On 21 August 2006 HMRC (HM Revenue & Customs) changed their guidance on the taxation of ratchets following legal advice, these will now normally not be taxed as income.
Private equity backed companies often incentivise management through ratchets. These are typically structured as "negative ratchets" (i.e. some shares held by institutional investors convert to worthless deferred shares thereby increasing the value of management shares to the extent performance targets are met).
Following the new employment-related securities taxing regime introduced on 16 April 2003, HMRC agreed a memorandum of understanding ("MOU") with the British Venture Capital Association. Compliance with the MOU was supposed to prevent ratchets being taxed as income.
HMRC Lay Down the Gauntlet
In a controversial move on 25 May 2004, HMRC announced that the increase in value of management shares as a result of the operation or ratchets would attract income tax charges. The interpretation applied to arrangements introduced after 16 April 2003 (even if the conditions in the MOU were met).
HMRC's stance hinged on demonstrating the operation of ratchets constitutes a "special benefit" (even if the ratchet was incorporated into the articles when management acquired the shares and the price paid for the shares reflected the value of the ratchet on acquisition).
HMRC Back Down
Two cases were due to be heard by the Special Commissioners later this year which prompted HMRC to take legal advice which in turn prompted the back-down. HMRC now say they will not impose income tax charges if the MOU conditions are met.
Outstanding tax returns can be amended to reflect the Revenue's revised stance. Taxpayers who have over-paid income tax can reclaim it by making an error or mistake claim under s33 Taxes Management Act 1970.
The position HMRC took was controversial and the anxiety caused should have been avoided. It appears as if HMRC were only forced to reconsider because a few courageous taxpayers took them to the Special Commissioners. A similar battle may be looming over the application of the special benefits charge to ordinary commercial dividends.
Coming on the back of the shock end to the employer's Home Computing Initiative and the Chancellor's volte face over putting residential property into post A Day pensions, HMRC seems to be getting quite adept at moving the goalposts -for once they appear to be putting them back where they found them.