UK Revenue Back Off Venture Capital Tax Threat

by Robin Pilgrim, LawAndTax-News.com, London

30 August 2006

The UK's tax authority last week backed away from its attempt to charge income tax on private equity managers' 'ratchet' gains, faced with a legal opinion that it was unsustainable.

In buy-out deals or IPO deals, private equity managers usually buy shares at the same price as other shareholders, but can benefit from a ratchet to acquire more shares if there is out-performance.

The Finance Bill 2003 governs the taxation of employment-related securities and options, and after discussions with the BVCA a joint memorandum of understanding was published on 25 July 2003 on the Income Tax treatment of managers' equity investments in venture capital and private equity backed companies. This MOU explains that provided:

• there were no personal performance conditions attached to the ratchet;
• the ratchet arrangements were in existence at the time the Venture Capitalist acquired his shares; and
• the managers paid a price for shares reflecting their maximum economic entitlement,

then there would be no further liability to tax, arising from the ratchet of itself.

However, HMRC has since suggested that tax charges could apply if the excess increase in value of the shares gained via a ratchet is disproportionate to the amount of capital invested by the manager compared with other holders of equity. HMRC also came to the view that a taxable benefit could arise where a company was thinly capitalised, where this gave rise to disproportionate reward in the hands of employee shareholders.

Last week HMRC said:

'Advice as to the applicability of such a Chapter 4 benefit charge was sought from legal counsel, who advised that a charge under Chapter 4 was not sustainable where the benefit to the holder of the shares from these ratchets reflected rights already present in that class of share at time of acquisition by the employee, or in terms of the thin capitalisation argument.

'Where shares are acquired under arrangements consistent with those described in Sections 1 to 5 of the Managers' MOU then, where there is a ratchet operating at an "exit", no Chapter 4 benefit charge will arise on the disposal of such shares or, if earlier, on operation of the ratchet. Where, in addition, the ratchet meets all the conditions in Section 6(2)(a) and (b) of the MOU, any gains realised on exit will be subject to CGT only, and not to Income Tax and NICs. Where the arrangements are not consistent with Sections 1 to 5 of the MOU, or where the Section 6(2)(a) and (b) conditions are not met, charges remain possible under:

• Chapter 3B (securities with artificially enhanced market value)
• Chapter 3D (securities disposed of for more than market value)
• Chapter 4 (post-acquisition benefits from securities)
• Section 62 (general earnings)

'Such cases will need to be considered on their own facts.'

Venture capitalists are happy at this result, but warn that the Treasury is likely to legislate further in next year's Finance Act, if not before.

Recommended