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Coronavirus - Private equity and the pandemic: The future of management incentivisation – Global

  • United Kingdom
  • Coronavirus - Tax issues
  • Corporate



Lockdown and forced home-working has had strange effects on people in different ways. The Times this week reports that bizarre online purchases have boomed with coffins, gazebos for apartment owners, mountain bikes and giant purple elephants topping the list. With the majority of purchases occurring between 7 and 10 at night, alcohol may explain some of this but it is possible that some of these purchases have been made the instant home-workers clock off from their day job.

As my 13 year old son has only had limited online schooling which swiftly transitioned into a (very) long holiday period (roll on September), to get him off the X-Box and Amazon, I persuaded him to help me devise a game of snake and ladders with a twist, it is based on tax rates going up and down!

Over the last twenty years, I have seen different attitudes from investors, management teams, HR directors, finance directors and GCs on how to approach incentivisation. As you would expect, this depends entirely on the point of view of the person you are talking to and their attitude to risk and complexity. The days of paying management teams in gold bars, carpets, fine wine and platinum sponge in an attempt to save tax disappeared right at least 18 years ago. However, attempts to mitigate tax have not gone away and for so long as there is an arbitrage between income tax rates and capital gains tax rates, it will not go away. Managers in particular remain convinced that they can pay less tax if they work for a PE portfolio company and whilst this may be true in certain cases, inevitably, this comes at some upfront cost and/or risk which they had not appreciated.

Notwithstanding the fact that tax may be a driver of the structure of incentivisation programs, in my view, the key driver must be the commercial objectives. It may seem obvious and it certainly seems obvious when writing this as a statement but, in my experience, regardless of the type of business, at least one party to the discussions on incentivisation arrangements will be allowing the tax outcome to drive the discussion. The discussion should and must be different depending on at what stage of the lifecycle of a business the discussions are taking place. What works at the time of an MBO will be very different to what works one or two years down the line and will be very different to what works a year out from Exit. What works for incentivisation of the management team of a bolt-on business may and should be very different to what is appropriate at other levels of the business. Finally, what works in the UK is quite possibly hugely different to what works in other jurisdictions. And then something like COVID comes along and disrupts everything. Or does it?

Back to tax snakes and ladders. The game is very simple. The board looks like a regular snakes and ladders board but you go up ladders and down snakes depending on whether you can come up with a higher or lower tax rate. Double points are scored for being able to apply a tax relief. Needless to say, I was not allowed to use Google but my son was (on an iPhone bought for him a few months ago at 7:01pm on a Monday evening).

We started with income tax and my son was pleasantly surprised to discover that his pocket money would not be taxed. He was quite distressed though to find out that his father might be paying tax at 45%. I started explaining how National Insurance works but gave up pretty quickly as the concept of weekly earnings was rather confusing although he quite liked employer’s NICs for its simplicity and was happy that UK social security charges were so much lower than those in continental Europe. I touched on pension tax relief but given that no one really understands it and it changes as frequently as we have an election, we moved on very swiftly.

He liked VAT for its simplicity but thought it was too high. He definitely did not like inheritance tax. I explained that the Chancellor was thinking of introducing a wealth tax which horrified him. Then we got onto Insurance Premium Tax – he thought this was cheap but I explained he would need to pay this for the insurance for his new rabbit (purchased on his new iPhone at 7:01pm on a Tuesday evening) and he was less impressed.

He kept asking about Eat Out to Help Out and whether that meant tax rates may go up and how EMI tax relief may be impacted by furlough arrangements given the requirement for employees to work a full week to qualify. On this latter point, he quickly spotted that tracking what employees were doing when they were working remotely would make my job of undertaking due diligence on whether EMI options at target companies qualified for tax relief incredibly difficult and wondered whether this would mean I would be spending longer in the office as a result. I explained that a majority of EMI option arrangements were implemented so badly that few satisfied the requirements in any event.

We then got onto capital gains tax. He couldn’t believe that the rate was only 20% and when I explained the various reliefs which were available (and a brief history of the reliefs including indexation, taper relief, Entrepreneur’s Relief, Business Asset Disposal Relief, Employee Ownership Trusts etc.) his eyes glazed over. He was though impressed by potentially achieving a 10% rate of tax but hopes were dashed when I explained this now only applied to the first £1m. I reminded him of the infamous headline from 2007, just a few months before he was born when Nicholas Ferguson sparked controversy when he said it was "unfair" that highly-paid executives in his industry pay a lower rate of tax than a cleaning lady. He wanted to know how to achieve this. We then started on acronyms: TCGA, MOU, BVCA, ICTA, CTA, ITA, IHT, EBT. But he fell asleep.

Clearly, the Government is going to have to plug the hole it is creating by spending its way out of the current crisis. A review of capital gains tax has been commissioned and we expect to hear the outcome in October this year. It is considered unlikely that this will result in significant changes but some tinkering may result. If there are changes, this is likely to impact on how incentive arrangements are structured. If rates of income tax and CGT are aligned (which is unlikely), the focus may switch again to cash. Cash has advantages in its simplicity and flexibility but some of the most complex incentive plans I have worked on are pure cash plans. Whilst cash may attract an unwelcome tax outcome, the cost to investors in the form of employer’s NICs should be counter-balanced by the ability to secure a corporation tax deduction.

The Pandemic is having a number of immediate impacts in the area of management and employee incentivisation. Valuations are perceived to be lower. In certain industries such as retail and leisure wholesale rethinks in how to make the business sustainable, or even simply survive, is resulting in switches in management teams and resulting in some excellent talent looking for a new role. Equity is being re-cut and re-shaped and debt is being restructured. In some cases, work done as recently as last year to introduce complex share incentive arrangements has been ripped up and new arrangements are being introduced.

Most PE investors take a majority equity stake in their portfolio companies. As a result, any liability to income tax arising at the time of award of shares to managers will be due under PAYE, and NICs will arise. The valuation of shares from a PAYE perspective is always complex and it is generally perceived that valuations in certain sectors should currently be very low with the result that new share awards can be made with little or no income tax cost. Some of this perception is driving new incentivisation structures. However, this may be a mistaken belief. Depending on when awards are being made in the Company’s lifecycle, and depending on the type of award which is made, it may be incorrect to look at the value today given that an expected returns valuation model should be applied; on the basis that valuations are expected to recover by the time of an Exit, the valuation of manager shares may not be as low as is perceived.

The likelihood is that the use of shares as an incentive tool will remain and there may be little by way of change in the available menu of alternative ways of incentivising managers in a PE portfolio company. Sweet equity, growth shares, jointly owned shares, share options, restricted stock and other structures intended to mitigate the upfront cost of manager shares are likely to remain relevant for the foreseeable future. Over the course of history, there has traditionally been a gap and usually a significant gap between income tax rates and capital gains tax rates and even if this gap is narrowed for a few years, to remain competitive and to promote entrepreneurism, the UK needs to have an attractive tax regime and continued tinkering around the edges is to be expected.

Next week in our final article in the series Ceri-Ann McGraa will be tackling restructuring considerations including accelerated M&A and redundancy considerations.