In a technical feature article which first appeared in Taxation Magazine on 15 February 2007, Colin Kendon considers the tax implications for EMI option-holders of a sale of a private company.
Colin Kendon considers the impact of the sale of a private company on EMI options.
- The importance of timing when granting options.
- The relationship between grant of options and negotiations can affect valuation.
- Corporation tax relief on the exercise of options.
- Paper for paper treatment for option shares.
- Spouse transfers and share identification rules.
- Taper relief and the earn-out structure.
This is the second of two articles looking at some of the tax pitfalls with private company acquisitions. The first article (‘Harry’s game’, Taxation, 8 February 2007, page 160) considered the personal tax position of owner-managers; this article considers issues relating to enterprise management incentives (EMI) options. References to ‘paras’ are to paragraphs of ITEPA 2003, Sch 5 unless otherwise stated.
Readers of the first article (available by clicking here) will recall our client Harry who owns 100% of Target Limited. Harry intends to sell Target to Acquisition Vehicle Limited, a subsidiary of Purchaser plc (a company traded on AIM).
Heads of terms will be signed shortly with Purchaser who hopes to buy the shares of Target for £3.6 million initial consideration and an earn-out of up to a further £2.4 million based on profits of Target for the years to 31 December 2007 and 31 December 2008. We assume (for the purposes of advising Harry now) that completion will occur on 31 May 2007 and we ignore deal costs.
Harry tells you he put 10% of Target under option in March 2006 (these options qualify for EMI) and he intends to put a further 10% under option before completion to satisfy past commitments. Options entitle participants to acquire the same class of ordinary shares as Harry and will participate in the sale on the same terms as him.
Granting options after signed terms
We advise Harry that he should grant more EMI options (if possible) which become exercisable immediately before completion. We have already checked that Target meets the conditions in paras 8 to 23; for an explanation of these see Philip Reeves’ article, ‘Devil is in the detail’ (Taxation, 5 October 2006, page 9).
However, we warn Harry that there may be a problem with the ‘independence’ test in para 9 if options are granted after heads of terms are signed. Target clearly is not yet a 51% subsidiary or under the control of another company, but para 9(3) says the test is failed if ‘arrangements are in existence by virtue of which’ the company could become a subsidiary or fall under such control. Arrangements are widely defined by para 58 to include ‘any scheme, agreement or understanding whether it is legally enforceable or not’. The question is whether the heads of terms constitute arrangements ‘by virtue of which’ Target could lose its independence.
As an aside, I recently advised a purchaser on an acquisition in which the vendor granted EMI options after heads of terms were signed. The vendor’s advisers raised the question of independence with HMRC who responded by issuing a notice of enquiry pursuant to para 46. The advisers argued that it is by virtue of the sale and purchase agreement (SPA) rather than the heads of terms that independence would be lost subject to due diligence, etc. They cited Scottish and Universal Newspapers v Fisher  SC 311 which established that even a conditional contract is insufficient to constitute arrangements until the condition is satisfied. Unfortunately, HMRC did not accept this and issued a closure notice pursuant to para 47. Even if HMRC are wrong in law, granting options after heads of terms have been signed may expose Target to a prolonged legal dispute.
Signing heads of terms is not, however, a ‘disqualifying event’ for the purposes of ITEPA 2003, s 534(1) so the status of the existing options will be unaffected. Target has to actually become a 51% subsidiary or Purchaser must obtain control for there to be such an event.
Even if we accept that the independence test – and other conditions in ITEPA 2003, Sch 5 – are satisfied, we will need to agree a valuation of the option shares at the time of grant to determine whether the options were granted at a discount and whether the options were granted within the £100,000 individual limit and £3 million overall limit (in paras 5 and 7 respectively). ‘Market value’ has the same meaning for these purposes as in TCGA 1992, s 272, but it is modified so that one ignores restrictions for the purposes of the limits.
Harry’s negotiations with Purchaser are not in the public domain so one can argue that the purchaser of a small minority holding would be unaware of the deal (see HMRC’s Share Valuation Manual at SVM11040). However, Harry ought to be aware that Target may be allocated to an Inspector who thinks otherwise and, in practice, it may be difficult to obtain a favourable valuation after heads of terms have been signed.
