Concede labor rights, cut your taxes

George Osborne's idea that employees should give up employment rights in return for receiving shares in their employers has received a frosty response from both mainstream employers and Parliamentary colleagues. This has led many people to write this development off as an irrelevance.

However, now that the UK government has managed to get the necessary legislation onto the statute book, the hunt is on for the situations in which employee shareholder shares (ESSs) will be used in practice. Unsurprisingly, this has meant looking at where the new capital gains tax (CGT) exemption for ESSs will be most valuable.  Attention is now firmly focused on its application in private equity deals for several reasons:

· These transactions rely on high gearing which can give significant capital gains if the company performs well, making the CGT exemption particularly valuable (despite the £50,000 limit on the initial value of the ESSs) – certainly valuable enough for executives to be willing to give up certain employment rights;

·Investors in such deals are committed to motivating senior management through equity participation and will usually be happy to maximize that incentive by ensuring that the management can take advantage of any available tax reliefs; 

· The ESS legislation is sufficiently flexible to enable ESSs to be used in suitable cases without compromising the commercial rationale of the transaction; and

· Senior managers are in a good position to understand fully the risks involved in giving up employment rights.

The CGT exemption is due to come into force in September 2013. Private equity houses will already be eyeing up their deals for the Autumn and should be considering whether ESSs can be incorporated into those transactions. In doing so, there are a number of factors that private equity managers would be well advised to take into account.

In the first place, an essential feature of ESSs is that they are given to the employee solely in return for employment rights being given up – if the employee gives anything else in return for receiving the shares, ESS status will not apply (so that the employment rights are unaffected and the tax benefits are lost). If investors want the senior management to “put skin in the game” by investing some of their own money then care will be needed to in order to structure this correctly.

Lawrence Green

Secondly, there is the need for certainty about the tax treatment of the shares given to senior managers. It is important to ensure that the detail of the ESS legislation is followed and evidence is kept that the shares are worth at least the minimum value of £2,000.

Thirdly, the Memorandum of Understanding (MoU) between the BVCA and HMRC (which governs the valuation of shares bought by management in private equity deals) will not apply directly.  However, in practice it should still be possible to follow the principles of the MoU in order to fix the income tax liability on the acquisition of the ESSs (subject to the first £2,000-worth being exempt from income tax in any case).

Furthermore, the fundamental features of ESSs are that employment rights are given up in return for an award of shares, with the government offering tax advantages to encourage this to happen. If these features coincide with the commercial drivers behind a private equity deal, then using ESSs should not involve reputational risk. However, if these fundamentals conflict with the commercial drivers on a transaction, then shoe-horning the use of ESSs into that transaction may cause problems (either with HMRC or wider public opinion etc.), especially if this becomes a widespread practice.

Finally, the ESS legislation is very flexible but it is possible that some anti-avoidance provisions may be added to the CGT relief as the Finance Bill goes through Parliament. These provisions will need to be considered before any ESSs are actually issued.

So what does the future hold for ESSs? If they are going to be used at all it is clear that the generous CGT relief will be a key factor. That means that use of ESSs will be focused on employees who anticipate paying significant amounts of CGT in the future. If that leads to widespread use of ESSs for senior management in private equity deals, will the government be relieved that the policy hasn't been a complete failure or will it put up barriers to limit the loss of CGT revenue?  Only time will tell.

Lawrence Green is a consultant in law firm Squire Sanders’ global taxation & benefits practice and specializes in structuring management equity participation.