A Practical Guide to Private Equity Transactions
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Tax issues for managers
as consideration for selling shares in Target (for example, on a secondary buy-
out). The effect of the deeming rules is that it is no longer possible to rely upon
the ‘founders’ argument, which historically allowed managers to argue that
their shares had been acquired in their capacity as the founders of Newco,
rather than by reason of employment/directorship.
The potential charges described below refer to the Newco shares acquired
by the managers. However, the provisions are equally applicable to other types
of securities, such as loan notes.
4.1 Tax on acquisition of Newco shares
There is a basic tax charge (known as the ‘general earnings charge’) which
arises whenever an employee or director acquires shares at an undervalue.
25
For example, an employee acquires 100 shares for £1,000 but the market value
of those shares is £11,000. The employee is treated as having received employ-
ment income of £10,000 and will be charged to income tax on that amount in
the same way as if the employee had received any other benet in kind.
This creates a difculty for the managers as the question of whether or not
a charge arises will depend upon the value of the Newco shares and valuation
is not a precise science; thus there is some uncertainty for the managers. It
was partly to address this uncertainty that the HMRC/BVCA memorandum of
understanding (see section 4.4 below) was introduced.
4.2 Restricted securities
The provisions referred to below will apply where the managers’ shares are
‘restricted securities’ for the purposes of the Income Tax (Earnings and
Pensions) Act 2003.
26
Due to the rights which typically will attach to the man-
agers’ shares (such as leaver provisions, restrictions on transfer, pre-emption,
drag along clauses and restricted voting rights),
27
it is almost inevitable that
such shares will be regarded as restricted securities for these purposes.
The effect of the shares being restricted securities is that some part of the
ultimate sale proceeds may be subject to income tax. To determine the amount
which may be subject to income tax, one rst ascertains the value of the shares
at the date the manager acquires them, taking account of all the restrictions (this
is known as the ‘restricted market value’ or ‘actual market value’ (AMV)). One
then ascertains the value of the shares at that date ignoring all the restrictions
(this is known as the ‘unrestricted market value’ (UMV)). If the manager pays
less than the UMV for the shares, then the amount by which he pays less than
UMV is expressed as a proportion of UMV, and upon a sale of those shares a
corresponding proportion of the sale proceeds is subject to income tax.
25 Section 62 of the Income Tax (Earnings and Pensions) Act 2003.
26 Chapter 2, Part 7, of the Income Tax (Earnings and Pensions) Act 2003.
27 As explained in more detail in chapter 5.
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Tax on private equity transactions
For example, if the AMV and UMV of 1,000 Newco shares is £9,000 and
£10,000 respectively. and the manager acquires 1,000 shares for £9,000, there
is no general earnings charge on acquisition (as described in section 4.1 above)
as the manager will have paid the AMV for the shares. However, the price paid
by the manager for his shares represents a 10 per cent discount to the UMV of
those shares. If the manager subsequently sells the shares for £100,000, 10 per
cent of that amount (i.e. £10,000) will be subject to income tax.
Given that the managers’ overall objective will be to acquire the shares
at a low value and to dispose of them at a higher value, it is highly desirable
to avoid an income tax charge on disposal. Broadly, there are two ways in
which to avoid such a charge arising in the circumstances referred to above,
as follows:
(a) enter into a section 431 election (see section 4.3 below); or
(b) pay full UMV on acquisition; thus, in the example above, no income tax or
NIC charge would have arisen on the sale of the shares if the manager had
paid £10,000 for the shares at the outset.
4.3 Elections
The managers have the option of electing wholly or partly out of the restricted
securities regime by entering into a section 431 election. The effect of making
the election in whole is that no part of the ultimate sale proceeds is subject
to income tax under the restricted securities rules described in section 4.2
above. Such election must be made within fourteen days of the acquisition of
the securities, and must be made jointly between the manager and the man-
ager’s employing company. The election is irrevocable and must be made in a
standard format. An election is not submitted to HMRC, but is merely kept for
future reference.
The other main effect of making an election is that, for the purposes of
computing any general tax charge (see section 4.1 above), it is the UMV, and
not the AMV, of the shares which is taken into account. As the UMV will
almost inevitably be higher than the AMV of the shares, this may result in an
income tax charge (or a greater income tax charge) for the manager on acquir-
ing his Newco shares.