Harry may have to grant deeply discounted options to satisfy past commitments if the Inspector will not agree much of a discount to the deal value. Discounted EMI options are subject to income tax on exercise on the amount of the discount on grant. The deal means the option shares will be ‘readily convertible assets’ on exercise so the amount charged to income tax will be subject to PAYE and National Insurance contributions.
We advise Harry that it may be better if he could ‘ease off’ on negotiations for a while to allow options to be granted before heads of terms are signed.
Corporation tax relief
It is possible for Target to obtain a corporation tax deduction on the exercise of options equal to the difference between the market value of the shares on completion and the exercise price, providing the conditions in FA 2003, Sch 23 para 4 are satisfied. For more detail readers are referred to the article ‘Quirks and pitfalls’, Taxation, 9 June 2005, page 266.
If we value the earn-out at £0.6 million on completion, the proposed deal values Target as a whole at £4.2 million. The existing option shares and shares to be put under option would be worth 20% x £4.2 million = £840,000.
If the total exercise price is (say) £240,000, the gain would be £600,000, so the deduction could be worth up to 30% of this (i.e. £180,000).
We will need to make sure that the option shares satisfy the conditions in Sch 23 para 4 on exercise to qualify for the relief. Paragraph 4(3) requires the shares to be listed on a recognised stock exchange or to be in an ‘independent’ company or in a company under the control of a non-close company that is listed on a recognised stock exchange. Purchaser’s shares are AIM traded (which is not recognised) so the options must be exercised immediately before completion when Target is still independent. If the terms of the existing options have to be amended to allow exercise immediately before completion, HMRC accept that this does not amount to the grant of a new right (see the minutes of a meeting between the Share Plan Lawyers Group and HMRC on 29 November 2004 at A.3).
We may have to negotiate with Purchaser over who obtains the benefit of the deduction. If Harry and the other vendors are given credit for it, it would usually appear as a deferred tax asset in the completion statements for which credit is given on a pound for pound basis. However, we warn Harry that purchasers often do not treat deferred tax assets in the same way as cash on the balance sheet. It may be that Purchaser is only prepared to give credit as and when the deduction is utilised.
If part of the consideration is deferred until the deduction is utilised and is referable to the amount of corporation tax saved, it will be unascertainable at the time of completion (because it is not possible to know for certain at the time how much tax the deduction will save). The consideration will be subject to Marren v Ingles  STC 500 treatment if it is settled in cash, or TCGA 1992, s 138A treatment if it is settled in loan notes or shares.
Initial consideration loan notes
Business asset taper relief runs from the grant of EMI options (TCGA 1992, Sch 7D para 15) so if completion occurs on 31 May 2007, the March 2006 option-holders will benefit from one full year of business asset taper relief on the option shares which they sell for cash.
Purchaser may be prepared to offer loan notes to key option-holders. None of them will be fully tapered on completion on 31 May 2007, so we may suggest they take some of their initial consideration in cash to utilise annual exemptions and the balance in loan notes structured as non-qualifying corporate bonds (non-QCBs) so business asset taper relief can continue to run.
Paper for paper treatment will be available for the exchange of option shares for loan notes if the conditions in TCGA 1992, s 135 are satisfied (thereby allowing the re-organisation treatment afforded by TCGA 1992, s 127 to apply). The loan notes must be issued by Acquisition Vehicle in order to satisfy s 135. TCGA 1992, s 137 disapplies s 135 where the transaction is not for bona fide commercial reasons or the main purpose (or one of the main purposes) is the avoidance of capital gains tax. Section 137 only applies to 5% plus shareholders. It is possible to obtain clearance that s 137 will not apply and we propose to do so anyway for Harry.
The non-QCBs must be ‘securities’ for the purposes of TCGA 1992, Sch A1 para 22 to qualify for business asset taper relief. TCGA 1992, s 251(6)(b) deems any debenture issued by Acquisition Vehicle as consideration for the sale of the shares in Target to be a security so there is no need to ensure the non-QCBs are securities as strictly defined.
