of the issued share capital of the company being made available to all employees through the plan over a given (10-year?) period.

Outline of the proposed ‘employees’ share scheme’

The idea is that, if a company commits to putting a prescribed minimum proportion of its issued ordinary share capital into joint ownership with all its employees (on an individual and ‘same-terms’ basis, subject only to a qualifying period of employment for eligibility), on terms whereby each participant will, for (at least) so long as he or she remains with the company (or group), benefit from all future growth in the ‘pro rata’ value of the jointly-owned shares (i.e. the growth to which they contribute as employees):

(a)  the taxable value of such ‘interests in employment-related securities’ acquired by each employee would be treated as their intrinsic value (nil); and

(b)  the company could then likewise permit selected employees to acquire such interests in additional numbers of shares of the same class (within a limit) on the basis of the same taxable value (nil).

It is suggested that such limit, on the number of additional shares in which interests as joint owner may be acquired on a selective basis, be a maximum of [8] times the number of shares in which every qualifying employee will acquire an interest as joint owner on that occasion.

To qualify for such favourable treatment:

(i) the shares used must be ordinary shares of the class which is both:

– that which is otherwise owned by the controlling shareholders; and

– the largest class (in terms of nominal value) in issue;

(ii) the ‘pro rata’ value of shares of that class would be determined by taking the ‘market value’ of the whole of the issued share capital of that class (as agreed with HMRC SAV), and dividing it by the number of shares in issue;

(iii) the threshold level, above which participants will be entitled to any increase in value, may be set at or above that pro rata value at the date of acquisition by employees of their interests as joint owners.

The co-owner of the shares would (typically) be the controlling company, but may instead be a trust established for the purpose.

Such an arrangement would:

  • allow all eligible employees to participate in the growth in capital value to which they contribute as employees;
  • require only minimal changes to current tax rules (with which it is entirely consistent) so as to provide that, if all conditions are satisfied, the initial taxable value of such an interest is deemed to be nil;
  • allow employees to participate as actual (joint) shareholders (as opposed to being mere optionholders), and therefore participate in (a pro rata share of) any dividends, and, if the joint ownership agreement so provides, the exercise of voting rights;

[An enhancement might be that, if the whole amount of any dividends on jointly-owned shares are paid to the employee joint owners, all such income would be treated as dividend income of the employee, not as ‘earnings’.]

–     (provided the initial market values of the shares is properly identified and agreed at the outset with HMRC SAV) present little or no scope for abuse or ‘tax avoidance’.

Aside from tax, the concept of such ‘joint ownership’ avoids the situation (as under a ‘qualifying Schedule 2 Share Incentive Plan’) in which the company first ‘gives away’ the current accrued value of the shares, only to have to repurchase, or fund the repurchase (through a trust) of that same value when an employee leaves or wishes to sell. Under a JSOP, the employee only ever acquires an entitlement to future growth in value.

If, on the conditional basis proposed, the initial taxable value of the interests is accepted as nil, the only issue to be settled with HMRC SAV is, in the case of unquoted companies, the initial market value of the whole of the shares of that class in issue immediately after any new issue for the purposes of an award under the plan.

If agreed that the IMV of the jointly-owned shares is to be taken to be their pro rata value (i.e. market value determined on a pro rata basis with no discounts for minority interest, lack of marketability etc.), the legislation might also provide that:

–      if a participating employee (or ex-employee) realises the value of his interest for a consideration calculated on the basis that the market value of the jointly owned shares is likewise determined on a ‘pro rata’ basis, there would be no charge to income tax on such disposal under Chapter 3D, Part 7, ITEPA (disposal of employment-related securities for more than market value); and

–       if the shares are bought back by the issuing company, such a ‘purchase of own shares’ would be treated as a capital transaction and not give rise to a distribution income tax charge (as it would if the interest had been held for less than 5 years).

Practical experience of such ‘joint ownership plans’ since 2001 has been very positive, albeit with the difficulties of determining the initial taxable values of the interests (as joint owners) acquired by employees – exacerbated by the withdrawal by HMRC SAV earlier this year of any facility to agree such values for PAYE and self-assessment purposes.

Encouraging companies to establish such plans by removing that obstacle (identifying the taxable initial value of the employee’s interest) by requiring participation to be extended on an ‘all-employee’ basis would, we believe, prove to be of real attraction to a range of unquoted companies which extends beyond those which presently offer, or could offer, employee share participation.

Crucially, it is estimated that the cost to HM Treasury of facilitating such plans would be de minimis.

Fresh thinking…a new share incentive scheme for employees of PE-backed companies?

A company under the control of another company cannot grant EMI share options and, unless it is under the control of either an employee-ownership trust or a fully-listed company, cannot establish a tax-favoured Share Incentive Plan or SAYE share option scheme. Given that (according to the BVCA) an estimated 515,000+ individuals are employed by UK companies owned by private equity and venture capital funds (which invariably hold their interests through a corporate vehicle), this excludes a substantial proportion of the workforce from participation in such plans.

Whilst members of the BVCA are keen to provide employee share incentives in investee companies, they are presently faced with having to incur significant fees to establish bespoke plans with uncertainty as to the quantum of any liabilities to tax and NICs on share awards. They seek a ‘well-trodden path’ which, if followed by investee companies, will allow employees to benefit from future growth in value on a similar basis to that of other investors.