Using the example set out in section 4.2 above, if the manager enters into
an election, then he will have a general earnings charge on £1,000. This is
because as a result of making the election it is the UMV (not the AMV) of the
shares which is now relevant for the purposes of determining whether any such
charge arises (and, if so, the extent of such charge). The manager has acquired
shares for £9,000 whereas the UMV is £10,000. As previously, the differential
is 10 per cent. Entering into the election means that the manager has to pay
income tax on that 10 per cent differential at the time of acquisition when the
differential is worth just £1,000 (rather than at the time of disposal when, in
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Tax issues for managers
the example above, the differential is worth £10,000). When the manager sub-
sequently sells the shares for £100,000, the whole of that amount is sheltered
from income tax under the restricted securities regime because of the election.
The whole of the gain will be subject to CGT rather than income tax unless
HMRC can apply certain other provisions (see section 4.5 below).
As will be noted, there are potential downsides to making an election.
First, the initial general earnings charge is calculated by reference to UMV
rather than AMV. Secondly, there is no guarantee that the shares will increase
in value. Should the value of the shares decrease, there is no mechanism for
the manager to reclaim any general earnings charge which arises as a result of
its being computed by reference to UMV. Despite these potential downsides,
it is usual for a well-advised manager to enter into an election. Even if the par-
ties are condent that UMV is being paid on acquisition, it is still advisable
to make an election to prevent any future disputes. Usually, the investor will
require the managers to enter into such elections
28
– the reason being that it
will want to avoid any employers NIC charge accruing to Newco in the event
of a subsequent exit (which would be the case if elections are not entered into,
and the managers pay less than UMV for their shares), as any such charge may
impact the value realised by the investor on an exit.
4.4 HMRC/BVCA Memorandum of Understanding
Following the introduction of the employment-related securities legislation,
there was signicant disquiet as to the uncertainty created by the fact that
immediate and future tax charges depended upon the valuation issues referred
to above. As a result, a Memorandum of Understanding (MOU) was agreed
between HMRC and the BVCA.
29
The MOU introduced certain ‘safe har-
bours’. The effect of falling within a safe harbour is that there is no general
earnings charge for a manager and no income tax charge on an exit under the
restricted securities legislation – this is on the basis that HMRC accepts that a
manager has paid UMV for his shares. Given this acceptance, there is no rea-
son for a manager also to have to enter into a section 431(1) election in relation
to his shares. However, it is invariably the case that a manager will still enter
into such an election as a precautionary measure.
The conditions which must be satised to fall within the MOU are as
follows:
(a) The managers’ shares must be ordinary share capital.
(b) Finance provided by the investor in the form of preference shares or loan
stock must be on commercial terms. This will be the case if the rate of
return is at least as expensive as the most expensive debt provided by a
28 This is often achieved by an express obligation on the managers to enter into such elections
in the investment agreement.
29 Issued on 25 July 2003, also referred to in chapter 3, section 3.1.
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Tax on private equity transactions
non-shareholder (e.g. the senior and mezzanine debt providers). Note that
reference is made to the single most expensive rate, and not a blended or
average rate. Where the nance is in the form of preference shares, the rate
of return is adjusted (for the purposes of determining whether this condi-
tion is satised) to take account of the fact that dividends on preference
shares are not tax deductible for Newco. Generally, any warrants granted
to senior or mezzanine debt providers are disregarded for the purposes of
making the comparison.
(c) Subject to there being no ratchet
30
in place, the price paid by the managers for
their ordinary shares must not be less than the price the investor pays for its
ordinary shares. Where there is a ratchet in place, the original MOU condi-
tion stated that the price which the managers paid for their shares as a propor-
tion of the total amount subscribed for all the equity shares must not be less
than the maximum proportionate share of the sale proceeds which the man-
agers could obtain on an exit. Since the MOU was rst introduced, HMRC
has changed its guidance on this point, so that arguably all that the managers
have to pay is the same price per share as the investor pays per share for its
shares. However, it is generally still the case that transactions where there is
a ratchet will be structured so as to comply with the original guidance.
31
(d) The managers must acquire their shares at the same time as the investor
acquires its ordinary capital.
