Resetting share incentive schemes – navigating the tax consequences

Share incentive schemes have, for some time, become a key mechanism to attract, retain and reward top talent. This holds true not only for listed companies, but also for unlisted companies – including those in the private equity sector.

Fund managers often want to incentivise key management in their portfolio companies with an equity slice in the business, thereby creating an alignment of interests to grow profits and, ultimately, returns.

The fortunes of participants in share incentive schemes have, unfortunately, been somewhat mixed over the years, given the volatility in macro-economic conditions, as well as the impact of ‘big bang’ events, such as the 2008 global financial crisis and the more recent COVID-19 pandemic. Many incentive schemes have ended up under water, leaving fund managers to consider what, if anything, can be done to reset these schemes to deliver the incentives that they sought to achieve.

Given the complexity of the relevant legislation, the tax consequences of amending and resetting incentive schemes need to be carefully considered. As a starting point, it is important to understand whether the scheme is ‘restricted’ or ‘unrestricted’. Broadly speaking, a ‘restricted’ equity scheme is one in which the participants are restricted from selling their equity shares (either for a period of time or as an outright prohibition), and/or where the participants may, for any reason, be forced to sell their equity shares at less than market value (for example, if they are dismissed).

In contrast, an ‘unrestricted’ scheme is one in which the participants are able to freely sell their equity shares, and where the participants cannot be forced, under any circumstances, to sell their equity shares at less than market value. Pre-emptive rights (also referred to as rights of first refusal) in favour of other participants or other shareholders that are exercisable at market value, as well as forced sales at market value, do not taint the shares as restricted for tax purposes.

From the participants’ perspective, the distinction between a restricted and unrestricted share scheme is fundamental, as each one is taxed differently. In an unrestricted scheme, the scheme shares are treated as having ‘vested’ in the participants’ hands upfront (at least for tax purposes), with any difference between the market value of such shares and the consideration paid therefor being subject to income tax. All future growth in these scheme shares would then typically be subject to capital gains tax (CGT), not income tax. Conversely, restricted scheme shares are only treated as ‘vesting’ for tax purposes on the earlier of disposal or when all the restrictions attaching to the share are lifted, with the difference between the proceeds/market value (as the case may be) of the shares and the initial consideration paid therefor being subject to income tax at such time only.

Resetting restricted and unrestricted share schemes that are currently underwater may also result in varied tax implications. For example, swapping one restricted share for another restricted share of a different class (with enhanced or reset participant rights) would not necessarily result in any immediate tax consequences for the participants. Instead, the newly acquired restricted shares would simply be subject to income tax upon disposal or vesting, as the case may be. Swapping an unrestricted share for another unrestricted share of a different class would, on the other hand, typically result in the value of the newly issued share being subject to income tax in the participants’ hands upfront. This is clearly not ideal from a cash flow perspective, but at least all future growth in these newly acquired shares would be subject to CGT, not full income tax.

Ad hoc special dividends may, in some cases, be used as a mechanism to reset scheme values, as these dividends would simply be subject to dividends tax at 20%, not full income tax. Obviously, however, this would move the cash flow burden to the company itself, which may be undesirable.

Like many areas of tax, the rules governing share schemes are complicated, and very widely drafted. Resetting these schemes, although done with the best of intentions, can result in very costly and unintended consequences if not carefully navigated.

Brian Dennehy is Director of Tax | Webber Wentzel

This article first appeared in Catalyst, DealMakers’ quarterly private equity publication.

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