Publish Date

Dec 05, 2019

Tax Health Check – Is Your Management Equity Plan Ready to be Scrutinized Under a Due Diligence Process?

Tax Insights

One of the most effective ways to incentivise a business’ senior executive team is a Management Equity Plan (“MEP”) which can be as simple as the acquisition of ordinary shares in a non-leveraged structure to a complex growth-share plan in a highly leveraged structure.

Due to the well-structured, sophisticated legislation that we have in the U.K., there is a high level of certainty in terms of its taxation treatment, which in turn boosts the incentive element of the MEP. For example, the attachment of leaver provisions is standard market practice and helps businesses retain their best managers. This is why MEPs work in the U.K. and are so popular. 

However, there is a downside. MEPs are under scrutiny in any due diligence process (whether sale or IPO) and the level of scrutiny has intensified over the years. The sophisticated legislation surrounding MEPs also entices errors and complexities which could lead to unintended tax consequences such as a significant proportion of the sale proceeds being fully subject to PAYE and NIC (including apprenticeship levy, if applicable), rather than capital gains tax treatment. An exit process is a busy and stressful time, therefore a pre-transaction health check into a MEP offers significant advantages. In what follows, we tell the story of very common issues that often could have easily been solved prior to a due diligence.

  1. The lack of section 431 elections

This will be the first key document any advisor on a due diligence will seek to obtain. This piece of two-sided paper that sits on people’s file is the most critical document. Why? Because it helps ensure that all proceeds on a market value disposal of Management’s equity is not subject to PAYE and NIC (but rather fall within the more beneficial capital gains tax regime).

However, a document that should have been made within 14 days of the acquisition date can be misplaced easily (especially as it doesn’t get filed with HMRC). Without this election, the due diligence risk increases even where valuation work was undertaken at the time the shares were acquired.

It is critical that these are checked and are ready to hand over to the due diligence team. In the event of a permanent misplacement of a 431 election or if it was never made, work can be done to review the tax position and prepare for the due diligence process and the inevitable questions that will arise.

  1. Ambiguity on the valuation position on the acquisition of the MEP shares

The second document an advisor will ask for during a due diligence process is a copy of any valuation work undertaken at the time of acquisition. The valuation work is to support the unrestricted market value (“UMV”) (i.e. the market value ignoring any restrictions for U.K. tax purposes). The valuation is subject to more uncertainty since the abolishment by HMRC of the post-transaction valuation check (“PTVC”) especially where equities are issued in a waterfall behind debt issuance. Advisors on a due diligence may not necessarily review the valuation report in great detail but they will look at the work undertaken to review if a forward-looking methodology has been utilised which is the basis upon which HMRC now usually expect these valuations to follow.

This is often a surprise element. An employer has obtained a valuation report from a third-party advisor and yet the other side is not convinced and adds the acquisition of shares under the MEP onto the pile of issues “to be discussed further”.

  1. Fair market value paid to a departing manager

An individual that falls within “good leaver provisions” or was deemed to be a good leaver by the discretion of the Board are generally paid fair market value (ignoring any discount for minority shareholding). These are also often set out in the Articles of Association of the company. Where a value includes the term “fair”, it may be natural to assume that there are no adverse tax implications…