(e) The managers’ shares must have no features that give them or allow them
to acquire rights not available to the other holders of ordinary share cap-
ital. The exception to this is that it is permissible for a ratchet to apply
in favour of the managers’ shares (without causing this condition to be
breached) provided that:
(i) the ratchet arrangements work by altering the entitlements of the man-
agers according to the performance of Newco or the Newco group or
according to the investment returns of the investor; the ratchet must
not alter the entitlements of the managers by reference to their per-
sonal performance; and
(ii) the ratchet arrangement must be in place when the investor acquires its
shares.
(f) The managers must be fully remunerated as to salary (and bonuses) through
a separate employment contract.
Commonly, the most difcult MOU condition to satisfy is that referred to in
(b), particularly if any mezzanine or other second-tier debt nance is being
provided to Newco as in that case the return on such nance is often relatively
high (and hence the coupon on the investor debt must be correspondingly high).
30 For ratchets, see chapter 3, section 3.2, and chapter 5, section 4.6.
31 Resulting in the structuring implications referred to in chapter 3, section 3.2.
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Tax issues for managers
However, given the certainty offered by the MOU, most investors and man-
agers will always seek to structure a deal in order to satisfy its conditions.
4.5 Potential income tax charges on exit
Sections 4.1 to 4.4 above describe the tax charge that can arise when the
managers acquire and dispose of restricted securities. However, Part 7 of the
Income Tax (Earnings and Pensions) Act 2003 imposes income tax (and pos-
sibly NIC) charges in a far broader range of circumstances such as:
(a) Convertible securities.
32
If the manager shares are convertible into another
class of shares, then on a disposal of such shares (or, if earlier, upon their
conversion or upon the shares ceasing to be convertible), an income tax
charge may apply. Broadly speaking, the income tax charge is levied on the
value attributable to the conversion right (or, as appropriate, on any consid-
eration given for the release of a right to convert or the receipt of money or
money’s worth received in connection with the conversion right).
(b) Securities with articially depressed or enhanced market value.
33
This
applies where the market value of the securities have been articially
depressed or enhanced by more than 10 per cent. It is comparatively rare
for securities with articially depressed value to be an issue in typical
private equity transactions. Where managers hold shares and the rights to
such shares (or to shares held by others) are varied, with the result that the
manager shares increase in value, then a charge may arise under the provi-
sions relating to articially enhancing the value of the manager shares.
(c) Securities acquired on deferred terms.
34
A manager may agree to pay mar-
ket value for shares but defer the payment until some later event. No gen-
eral earnings charge arises for the manager in relation to such arrangement
as the manager is obliged to pay market value for his shares. However, the
amount outstanding is taxed as if it were an interest-free loan from his
employer, with the result that the manager is treated as having an annual
taxable benet in kind equal to a notional interest charge on the amount
outstanding. Further, if the shares are disposed of without the manager
paying the amount outstanding, or if that amount is waived, the manager
will be treated as having taxable income of a corresponding amount. This
provision arises most commonly where the manager shares are issued nil
or partly paid, or their shares are bought on deferred payment terms.
(d) Securities disposed of for more than market value.
35
This is designed to
catch arrangements which give a manager a disproportionate amount of
consideration for the securities being disposed of. Upon a sale of the entire
32 Chapter 3, Part 7, of the Income Tax (Earnings and Pensions) Act 2003.
33 Chapters 3A and 3B, Part 7, of the Income Tax (Earnings and Pensions) Act 2003.
34 Chapter 3C, Part 7, of the Income Tax (Earnings and Pensions) Act 2003.
35 Chapter 3D, Part 7, of the Income Tax (Earnings and Pensions) Act 2003.
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Tax on private equity transactions
issued share capital of Newco to a third party where the manager receives
his strict pro rata share of the proceeds of sale (in accordance with the
rights attaching to his shares), this provision will generally not be relevant.
Examples where it may be relevant include:
(i) on an exit, if the manager, taking into account the rights attaching to
his shares, receives more than that to which he is entitled; or
(ii) the manager sells his shares in advance of the exit (say, under the
leaver provisions common in the articles of association of Newco);
in this case, even if the shares are sold at what is described as a fair
price, HMRC is likely to regard this as exceeding their market value
if the price is not discounted to reect that a small minority holding
is being sold; or
(iii) if the shares are sold to Newco, the investor or any related party, and
the price paid to the manager is not discounted to reect that a small
minority holding is being sold.
