PLC - Private Equity - Overview

Question 1

How is private equity defined by the BVCA?

Answer 1

Medium to long term finance provided in return for an equity stake in potentially high growth unquoted companies.

Question 2

When is venture or seed capital provided?

Answer 2

At the start of a business

Question 3

When is development capital provided?

Answer 3

This is funding for an existing business to help it develop and expand

Question 4

What is a buyout that involves a high level of debt to equity funding often referred to as?

Answer 4

A leveraged buyout

Question 5

Shares issued in return for venture capital usually carry what?

Answer 5

Preferential rights

Question 6

What are the three key tax issues for management who are participating in a funding round by way of a subscription for shares?

Answer 6

Whether they are entitled to income tax relief on borrowings to fund the equity investment, whether the shares acquired are within the income tax or CGT regimes, and whether the EIS or SEIS is applicable.

Question 7

Do overdraft or credit card debts count as ‘loans’ for the purposes of obtaining tax relief on borrowings by managers to fund equity investments in a company?

Answer 7

No

Question 8

What must a loan be applied for in order for a manager to obtain tax relief on borrowings to fund equity investment in a company?

Answer 8

Ordinary shares in a close company (the company can cease to be close after the investment is made).

Question 9

Does a company have to be resident in the UK for managers to obtain tax relief on borrowings to fund an equity investment in that company?

Answer 9

No; from 6 April 2014, companies resident in the EEA can be ‘close companies’ for these purposes; see ss13-14 FA 2014.

Question 10

In order to obtain tax relief on borrowings to fund equity investment in a company, what must that company do in all periods in which interest is paid?

Answer 10

The company must exist wholly or mainly for the purposes of (a) carrying on a commercial trade or of (b) holding shares in, or securities of, or making loans to trading companies.

Question 11

To obtain tax relief for the interest on a loan to acquire an equity investment, what level of interest must a manager have in the relevant company at the time the interest payments are made?

Answer 11

They must have direct or indirect control of more than 5 per cent of the OSC in the company.

Question 12

To obtain tax relief for the interest on a loan to acquire an equity investment, must a manager hold some OSC in the relevant company?

Answer 12

Yes

Question 13

To obtain tax relief for the interest on a loan to acquire an equity investment, what work must a manager do in relation to the company and when?

Answer 13

They must spend the greater part of their time in the actual management or conduct of the company during the period from the subscription to each payment of interest.

Question 14

Is tax relief available to a manager for the interest on a loan to acquire an equity investment if the interest on the loan is ‘excessive’?

Answer 14

No

Question 15

Is tax relief available for the interest on a loan to a manager to acquire an equity investment if investiors are guaranteed to make a profit from arrangements including a relevant loan?

Answer 15

No; relief is only available for genuine commercial investments.

Question 16

Is tax relief for interest on loans to managers to acquire equity investments limited by the cap on income tax reliefs which has effect from 6 April 2013?

Answer 16

Yes.

Question 17

How are shares treated for tax purposes where they are acquired by a manager as part of an equity stake?

Answer 17

Subject to one exception for personal and family relationships, the shares are employment-related securities and fall within the income tax regime in Pt 7 ITEPA 2003.

Question 18

Which ERS rules affect private equity subscriptions in particular?

Answer 18

The restricted securities regime in Chapter 2 of Part 7.

Question 19

What are ‘good and bad leaver’ restrictions in relation to shares for which managers subscribe in private equity transactions?

Answer 19

The shares are forfeited for full market value in relation to ‘good’ reasons (ill-health, redundancy) but only for the subscription price for bad reasons (ie not a good reason) and are restricted securities for the purposes of ITEPA 2003. Forfeiture for misconduct is not within those rules though.

Question 20

Does a lock-in period in equity subscriptions of managers in private equity deal trigger the ITEPA Part 7 restricted securities regime?

Answer 20

Yes.

Question 21

If a share has no voting or dividend rights, does that fact by itself mean the share is a restricted security?

Answer 21

No; without more it is simply a different class of share.

Question 22

What effect must a restriction on shares have in order to trigger the ITEPA restricted securities regime?

Answer 22

It must depress the market value of the shares.

Question 23

What is the effect of the ITEPA restricted securities regime?

Answer 23

An income tax charge and possibly NICs may arise on the acquisition, lifting or variation of the restrictions and on the disposal of the shares.

Question 24

How is any income tax charge calculated pursuant to the ITEPA restricted securities regime?

