Much Ado about Tax

As the introduction of the new "super-rate" 50 per cent income tax increase looms (from 6 April 2010) together with the degradation of personal allowances and the restrictions of tax relief on pension contributions, our legal practice has seen many tax planning schemes being marketed to our clients. In most cases, our advice is "caveat emptor" i.e. let the buyer beware, as many of these schemes are highly artificial in construct and unlikely to withstand a challenge by HM Revenue & Customs. Moreover, the financial costs of implementation are usually high (often with limited recourse against the promoter), and will often carry unintended but significant non-tax risks, particularly where the schemes involve complex instruments or where income is being 'recharacterised' as capital. Indeed, we anticipate that whatever the political landscape post May 2010, the gap between the rates of income tax and CGT will be narrowed.

At the same time, there are cost effective and low risk tax planning strategies which can be adopted by a taxpayer ahead of the introduction of the various changes. However, these should only be adopted once the legal and economic consequences for each situation are fully understood. It should also be born in mind that with a General Election in the offing and with tax becoming a battlefield between the political parties, no action may well be a better approach than a panicked and rushed reaction.

With these issues in mind, I have set out below some strategies which may be of particular relevance to players in the private equity community. These suggested strategies may also be of relevance to managers of investee companies; the suddenness of the tax changes will clearly impact on projected returns for both investors and the management teams. Finally, I have outlined the principal features of the Enterprise Investment Scheme ("EIS"). As a tax lawyer who works closely on the design and implementation of investment structures, it is my personal view that EIS investments can play a pivotal role in the new economic climate of tight liquidity. Whilst investments in EIS companies typically involve higher commercial risk, these are more easier to assess and are compensated by generous tax reliefs which generate cash. EIS is particularly attractive for investors, with an appetite for risk and with substantial tax liabilities that require a sensible shelter, without messy disputes with HMRC.

Summary of Tax changes

• From 6 April 2010, the introduction of a 50 per cent top rate of tax for individuals with income more than £150k per year.
• From 6 April 2010, the withdrawal of personal allowances for individuals earning more than £100k per year (resulting in an effective rate of tax of 60 per cent for income between £100k and £112k).
• From 6 April 2010, an increase in the effective rate of income tax for dividends from 25 per cent to 36.11 per cent for individuals with income of more than £150k.
• From 6 April 2011, an increase of 1.5 per cent in employee national insurance contributions for higher earners (i.e. giving a combined highest rate of tax/NIC at 51.5 per cent); and
• From 6 April 2011, complicated restrictions which significantly limit tax relief for pension contributions made by higher earning individuals, subject to stingy anti-forestalling rules on payments made prior to that date.

Some Practical Strategies

Any of these suggested strategies may be of relevance to both private equity participators and to employees of their investee companies.

• Accelerate income prior to 6 April 2010: Any such income will be taxed at the current 40 per cent rate and should therefore escape the new super-rate income tax for higher earners. Employers should consider whether it is possible to claw back any accelerated income paid to an employee who subsequently leaves or underperforms.
• Accelerate dividend payments. Such payments are of course only permitted where the paying company has sufficient distributable reserves.
• Increase pension contributions prior to the restrictions that will take effect from 6 April 2011. Such contributions are subject to the complex anti-forestalling rules which apply to limit tax relief for any contributions which are not regular (at least quarterly) and in place prior to 22 April 2009 (other than for the first £20k of contributions each year).
• For private equity executives, we do not recommend any manipulation of carried interest arrangements, as any aggressive planning could prejudice CGT treatment.

EIS: A Renaissance in UK venture capital?

EIS (and its predecessor reliefs) has been in place for several decades, and offers generous tax reliefs to individuals in order to encourage them to invest in small trading companies that may otherwise find it difficult to raise capital on the same terms as larger companies.

A useful guide to the commercial performance of EIS companies ("HMRC Research Report 44") that was prepared by the Institute of Employment Studies and Exeter University on behalf of HMRC can be found at www.snipurl.com/24hjw.

In essence, the EIS reliefs are available to a 'qualifying investor' who subscribes for 'relevant shares' in 'qualifying company' that is carrying on a 'qualifying business activity'. The EIS rules are complex, so it is crucial that advice is sought from a professional adviser who is experienced in this field. The outline below is a very broad summary of these complex rules, and is not intended to provide a definitive guide to the EIS legislation but will (hopefully) provide a taster of potential benefits.

In very broad terms, a 'qualifying company' is an unquoted company (this will include AIM listed companies) whose gross assets must not be greater than £7 million (prior to the EIS investment) and which cannot be involved in certain prescribed businesses (for example, dealing in land, shares/securities or providing banking or financial services). The rules governing 'qualifying companies' are particularly complex, given the generous nature of the tax reliefs.

In broad terms (again), 'qualifying investor' is an individual who is not 'connected' to the qualifying company in question. An individual will be 'connected' if he/she is an employee/director or if he/she holds an interest in excess of 30 per cent of the company. There are also anti-avoidance rules aimed at 'associates' of connected individuals. Notwithstanding the strict rules prohibiting 'connected' investors, it is often possible to structure an investment which would allow an investor to play a more active role, typically as a 'business angel'. As a law firm, we have successfully implemented EIS compliant structures which permit these types of participation.

For a 'qualifying investor', the principal tax reliefs are:

• A reduction of income tax liability by an amount equivalent to 20 per cent of the amount subscripted in the qualifying company. The minimum subscription is £500 and the maximum is £500k pa. At present, this means a maximum income tax reduction of £100k pa.

• No CGT on disposal of the EIS shares after a 3 year ownership period.

• Deferral on CGT gains realised on a different asset share where that gain is reinvested into eligible EIS shares. An attractive feature is that there is no cap on the amount of the CGT gain that can be deferred. This relief may become particularly relevant if (as we anticipate) changes are made to CGT.

• If the EIS shares are disposed at any time at a loss, that loss can be set against the investor's capital gains or income in the year of disposal.

To conclude, the fundamental change in economic climate, coupled with the arrival of a more aggressive tax regime, mean that both investor and investee parties of a PE backed structure should review their tax options and consider if they need to take action before 6 April. As always, the tax tail should not wag the commercial dog, particularly given that further changes to UK tax are likely to happen in an election year. With that important fact in mind (and as outlined above), there are practical strategies that can be taken in sheltering
taxable income in the immediate term. Other planning strategies – notably EIS structures – do not rely upon the 5 April deadline as such but deserve detailed consideration, particularly as equity backed structures reappear on the UK corporate stage.