(e) Post-acquisition benets from securities.
36
There is a wide-ranging provi-
sion pursuant to which HMRC may seek to tax ‘special benets’ derived
from the manager shares as employment income. The scope of this pro-
vision is unclear: on one reading, it could catch any benet received
from employment-related securities or from their sale. HMRC has tried
to develop arguments that this provision allows it to tax some or all exit
proceeds as employment income rather than capital gain in cases where
it perceives there to be some abuse. Two situations in particular in which
HMRC has suggested that these provisions may apply are where there is a
ratchet or where a company is perceived by HMRC to be thinly capitalised
(i.e. the level of debt compared to equity is high).
HMRC now accepts that, where the MOU applies, there will be no income
tax liability arising under this provision as a result of the operation of the
ratchet. HMRC has not formally accepted that this provision is not applic-
able in situations where the MOU conditions are not satised. However,
HMRC has retreated somewhat from its original stance, although it will
scrutinise a ratchet very carefully to determine whether or not any amount
paid under the ratchet will attract income tax. To minimise the chances of
the HMRC successfully applying this provision in the context of a ratchet,
it is advantageous to structure the ratchet in the manner referred to in sec-
tion 4.4(e), and also to satisfy the condition referred to in section 4.4(c).
4.6 PAYE/NIC
If the managers have an income tax charge upon acquiring their Newco shares,
the question to be determined is whether their employer is obliged to account
36 Chapter 4, Part 7, of the Income Tax (Earnings and Pensions) Act 2003.
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Conclusion
for that income tax through the PAYE system or whether the managers are
liable to pay the income tax through their personal tax returns. If PAYE is
applicable, then NIC (both employers and employees) will also be payable.
Generally, there will be an obligation upon Newco to apply PAYE and NIC
if the shares are ‘readily convertible assets’.
37
For these purposes, shares will
be readily convertible assets if:
(a) they can be realised upon a recognised investment exchange (i.e. broadly
where they are listed shares) or there are trading arrangements in place (or
which are likely to come into place) in relation to the shares (e.g. an internal
market or other mechanism through which the shares can be bought and
sold); or
(b) the conditions which must be satised for the employer to secure a corpor-
ation tax deduction under Schedule 23 to the Finance Act 2003 in respect
of the managers’ acquisition of shares are not so satised.
If an income tax charge does arise, and the employer is obliged to account for
any income tax through PAYE, the obligation on the employer is to pay the
‘best estimate’ of any PAYE due.
38
It is possible, once the shares have been
acquired by the managers but before the PAYE is due, to agree the value of
the shares for PAYE purposes so that the employer can discharge its PAYE
obligations. This valuation does not bind HMRC, in that if it later comes to a
different view of the valuation it can seek to obtain further income tax from
the managers.
If any PAYE is due from the employer and the manager does not reim-
burse the PAYE to the employer within ninety days, an amount equal to such
PAYE will itself be taxable as a benet in kind and attract further income tax
and NIC.
39
If the managers reimburse the employer after the expiry of the
ninety-day period, such benet in kind charge stands notwithstanding such
reimbursement.
If the managers are liable to any of the other income tax charges referred
to in section 4.5, it is likely that most will arise in circumstances requiring the
employer to account for such income tax through PAYE (and thus for NIC to
also be payable).
5 Conclusion
Since 2003, there has been a signicant amount of change in the tax regime
applicable to private equity investors and their investments. As a result of
the buyout boom, and the subsequent credit crunch and economic down-
turn, there has been a particular focus upon the taxation of the returns paid
37 Section 702 of the Income Tax (Earnings and Pensions) Act 2003.
38 Section 696(2) of the Income Tax (Earnings and Pensions) Act 2003.
39 Section 222 of the Income Tax (Earnings and Pensions) Act 2003.
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Tax on private equity transactions
to private equity executives under carried interest and co-investment schemes.
