Pressing the reset button: tax considerations of resetting management equity

Resetting management equity is common practice. It can arise as part of a plan to incentivize incoming or existing management, for example, in an underperforming business or where the interest rate on the investor’s loan note outstrips the growth in value of the business. There are various ways to reset management equity, however careful planning is required to limit the risk of an unintended tax liability arising. The five most common ways to reset equity and the associated UK tax implications are explained below.

1. Contractual bonus

Paying a cash bonus is one of the simplest options available to incentivize the management team. There should be no tax payable by the management team when the conditional bonus is awarded. Instead, employment taxes (including PAYE and employee and employer NICs) will be due when the bonus is ultimately paid on exit. This makes a bonus more expensive in overall tax terms than some of the other options.

2. Amend management’s shareholder rights

Another method that is relatively easy to implement is an amendment to the terms of management equity. This should ensure that the management team become within reach of the ratchet or waterfall arrangement at an earlier stage. The key consideration here is that any increase in the market value of shares held by the management team is likely to be taxable. However, it may be possible to amend the shareholder rights to get closer to the ratchet and so incentivizing the management team effectively while simultaneously not increasing the share value.

3. Reduce the interest rate on the loan note

If the interest payments on the sponsor’s loan note outstrip the value of the business, then reducing the interest rate may help to bring the management equity “closer to the money.” Again, the key point from a tax perspective, is whether there is an enhancement in value in the management team’s equity from the interest rate reduction. However, in many cases when the equity is so deep underwater bringing it a little closer to the surface (but not quite in the money) should not prompt an increase in value. If this were to become an issue, then another option may be to temporarily reduce the interest rate via an interest holiday rather than a permanent change. From the company’s perspective, thought will need to be given to whether the amendment of the loan note results in a credit becoming recognized in the accounts. If there is a credit, then it would be taxable unless an exemption applies.

4. Waive the outstanding debt

If there is a large amount of sponsor commitment in loan notes outstanding, simply reducing the interest rate may not be sufficient to re-incentivize management. In that case, one option to consider is to waive some or all of the sponsor loan note to increase the likelihood that the management team will be above water on exit. The tax issues that could arise on releasing the outstanding debt are similar to the example of a reduction in interest rate. The management team will need to understand whether an employment tax charge arises, and (as explained above) this will depend on whether the release of debt creates significant value in circumstances lacking a genuine commercial purpose. From a corporate perspective, whether a tax charge arises depends on whether the release is recognized as a credit in the accounts. If it is, there are a number of exemptions that could apply to mitigate this – the most obvious exemption is a debt-for-equity swap.

5. Transfer a portion of the sponsor’s loan notes to management

An alternative to amending the terms of the loan note involves transferring a portion of the loan to the management team. This option is only likely to be viable if the company is so far underwater that the loan note has no value at the time of transfer, otherwise it could result in an employment tax charge for the management team.

Peter Abbott advises on a wide range of tax and structuring matters but has a particular focus on public and private M&A and private equity transactions. He specializes in advising investment fund clients on the structuring of their private equity and special opportunity investments, as well as related refinancings and exits. In addition, Abbott advises the management teams of private equity-backed companies, including in relation to their equity incentive arrangements.

Abbott is a chartered tax advisor and regularly speaks and writes on tax matters.