For venture capitalists and managers involved in management buy-outs (MBOs) in particular, the delayed revelations bring bad news. This is linked to a technical change made under the heading "Remuneration in shares subject to forfeiture or conversion".
The change was intended to clarify the way in which employees are taxed if they receive shares that might subsequently be forfeited, depending on the performance of their employer. In addition, the Inland Revenue has announced forthcoming changes inthe way that convertible shares are taxed.
Neither of these changes seems, at first glance, to be particularly far- reaching, and it is difficult to see how the Revenue can justify the sizeable figure that they estimate would otherwise be lost to the Exchequer: more than pounds 100m. In practice these measures will not net much additional tax, as such types of arrangement will no longer be used. Tax planners will simply find other ways of achieving a similar commercial result. These alternative methods are tried and tested, and the Inland Revenue is unlikely to have a problem.
So where is the problem? The answer lies in the fact that, without even the briefest mention of it in his Budget statement, the Chancellor has created a trap affecting almost every management buy-out taking place from now on.
MBOs operate by means of managers buying a substantial equity stake in the new group of companies formed by the buy-out. It is usually agreed that the value of their shares will later be enhanced if the company achieves targets set by their financial backers - a system known as an "equity ratchet". The other investors accept this dilution of their own equity stake in order to give the management the greatest possible incentive to make the buy-out company successful.
Prior to the Budget, managers faced a tax charge when they bought their MBO shares only if the shares were worth more than they paid for them at that time. Of course, this situation was rare because such initial investments, by their very nature, are high risk. They would also pay capital gains tax on any profit made when the shares were sold.
The changes mean that in future managers would have to pay income tax at the time that the equity ratchet kicks in - that is, at the point when they receive all increased share of equity, in line with enhanced business performance. Although this ratchet system is often linked to a sale, where the impact of the change will be less keenly felt, in a significant number of cases the ratchet is negotiated as an on-going benefit. Such managers would be required to pay tax before realising any profit.
Clearly, this situation would be unacceptable to managers involved in a buy-out. The result could be extreme short-termism, as managers clamour to turn paper profit into cash proceeds by selling the business in order to pay off their income tax bill. This cannot be what the Chancellor intended.
In practice, the worst case scenario is unlikely to materialise, as any skilled tax planner will be able to seek out alternative ways of making an equity ratchet system work. These alternative routes are also likely to be more complicated, and therefore costly. Unfortunately, this means that commercial needs will play second fiddle to tax considerations.
The main fear is that while the industry takes time to wake up to the effect this change has brought, a steady stream of management buy-outs has been proceeding on the old type of equity ratchet, so that the managers involved will face unexpected tax charges at a time when they have no money with which to pay them.
Having jumped in at the deep end the Revenue is now left with just two ways in which it could help. The oversight (if such it was) might be acknowledged and dealt with before the publication of the Finance Bill, or, better still, the Revenue might choose to differentiate between normal employee share benefits and entrepreneurial MBO investments, and tax them accordingly.
The writer is a share incentive specialist at the law firm Eversheds.Reuse content