The replacement of the historic taper relief regime with a at CGT rate was,
in part, a response to the widespread media coverage of the 2007 Treasury
Select Committee – and in particular the headline-grabbing comments that
private equity executives were paying a lower rate of tax than their cleaners.
The amount of debt within private-equity-backed investee companies has also
resulted in many such companies paying little or no corporation tax on prots,
and the extension of the transfer pricing rules referred to above is an attempt to
address a number of concerns raised in that context.
With the private equity industry continuing to be the focus of much polit-
ical comment on a UK, European and worldwide basis, it seems inevitable that
the taxation of the industry and its investments will continue to be scrutinised,
and that there will be further changes in what is already a complex area.
285
10
Public-to-private transactions
1 Introduction
In this chapter, we will look at the specic issues relevant to a public-to-private
(also often referred to as a ‘take private’) transaction. A public-to-private trans-
action involves the acquisition by a private-equity-backed vehicle of a public
target company (which we will refer to in this chapter as ‘P2P Target’), and as
a result combines the features of a traditional private company management
buyout with the structural and regulatory requirements of a public company
takeover.
In this chapter, we explore some of the particular features which are inherent
in such a structure, and the ways in which the private equity and bank fund-
ing documents need to adapt to suit the particular requirements of this type of
transaction. Other features common in a public bid (for example, the absence of
warranties beyond title and capacity) can create challenges for the typical private
equity investor. There can be reduced access for the purposes of due diligence,
and the regulatory framework and timetable in which a public offer must be
made in the United Kingdom has caused such deals to be an increasingly differ-
entiated part of a private equity offering (in the sense that some houses are better
equipped, and experienced, to complete them than others). However, with appro-
priate consideration, they can afford excellent opportunities to private equity
investors looking to acquire good businesses with strong management teams.
This chapter highlights the key issues which are likely to arise, and which
should be appreciated by the private equity investors and the P2P Target man-
agement team from the outset. The chapter is split into three sections:
(a) the issues which are specic to public-to-private transactions;
(b) a brief overview of some of the key takeover rules relating to public takeo-
vers; and
(c) specic issues in relation to the funding to be provided to the Bidco mak-
ing the offer.
Much of the content in this chapter relates to the issues on the assumption
that the transaction is structured as a public offer. However, in recent times,
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Public-to-private transactions
public-to-private transactions have also been effected by way of a scheme of
arrangement which is considered in section 3.8 below. This chapter does not
set out a full discussion of all the issues involved in a public offer in the United
Kingdom, but it does highlight the particular considerations which affect pri-
vate equity as the funders to Bidco.
2 Issues specific to public-to-private transactions
2.1 The City Code on Takeovers and Mergers
As with all public company takeovers, the City Code on Takeovers and Mergers
(‘the Takeover Code’), as applied by the Panel on Takeovers and Mergers (‘the
Takeover Panel’), will regulate the conduct of the transaction.
The Takeover Panel will provide guidance on the application of the
Takeover Code to the advisers to the private equity investors, Bidco and P2P
Target itself, each of whom will liaise closely with the Panel to ensure that
the structure and conduct of the transaction is consistent with the Takeover
Code. The Takeover Panel has statutory powers and can apply to the court for
enforcement of the Code.
2.2 Conflicts of interest
Those directors of P2P Target who will form the management team of the new
group going forward must rst deal with their existing responsibilities to P2P
Target. Specically:
(a) as a director, each has duciary duties, including a duty to promote the
success of the company for the benet of its members as a whole;
1
and
(b) as an executive, each has obligations to P2P Target under an employment
contract.
There is an inherent conict of interest for the P2P Target directors who will
be participating in the proposed offer. For example, the directors of P2P Target
will be obliged to secure the best price for their shareholders before deciding
to recommend any offer to their shareholders, which will be in direct con-
ict with the interests of the private equity investors and Bidco in obtaining
control of the company on the most attractive terms practicable. Many of the
issues discussed in this chapter stem from the need to recognise, and man-
age, that conict and to prevent any suggestion that a conict of interest has
inhibited the directors of P2P Target from acting in the best interests of its
shareholders.
In dealing with the conict of interest in this situation, public appearances
are particularly important. Not only must everybody act properly in relation to
any conict, they must be publicly seen to do so. Any perception in the market
1 See further chapter 11, section 6.4.