The recent Office of Tax Simplification ('OTS') report considering capital gains tax ('CGT') contained a chapter on "Boundary issues" – the issues associated with characterising something as income or capital, so as to determine how it is taxed. This chapter mentions the tension created by employment incentive arrangements in which the participator is treated as receiving something which might otherwise be earnings (and subject to income tax and NICs) as a return on capital investment, and so subject to CGT rates. The discussion considers, in particular, share schemes and certain types of shares, such as growth shares.
The OTS report does not mention any particular business sector, but in practice, senior management in PE backed businesses are often incentivised using such arrangements. If the Treasury is to increase the tax take to fund the cost of COVID, equalisation of income tax and CGT rates is a possibility. Where would this leave individuals whose incentivisation is predicated on receiving something taxed at CGT rates?
Growth shares are designed to benefit only from increases in the company's value from their date of creation or possibly a future date. Assuming the shares are negligible value when acquired, there will be no or negligible income tax and NICs to pay upfront, or the individual may pay the market value (typically low) in which case there is no tax charge. On disposal, the difference between the sale price and the amount paid on acquisition is taxable to CGT.
This is preferable to a performance related cash bonus on exit which attracts income tax and NICs, although the employer may obtain corporation tax relief. A phantom share scheme is, in effect just like cash bonus – the shares are not actually issued and a payout is calculated by reference to what the return would have been on shares had equity been given. However, such schemes are relatively uncommon because although the commercial effect is the same as for growth shares, the taxation onerous.
The OTS report also mentions unapproved share option schemes. Such shares would vest on exit and yield value subject to certain targets being reached. However, given their unapproved nature the difference between the market value at exercise and value of the option when acquired is subject to income tax and NICs, although the employer may get corporate tax relief. Most private equity backed structures cannot meet the conditions enabling them to provide approved option schemes.
Where does the OTS report leave share incentivisation?
The OTS report says that
"If share ownership has the positive effect envisaged, one might expect businesses to continue to support it even if the income or gains arising were taxed in the same way as other forms of remuneration. After all … share schemes can be an important part of a balanced employee reward package, so are salaries and bonuses – which are taxed at the normal income tax and NICs rates." "One respondent told the OTS that if tax rates were harmonised then mechanisms such as growth shares would not be used at all, and another senior tax practitioner said the boundary leads to a lot of fancy foot work and machinations, which suggests that the tax position is key here."
It's important to differentiate between share incentive arrangements remaining within the CGT regime, where CGT rates rise in line with income tax, versus the risk that they might be treated as income and, in fact, subject to both income tax and NICs. There could therefore continue to be advantages associated with shares which benefit from CGT treatment. Arrangements which fall within the CGT regime still means:
- no NICs, which will be a significant advantage for employers in particular, who pay 13.8% employer's NICs;
- improved cash flow, since CGT is often paid by taxpayers sometime after the end of the tax year in question, although this might be balanced by the fact that it may not be necessary to pay up front for securities; and
- the calculation of the charge will be based on the growth in the value of an asset from its original acquisition, so not all of the amount received will be subject to tax.
Perhaps personal holding companies could be used by management so that the return on their shares is subject to corporate tax rates. However, creating such a structure needs careful planning, it relies on corporation tax rates not increasing generally or more specifically for such personal companies, and if access is needed to value from the personal holding company, the dividend will be a further layer of tax. Also, such companies could be within HMRC's sights when reviewing how structures are used to mitigate tax.
In practice, whether the form of incentivisation needs to be or, indeed, can easily be re-structured because it becomes subject to higher rates of tax will depend on whether an alternative would make any material difference to the economics. However, if the increase in CGT rate is say to 28% this will be an increased "cost" but at least there will remain a material saving and, thus some incentive. Equally, we could see CGT increase for only certain types of taxpayer (as we previously saw with the increase in CGT rates for owners of residential property and carried interest) and those taxpayers may well await Rishi Sunak's next Budget with some anxiety. For them, forward planning may be the key to mitigating the impact of any changes.