Option-holders will qualify for business asset taper relief on the loan notes if Purchaser is a trading company. TCGA 1992, Sch A1 para 6(1A) may still allow them to qualify if Purchaser is an investment company provided that each option-holder remains an employee/officer within Purchaser’s group and they do not hold more than 10% of the loan notes as a class. However, option-holders may be surprised to learn that the taper relief clock re-starts from the issue of the loan notes on completion. TCGA 1992, Sch 7D para 15 says that taper relief runs from the grant of EMI options, but it only applies to disposals of ‘qualifying shares’; Sch 7D para 14(3)(b) extends the relief to replacement shares where the re-organisation rules in TCGA 1992, s 127 apply, but not to loan notes (see Mike Warburton’s article, ‘Tricky bear trap’, Taxation, 2 June 2005, page 247).
We might suggest that option-holders transfer some of their option shares to their spouses immediately after exercise, but before completion. This would allow the transferee spouse to sell some of the option shares to Purchaser to utilise annual exemptions (particularly as banked business asset taper relief will be lost on the exchange of shares in Target for loan notes).
The transfer to the spouse is a no gain/no loss transaction (TCGA 1992, s 58). The question is when does business asset taper relief run from on the disposal of the option shares by the transferee spouse to Purchaser?
The legislation is clear; the transferee spouse is treated as acquiring the option shares on the grant date (TCGA 1992, Sch 7D para 15 and Sch A1 para 15(3)(b)), so shares acquired pursuant to options granted in March 2006 would benefit from one year’s business asset taper relief on sale by the transferee spouse. Practitioners should be aware of an error in HMRC’s Guide, EMIs for Employees, Employers and Advisers on page 22, which suggests that taper relief runs from the date the option-holder exercises the option in these circumstances.
|Suppose Robin has the following qualifying EMI options:|
|Grant Date ||AMV on grant ||Exercise price||No of shares|
|1 March 2006||£4||£4||10,000|
|1 February 2007||£8||£8||5,000|
|Robin exercises both options on completion. He wants to sell sufficient shares for cash to utilise his annual exemption and exchange the rest of his option shares for loan notes. Robin’s computation for 2007-08 is: |
|Sale proceeds 1,726 shares x £15 ||25,890|
|Less pooled base cost £80,000 x 3.6/4.2 x 1,726||(7,890)|
|Less business asset taper 18,000 x 50%||(9,000)|
|Less annual exemption (say)||(9,000)|
|Note: TCGA 1992, s 105(1)(a) requires the base cost to be pooled for same day acquisitions and sales. The resulting base cost is apportioned between the initial and deferred consideration. The calculation of business asset taper relief assumes all 1,726 of the shares sold for cash are identified with the March 2006 option shares so qualify for 50% business asset taper relief.|
|Robin receives cash of £25,890 on completion but has to find £80,000 to fund the exercise price. Unfortunately Robin may need to borrow to fund the shortfall. Paragraphs 34 and 35 arguably combine to mean his option is not a ‘qualifying option’ if he were to provide an undertaking to pay the exercise price.|
The total initial consideration is £3.6 million and the net present value of the earn-out is assumed to be £0.6 million, deal costs are ignored.
Share identification rules
It is likely that all option-holders will exercise their options on the same day at the same time immediately before completion occurs.
Option-holders with larger holdings may want to sell some option shares for cash and exchange the balance for loan notes. TCGA 1992, s 105(1)(a) requires that the base cost of the option shares to be pooled (as there will be a same day acquisition and disposal of the option shares).
If an option-holder has several EMI options which qualify for different rates of business asset taper relief, it is impossible to identify which of the option shares are being sold and which are being exchanged for loan notes (and it is necessary to know this for the purposes of calculating the business asset taper relief to be applied in calculating the gain on the disposal). Obviously, in these circumstances option holders want to sell the option shares which qualify for the most favourable rate of business asset taper relief and exchange the ones which do not for loan notes.
We have already advised Harry that the deal should be structured so that TCGA 1992, s 138A applies to the earn-out (see ‘Harry’s game’ for more detail) thereby allowing the earn-out to qualify for paper for paper treatment. TCGA 1992, s 138A(3)(b) says the earn-out right is treated as a security which is not a qualifying corporate bond (QCB) so business asset taper relief can continue to run. When the earn-out is settled in loan notes, these can be QCBs or non-QCBs. If the earn-out is settled in QCBs, TCGA 1992, s 116(10) applies and freezes the gain when the loan note is issued, it is held over until the loan note is sold or redeemed. If the earn-out is settled in non-QCBs, s 138A(3) treats the event as an ‘internal re-organisation’; business asset taper relief continues to run until the non-QCB is sold or redeemed.