HM Treasury is alive to the difficulties experienced by PE and VC fund managers in implementing a simple, easily-understood, and cost-effective employee share scheme in a manner which affords both capital treatment for employees in relation to future gains and security for the employer against HMRC enquiry or compliance challenge. One solution would be to allow a trading company controlled by a “PE vehicle” – if such a term were exhaustively defined – to grant EMI share options and establish a SIP or SAYE share option scheme. However, there are obvious difficulties in identifying and then defining the types of PE and VC funds and their investee companies which should enjoy such privileges.

Earlier this year, representatives of the BVCA and the ESOP Centre met with officials at HMT to propose a solution to this conundrum which I have been developing with those bodies. The idea builds upon the concept of ‘joint share ownership’ first developed in 2001, which has since been widely implemented by British companies. The tax treatment of that concept has long been settled with HMRC.

In brief, the proposal is as follows:

  1. A trading company (or holding company of a trading group) under the control of another body corporate (and not otherwise eligible to make awards under a qualifying SIP) may from time to time invite all employees having a qualifying period of employment to accept the award of interests as beneficial joint owners of a given number of ordinary shares in the company, being shares of the largest class in issue and of the largest class held, or ultimately owned, by the PE or VC fund. Such an interest would entitle the employee participant to growth in value of the jointly-owned shares above a threshold level which is not lower than the pro rata value of such shares at the time of award. Crucially, HMRC SAV should – it is suggested – be willing to agree the value of an investee company for these purposes. Provided that such interests are awarded on an ‘equal terms’ basis (broadly as per Share Incentive Plan participation), and subject to a limit on individual participation, the initial taxable value of an employee’s interest would be taken to be zero. (Given that no discount for minority interest, etc., would be applied, the value of such an interest would otherwise have been determined as a ‘premium-priced option’ and therefore it is suggested that any loss to HM Treasury of ‘up-front’ tax would be relatively modest – if any.) A deemed s431 tax election would then ensure that, in the absence of any tax avoidance feature, gains realised upon the disposal of such interests would fall to be taxed as capital gain (and, if the Government were particularly generous, might qualify for the reduced 10% rate of CGT by way of Entrepreneurs’ Relief, as in the case of certain disposals of EMI option shares).
  2. By way of an inducement to qualifying companies to establish such a plan, such certainty of tax treatment might also be extended to similar awards made on a selective basis to key employees over greater numbers of such shares, provided that such number of jointly-owned shares does not exceed a specified multiple (of, say, 8 times) of the number of shares in respect of which awards are made to all eligible employees on the same occasion.

The perceived attractions of such a plan include:

  • its relative simplicity to establish and document: the co-owner could, for example, be the holding company of the company whose shares are used, and the relationship with participants would be governed by contract. The co-owner could easily repurchase interests from participants who leave at a price determined on a ‘good/bad leaver’ basis;
  • the fact that, unlike a SIP, a participant benefits only from future growth in value of the jointly-owned shares and, unlike a ‘market value’ share option, the employee is not put to the expense of funding the acquisition of the shares, only for the shareholders then to be burdened with the cost of funding the repurchase of shares from ‘good leavers’ – rather, it is only the growth in value to which the participant ever becomes entitled;
  • the fact that only if and insofar as there is growth in value will benefit accrue to both employees and, to the extent that a charge to CGT arises, to HM Treasury – most existing forms of ‘growth share’ plans or JSOP arrangements involve an initial charge to tax at a time when any real growth in value has yet to accrue;
  • setting the threshold level (above which the participant benefits from growth in value) at the ‘pro rata’ value of an ordinary share, and acceptance that the initial unrestricted market value of such an interest is nil, would avoid the complex and expensive process of estimating the value of a ‘growth interest’; the valuation exercise would normally be confined to a valuation of the whole of the issued share capital or of the class of share used.

It should be emphasised that this is merely a proposal made to HM Treasury officials who are understood to be ‘kicking the tyres’. It is not claimed to be a panacea, and others may come up with better solutions, but it does address the concerns of private equity and VC-backed companies excluded from existing tax-favoured government sponsored share plans and has the support of the BVCA. Thus far, no fundamental objection or technical obstacle has been raised, although as it will require primary legislation, we should not perhaps hold our breath…

© David Pett  November 2017

Longmark London Tax Conference 2017

On Thursday, 9th November 2017, David Pett will be presenting at the Longmark Annual London Tax Conference for ambitious unquoted companies, at Lord’s Cricket Ground. David will be discussing “Share Based Incentives for Unquoted Companies”, covering the following topics:

  • Share Incentive Plans – why are they worth a fresh look?
  • JSOPs and growth shares
  • Alphabet shares, the current position
  • Putting shares into the hands of employees is one thing: how can you get them back?
  • Update on the expanding reach of the disguised remuneration and DoTAS rules as they apply to employee share arrangements

The roster of speakers also includes Anne Fairpo, Jonathan Bremner, Alun James, Pete Miller and Michael Thomas.

For more information, log on to www.longmark.co.uk

© David Pett November 2017