BusinessCorporate FinanceRevenue builds stumbling blocks for MBOs

Revenue builds stumbling blocks for MBOs

Adopting a US-style approach to employee shareholdings will have far-reaching effects on MBOs. While some analysts are not impressed with the Inland Revenue's Finance Bill, others believe it is a sensible measure.

With a truly astonishing lack of consultation, the Revenue revealed on 16 April in its Finance Bill that it wants to move immediately to a US-style treatment of employee shareholdings. This involves employee shareholders, including management, making an early election – within 14 days according to the bill – as to whether to be treated inside the provisions of the bill or outside it.

Electing to be outside the bill could trigger an immediate PAYE 40% tax charge, plus national insurance on any difference in value between the market value of the shares and what the employee paid for them.

Being inside the bill could trigger tax at 40% any time and any condition attached to the shares is changed, even if no actual sale of the shares takes place. The move has far-reaching implications for the way management buyout and buy-in deals are structured in future, and has been attacked by many corporate finance specialists as a serious stumbling block to MBO and MBI deals.

John Hodgson, a tax partner at Grant Thornton, is currently advising on an MBO that is nearing conclusion. He believes the bill creates uncertainty for management and that it is standing in the way of completion.

David Tuck, tax partner at KPMG, agrees: ‘We are supposed to be heading for tax simplification and now have legislation thrust upon us that leaves tax specialists struggling to understand how this is going to work. We have deals in process right now and simply do not know how this is supposed to play between now and July when the draft legislation becomes law.

The problem is the lack of certainty in knowing if the legislation bites in specific circumstances. It is incredibly unhelpful for MBO activity at this crucial juncture in the market.’

The shift to a US-style system is not made explicit in the bill. Nowhere in the bill does the Revenue come right out and say: ‘We think the US system is a great idea, so we’re going to throw caution to the wind and adopt it here.’ Instead, to the surprise of the profession, the Revenue has simply slotted a 76-page section (schedule 22) into the bill that is incredibly dense in changes and refinements to established practice.

Tim Hughes, tax partner at PricewaterhouseCoopers, has worked on a number of MBOs in the US and knows the US system quite well. Within a few minutes of perusing schedule 22, it was clear to him that he was looking at a US-style system. Perhaps because of his understanding of the US system, he takes a different line from Hodgson and Tuck. He sees the bill as ‘quite sensible’, and believes ‘the old legislation was very Draconian’. He adds: ‘If you fell foul of various parts of it as an employee, you ended up being charged large amounts of tax on things that should not have incurred tax at all. The new legislation is much better targeted in that regard.’

Neville Bramwell, tax partner at Deloitte and Touche, agrees. ‘I certainly would not put myself in the camp of those who claim this is a horrendously bad piece of drafting and a terrible mistake by the Revenue. My view is that the bill is actually rather well drafted and has been carefully put together. There may be some unintended consequences there, particularly for the venture capital community and for MBOs, but that is not the point of the bill,’ he says.

In Bramwell’s view, the bill aims to bring more flexibility into some areas of the law relating to employee shareholdings that the industry has long been saying were too inflexible. It has also brought in a great deal of anti-avoidance legislation, aimed at the way in which big financial institutions pay staff bonuses to avoid tax.

There is a risk, however, that this could have unintended consequences for MBOs, and the profession will clearly be arguing that MBO deals have many commercial characteristics and should not be lumped in with artificial avoidance, he explains.

The point Bramwell wants to stress is that the bill is rather helpful to share ownership. Hodgson, on the other hand, disagrees and says: ‘We all understood what the rules were under the old legislation, and we knew how to avoid the bad bits and maximise the good bits.’

Bramwell argues, too, that there should be little difficulty for MBO managers to elect immediately to be outside the Finance Act since MBO shares are generally pretty low in value anyway. ‘The Revenue has shown itself in the past as willing to take whatever the institution involved paid for the shares as constituting fair market value, so that removes uncertainty.’

Again, Hodgson disagrees. ‘We must not be naive about this. Venture capitalists will issue preferential shares and ordinary shares, and there is a switch in value between the two.

‘The point is that valuing MBO shares is difficult, even for experts. I can’t say with confidence to managers, who are not necessarily men of great wealth, that they will not incur a significant tax charge if they make an election, as the bill suggests. The thought that they might pay £10,000 for their shares and then finish up incurring an additional tax charge of £20,000 or £30,000 is a significant deterrent to an MBO in the first place. I cannot believe the Revenue intended to catch MBOs in this way. Nor am I particularly confident that having caught MBOs it will all be sorted out and put right in a reasonable time frame,’ says Hodgson.

Tuck agrees and says: ‘The Revenue has had a real attempt at closing down all bonus planning the banks and financial institutions, in particular, have been entering into to avoid national insurance. As such, it has used the bill to take a shotgun to the whole thing and has, in effect, said it is going to catch anything that moves.’

In the process, he says, it has caught bona fide employee shareholders in unlisted companies and these companies will find it difficult to understand how the legislation affects them.

  • Anthony Harrington is a freelance journalist. This article first appeared in the June edition of Financial Director.


Finance Bill

The bill has so far caused ructions for other reasons than its tax implications for employee shareholdings.

Unexpectedly large, the bill has prompted a chorus of disapproving comments that not nearly enough time has been available to debate it all in the House of Commons.

Indeed, the committee stage of the bill has been allocated only seven days to complete its work with a deadline set of 12 June for a finish.

While this may seem a reasonable period for the work, Tory chiefs note the bill is the fourth largest on record at 447 pages.

Contained in the bill are some complex proposals for stamp duty, which comprise at least a third of the bill’s contents. The Chartered Institute of Taxation has complained that measures on VAT security could not be properly scrutinised.

Employee shareholdings

Employee shareholdings have also met with controversy elsewhere. There was uproar when the International Accounting Standards Board suggested changes to the way that stock options are accounted for by companies.

Although the final standard is still under discussion, it seems almost certain that when it is eventually published companies will have to treat shares in the same way as any other form of payment. The move is backed by the UK Accounting Standards Board, and the US-based Financial Accounting Standards Board has also announced plans to put similar measures into effect.

Groups, such as Proshare and the International Employee Stock Options Coalition are still lobbying hard to gain some exemptions to the standard.

In particular, there is great opposition to expensing broad-based employee share option schemes rather than for executive payments as many feel that these schemes will be withdrawn by companies if the new rules are implemented.

There is still some hope that exemptions can be gained but the IASB has previously said it would find it difficult to justifiably distinguish between the two types of scheme.

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