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. 

2. 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”.

3. 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. 

Unfortunately, more often than not, this is a typical “Chapter 3D” case where, in the absence of a more formal structuring, a proportion of the proceeds paid is likely to be subject to PAYE and NIC and not capital gains tax. Of course, it will depend on the facts and circumstance, but commonly, a substantial minority discount should be applied for the purposes of calculating market value for tax purposes.

4. Shares prior to an exit event

There may be unallocated shares for the Management team (either unissued or sat within a warehouse such as an Employee Benefit Trust) that need to be allocated prior to an exit event. 

HMRC are beginning to challenge acquisitions of shares near a realisation event. HMRC will challenge the upfront valuation of the shares if significant returns are made in a short timeframe. Occasionally, HMRC has even challenged the “best estimate” position even where the employer obtained third party valuation advice. 

However, early discussions about unallocated shares could assist in such matters. Shares should be issued as soon as possible as the UMV is likely to be lower than close to an exit event. Alternatively, the Group may decide that a cash bonus plan is simpler to communicate to the Management team. 

5. Founder shares 

In relation to founder shares, there are a number of problems that can arise. HMRC specifically issued a statement that founder shares fall within employment-related securities (“ERS”) legislation which can impose employment tax charges on the acquisition, holding and disposal of shares. 

Generally, there is no issue with founder shares because the price paid (even nominal value) for shares in a shell company must be at least the UMV. 

However, what happens if you are not the founder of the business itself, just the company? What if you transferred over from a pre-existing business that was founded by someone else? Have you still paid UMV? 

What if your shareholding changed from incorporation and then increased (e.g. you subscribed for further shares after you brought in a new employee shareholder)? What did you pay for those shares? 

Just because “you acquired your shares years ago” doesn’t mean there is no issue. Advisors will check through every acquisition of shares you currently hold as a minimum and you need to be prepared to face these questions. 

6. Enterprise Management Incentive (“EMI”) plan

EMI plans are by far the most common HMRC ‘approved’ plans. Yet, when working on a due diligence, an EMI scheme requires careful scrutiny. There are many potential problems with EMI plans, and it is important that management is prepared for the possible taxes they could pay. There is a big difference between being told you are paying tax at 10%, instead of being subject to tax and employee NIC at 47% (plus employers NIC at 13.8% and potentially apprenticeship levy at 0.5%). 

Given the significant tax at risk (and the communication needed to Management if they are not qualifying for EMI options), many bidders have asked targets to seek clearance from HMRC on aspects of their EMI scheme. These have included a business that operated in an area that falls within “excluded activities”, performance targets that have been amended, companies that did not register the plan with HMRC and/or cannot locate the notification of grants.

As an approved plan, perhaps the target management team do not consider much review is needed. However, presentation is key, especially when plans come with specific tax advantaged status.  

7. ERS annual share plan reporting (formally known as Form 42)

It is quite surprising how many target management teams fail to provide evidence that the annual share plan reporting has been done despite being sure they have completed it on a timely basis (i.e. by 6th July each year). What is the problem with this? The HMRC portal doesn’t allow you to see the excel spreadsheet you uploaded again. Therefore, you need to ensure that you have saved it somewhere before uploading it to HMRC. 

The due diligence team will ask for copies of annual ERS returns and if you cannot confirm when you submitted it, it will make it into the report despite the immaterial late filing penalties. However, penalties for inaccuracies can get hefty (£5,000 per error) and although we haven’t seen many of these being levied by HMRC it is advisable to make sure all annual returns have been submitted and copies retained on file. 

8. Do you know your waterfall? 

Unintended economic consequences can happen - this is the challenge with a very complicated waterfall (e.g. multiple growth shares with multiple metrics for the hurdle). Even with careful modelling and drafting on implementation, it is not necessarily easy to predict the future when your variables include restructuring, material capital contributions and/or distributions.  

It is always advisable to do a fresh modelling of the economics prior to the journey to an exit event. 

Key takeaways

The due diligence process is time consuming and occurs when the pressure is at its peak. These steps take you through the potential problems you may come across when preparing for the gruelling process to alleviate some of the stress. When the hundreds of questions come through, it is easy to overlook certain details. The right preparation (that requires time) will enable you to present your workings in the most appropriate way. A clear presentation of answers and documents are key. If it’s messy, the questions will only increase. 

If presentation isn’t the only issue, it is far better to resolve these and avoid having issues uncovered during a formal due diligence process. 

How can we help?

If you are considering an exit in the foreseeable future, we would recommend that you consider the issues flagged above.

With extensive experience in due diligences, A&M Taxand is aware of what questions and issues are likely to be raised. We can assist in all points noted above prior to the commencement of an exit process which can ensure that matters are resolved outside and well in advance of the pressurised environment of a formal due diligence process. 

For more information regarding our ‘Reward & Employment Tax Solutions’ please click here.