Answer 24

By reference to the portion of the share value that has not been paid for or subject to income tax and the UMV of the share at the time of the relevant taxable event (ie the market value ignoring all restrictions that depress that value).

Question 25

How can managers avoid post-acquisition income tax charges on restricted securities?

Answer 25

The manager can pay full UMV when the shares are acquired and a s431 ITEPA 2003 election is entered into whereby the manager pays income tax on acquisition on the difference between the price paid and the full UMV.

Question 26

How can a manager be sure that full UMV has been paid for the acquisition of restricted securities in order to potentially avoid an income tax charge on disposal?

Answer 26

HMRC accept full UMV has been paid if the manager complies with the conditions set out in the HMRC/ BVCA Memorandum of Understanding.

Question 27

Why are section 431 ITEPA elections generally entered into by managers as a precautionary measure in relation to restricted securities?

Answer 27

It limits any further income tax and NIC liabilities to the difference between the price paid by the manager and HMRC’s own calculation of UMV on acquisition.

Question 28

What is the key benefit of EIS relief?

Answer 28

Any gain made on the disposal of EIS qualifying shares is exempt from CGT.

Question 29

Why are private equity investors rarely able to obtain EIS relief?

Answer 29

EIS relief is denied to any person who, in the two years before subscription and three years after, is connected with the investee company.

Question 30

How can private equity investors satisfy EIS relief criteria by not being ‘connected’ with the investee company?

Answer 30

Apart from being a director, they must have no other connection with the company (including being involved in the company’s trade) and they must only receive ‘reasonable remuneration’ for their services.

Question 31

If EIS relief is available for investors, will income tax relief for interest payments also be available?

Answer 31

No.

Question 32

What is the qualifying period for CGT on SEIS qualifying shares?

Answer 32

Three years

Question 33

Can an investor be a paid or unpaid director of an SEIS company and still obtain relief from CGT on SEIS qualifying shares?

Answer 33

Yes

Question 34

What is ‘Employee shareholder status’?

Answer 34

In the absence of a s431 ITEPA election, the NIC and IT-free grant of at least £2000 worth of shares in their employer (or a parent company of their employer) in return for giving up some employment rights (inc. UD, statutory redundancy payment). Shares worth less than £50k on acquisition are also free from CGT.

Question 35

Why are EMI, EIS and SEIS reliefs often not available in the context of venture-capital backed investments?

Answer 35

Because the investee company usually fails the independence requirements of those reliefs due to the involvement and control of the corporate general partner.

Question 36

What are the three main tax benefits for Enterprise Management Incentive option holders?

Answer 36

No income tax/ NICs on grant of the option.

No income tax/ NICs on exercise if exercise price was mv when granted.

Entrepreneurs relief on exercise of EMI options on or after 6/4/13

Question 37

What is the significance of SME status?

Answer 37

SMEs are exempt from the UK transfer pricing regime and they are entitled to R&D tax relief.

Question 38

An SME has fewer that [ ] members of staff (including employees, owner-managers, secondees and partners).

Answer 38

250 (doubled to 500 for R&D relief)

Question 39

An SME has an annual turnover of less than EUR [ ] or a balance sheet total (ie gross assets) of less than EUR [ ].

Answer 39

50m (doubled for R&D relief)

43m (doubled for R&D relief)

Question 40

Why do SMEs risk failing the relevant SME tests when owned by venture capitalists?

Answer 40

Where there is extensive control and ownership a proportion of the parent can be included in determining whether the relevant tests are satisfied.

Question 41

What are the three transactions involved in a management buy-out (MBO)?

Answer 41

Establishing the acquisition group, financing the acquisition group and acquiring the target.

Question 42

Why is a double Newco structure often used in an MBO?

Answer 42

To separate the management interests from the debt finance vehicle.

Question 43

On what basis can companies recover input tax on supplies made to them relating to equity or debt finance?

Answer 43

Recovery in principle is based on their residual input tax rate, ie as a general business overhead (Kretztechnik AG v Finanzamt Linz [2005] 1 WLR 3755) except to the extent that such costs flow through to non-economic activities.

Question 44

Do the UK’s VAT grouping rules contravene EU law by permitting non-taxable persons to be members
of a VAT group?

Answer 44

No. The CJEU has confirmed that Article 11 of Council Directive 2006/112/EC does not require members of a VAT group to be taxable persons, either on its wording or in light of its context and objectives.

Question 45

Are companies that grant share options or award shares to their employees entitled to a corporation tax deduction?