The taper relief clock is re-set on completion for the earn-out as well as for loan notes issued in settlement of the initial consideration for the same reason (i.e. that the earn-out is a security, but not a share for the purposes of TCGA 1992, Sch 7D para 14(13)(b)).
If completion occurs on 31 May 2007, no option-holders will qualify for full business asset taper relief until two years later on 31 May 2009 yet the earn-out is likely to be settled in March 2008 and March 2009. We might suggest that for larger option-holders (like Robin in the example) the earn-out is settled in non-QCBs so business asset taper relief can continue to run after the loan notes are issued. This will allow Robin to be fully tapered when he eventually redeems or sells his loan notes.
Earn-out loan notes
The loan notes issued in satisfaction of the earn-out should be non-QCBs (where option-holders will not, by then, be fully tapered) and structured as securities as strictly defined to allow business asset taper relief to continue to run.
Business asset taper relief is available for ‘shares’, the definition of which includes securities and debentures which are deemed to be securities for the purpose of TCGA 1992, s 251(6) (see TCGA 1992, Sch A1 para 22(1)). It is not clear that TCGA 1992, s 132 and s 251(6) combine to treat debentures issued by Acquisition Vehicle in satisfaction of the earn-out as securities for taper relief purposes. The lack of clarity is because the loan notes are issued in satisfaction of the earn-out, not as consideration for the sale of shares in Target.
The leading cases on the meaning of ‘security’ (or, more strictly, a debt on a security) in the context of s 132(3)(b) are Ramsay (WT) Ltd v CIR  STC 174 and Taylor Clark International v Lewis  STC 1259. These are, to a considerable extent, reproduced in HMRC’s Capital Gains Manual at CG53420 to CG53442. The loan note must have an ‘investment quality’ so it must carry a commercial rate of interest (or be issued at a discount or carry a premium on repayment). It must be capable of being realised at a profit so (preferably) it should have a fixed rate of interest. It should not be redeemable within twelve months of issue (unless there is an early redemption penalty) and it should be transferable. The loan notes should not be QCBs within TCGA 1992, s 117 to allow taper relief to continue to run. The most common way a security is caused not to constitute a QCB is to provide for redemption in a currency other than sterling (but so as to restrict any gain due to currency fluctuations so as to prevent the investment constituting a deeply discounted security for the purposes of ITTOIA 2005, Pt 4 Ch 8).
Marren v Ingles and applications for COP 10 clearance
Purchaser may prefer the earn-out to be settled in cash for smaller option holders. Marren v Ingles treatment would apply resulting in the up-front value of the earn-out being brought into charge on completion. This may not be a concern, however, if the gain is absorbed by annual exemptions.
Option-holders should be included in the Code of Practice 10 (COP10) application if their earn-out is settled in shares or loan notes. The application is made to obtain clearance that securities option treatment will not apply to the earn-out. Option-holders participate in the earn-out on the same terms as other shareholders so the conditions in Q&A 5(l) of HMRC’s ‘Frequently Asked Questions on the Taxation of Employment Related Securities’ (available by clicking ), should be satisfied.
One issue which is often overlooked at the heads of terms stage is what happens to the forfeited earn-out. The SPA should say forfeited earn-outs either fall into a ‘pot’ to be distributed to employees as a bonus or revert to Purchaser, it should not be distributed as additional consideration to the remaining vendors (as HMRC will not accept that it is additional consideration for the sale of the shares).
It may be thought that EMI option holders are on a level playing field with existing shareholders, but I hope this article demonstrates that this is not the case. The main difference is that the taper clock re-starts on completion for loan notes issued in settlement of the initial and deferred consideration. There seems no good reason for this and it is hoped that the Government may rectify this anomaly as a consequence of their current review of the EMI legislation.
Colin Kendon is a senior associate in the Employee Incentives and Benefits Group of international law firm Bird & Bird.