The UK's private equity industry will be relieved that the Chancellor did not announce any new rules on the benefits delivered by ratch

The UK's private equity industry will be relieved that the Chancellor did not announce any new rules on the benefits delivered by ratchets in the Pre-Budget Report on 6 December 2006.

Following an acknowledgement from HM Revenue & Customs in August that their stated views were wrong, there was clearly a possibility that new legislation would be introduced to make those views right. In a statement issued after the Pre-Budget Report Peter Linthwaite, chief executive of the British Venture Capital Association, welcomed the strong emphasis on the increasingly important role of science, innovation, investment and entrepreneurship and said the BVCA is looking forward to continuing the dialogue with the Chancellor about how London and the UK can be kept at the centre of the European private equity and venture capital industry.

Structure of a Typical Private Equity Acquisition
In a typical private-equity backed management buyout a new company (Newco) acts as the acquisition vehicle. Members of the management team buy a significant (15 – 20 per cent) equity stake in Newco, often with a ratchet attached which can vary the proportion of the total equity held by them, depending on performance. Depending on how management’s equity acquisition is structured they can either pay 10 per cent CGT on increases in value or a proportion of it can be subject to income tax with employees’ and employers’ national insurance contributions also being payable.

Clearly it is in everyone’s best interests for management’s shares to qualify for CGT treatment.

Summary of the Tax Rules
The rules are complex, but very broadly management’s shares are automatically “employment-related securities” and they are also almost always “restricted securities” because of good and bad leaver provisions in Newco’s articles of association which require them to sell their shares back for the lower of the price paid and their then market value if they are a bad leaver.

However, as long as the price management pay for their shares is not less than their IUMV (initial unrestricted market value, i.e. what their value would be without the good and bad leaver provisions and any other restrictions) there is no problem and management’s shares will qualify for CGT treatment. If the price paid is less than IUMV management can elect to pay income tax on the difference at the time of acquiring their shares (and elections are generally entered into as a protective measure anyway just in case HMRC do not agree that the price paid was IUMV).

The Joint Inland Revenue Memorandum of Understanding
Following the introduction of the new tax regime in the Finance Act 2003 (now in the Income Tax (Earnings and Pensions) Act 2003) HMRC (then still known as the Inland Revenue) issued a joint memorandum of understanding (MOU) with the BVCA relating to the tax treatment of managers’ equity investments in venture capital and private equity backed companies. The MOU contains safe harbour conditions and provided these are satisfied HMRC say they will accept that management have paid full IUMV for their shares.

Where there is a ratchet the additional safe harbour conditions are that:
· the ratchet exists at the time the private equity investor acquires its shares;
· the rights of different shareholders may vary depending on the performance of the company but not the performance of any individual; and
· the price paid by management reflects their maximum economic entitlement.

The MOU then goes on to discuss what the "maximum economic entitlement" is where there is a ratchet. If the ratchet could operate to reduce the overall proportion of the equity held by management (for example from 20 to 15 per cent with a corresponding increase in the private equity investor’s stake from 80 to 85 per cent) they should pay the same price per share for their 20per cent stake as the private equity investor pays for its 80 per cent stake.

If the ratchet operates the other way round and management start off with 15 per cent of the equity which could increase to 20 per cent if the performance conditions are met, the MOU says management must pay a premium for their shares relative to the price per share paid by the private equity investor.

Conflicting Views of HMRC and the Private Equity Industry
If the price paid by management is less than the IUMV then the view of the private equity industry (and the MOU appeared to support this view) was that any difference should be subject to income tax (and employees’ and employers’ NIC if the shares are readily convertible assets) under the restricted securities rules - upfront if elections are made at the time of acquisition or, if no elections are made, when the shares cease to be restricted or are disposed of on a proportion of their then value (derived from the difference between the price paid and the IUMV).

However, the view expressed by HMRC was that if management had not paid for their full economic entitlement they could suffer a charge to income tax when a ratchet kicked in, not under the restricted securities rules but under the rules imposing a charge on post-acquisition benefits from securities. The taxable amount under these rules is the amount or market value of the benefit. What this meant in practice therefore was that if management had not paid for their maximum economic entitlement, then regardless of whether or not they had made a restricted securities election to pay income tax upfront on the difference, they would suffer income tax on the full value delivered by the ratchet.

In a statement published on 21 August 2006, HMRC said they had sought advice from counsel who had advised that a charge under the post-acquisition benefits rules was not sustainable where the benefit of a ratchet reflected rights already present in that class of share at the time of acquisition. This was very welcome since it restored the position to what it had originally been thought to be, i.e., even if the price paid by management does not reflect their maximum economic entitlement, any discount should be taxed under the restricted securities rules – upfront if an election is made at the time of acquisition – and there should be no post-acquisition benefits charge when a ratchet kicks in.

Not surprisingly, the private equity industry and its advisors anticipated that the Chancellor might announce new legislation in the Pre-Budget Report to facilitate an income tax charge on increases in value delivered by ratchets.

The welcome absence of such an announcement gives certainty of tax treatment, at least for the present.