Answer 45

Yes; provided certain conditions are met, such companies are automatically entitled to a corporation tax deduction under Part 12 of the Corporation Tax Act 2009. The amount of the deduction is, broadly, the difference between the price paid for the shares and the market value of the shares on acquisition (which in turn gives rise to a corresponding tax charge for the employee). [There are special rules for the acquisition of restricted and convertible securities.]

Question 46

What is a performance ratchet?

Answer 46

A performance ratchet is often a complex algebriac formula found in a Private Equity Newco’s articles of association). The ratchet usually operates in favour of management so that the private equity fund’s shareholding ratchets down by the conversion of some of their shares into shares with no economic rights if performance targets are met.

Question 47

Does any additional income tax liability arise due to a normal performance ratchet being attached to a manager’s stake in a private equity structure?

Answer 47

Of itself, no.

Question 48

What is a secondary MBO?

Answer 48

In a secondary MBO, the original private equity fund and the management team (who are the owners of the business) dispose of a
group (including the old acquisition group and original target) (Target) to a team led by its existing management team with funding
provided by a new private equity fund. In essence, a secondary MBO is a buyout of a buyout.

Question 49

How do QCBs, CGT and Entrepreneur’s Relief interact?

Answer 49

The manager can elect to treat the receipt of QCBs as a disposal of the Target shares and claim ER on the gain. However, if the manager makes no election, the gain is held-over until a disposal of the QCBs but the full amount of the gain (rather than an amount which is first
reduced by the relief) is taxable at up to 28% (section 169R, TCGA 1992).

Question 50

How does a share-for-QCB exchange now put a vendor in the same position as a share-for-non-QCB exchange?

Answer 50

In both cases, the vendor must choose between (1) taking loan notes to hold-over the gain (QCB) or defer the gain (non-QCB) (but seeing it taxed later at up to 28%) and electing to treat the exchange as a disposal of the shares and (2) claiming entrepreneurs’ relief for any gain (then having to fund the capital gains before receiving cash from the loan note redemption).

Question 51

What are the potential disadvantages of receiving QCBs?

Answer 51

(1) If the issuing company fails to repay the notes, the manager gets no tax relief for the bad debt.
(2) It is not possible to effect a subsequent roll-over of the gain, even if the loan notes are exchanged for further shares or loan notes.

Question 52

What can an earn-out sometimes be construed by HMRC as constituting?

Answer 52

Disguised remuneration which must be taxed as income (where the managers continue to be employed in the business going forward), rather than further consideration for the disposal of Target shares (in which case it is taxed as capital).

Question 53

What is the problem with interest paid by way of payment-in-kind or ‘PIK’ notes?

Answer 53

While the PIK notes give rise to a cash flow advantage to the borrower while allowing it to claim a corporation tax deduction for the interest “paid”, for individual taxpayers, receiving PIK notes is disadvantageous. The issue of a PIK note is treated for tax purposes as payment of the interest, so taxpayers other than basic rate taxpayers will have an income tax liability of up to 45% on that interest (although 20% may have been withheld and paid to HMRC) but no cash from which to meet it.

Question 54

What is “Investor’s Relief”?

Answer 54

The Finance Bill 2016 introduces a new relief for shares issued on or after 17 March 2016 called Investor’s Relief. Under this relief gains arising on the disposal of shares in unlisted trading companies are subject to a 10% rate of CGT provided certain conditions are met. These conditions include a minimum 3 year holding requirement and a requirement that the investor is not connected with the issuing company.

Question 55

What are the basic rules on corporation tax deductions for discount as of December 2014?

Answer 55

For debtor relationships entered into by a company or materially modified on or after 3 December 2014 and otherwise from 1 January 2016, subject to exceptions, tax relief for the borrower in respect of the discount will be deferred until the accounting period in which the discounted loan note is redeemed, if (i) the loan note is a deeply discounted security and (ii) the borrower is a close company and the lender is a participator

Question 56

What are the basic rules on corporation tax deductions for late paid interest as of December 2014?

Answer 56

For debtor relationships entered into by a company or materially modified on or after 3 December 2014 and otherwise from 1 January 2016, a borrower is denied a deduction for any interest that is not actually paid within 12 months of the end of the accounting period in which it accrues if (i) the borrower is a close company and the lender directly or indirectly is a participator in the company or (ii) the lender does not bring into account the whole amount of the interest under the loan relationship rules (in that accounting period or otherwise). Instead, the borrower obtains the tax deduction in the accounting period in which it is actually paid.