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Autumn 2003 Newsletter

All change for earn-outs

Sometimes the Revenue consult everyone before making a tax change, and sometimes they go back to the bad old days of springing surprises. This year's Budget included a complete overhaul of the rules for employees who are paid in shares - free shares, share options, shares provided by employee trusts and so on - if the arrangement is not a "Revenue approved scheme".

The changes were not trailed in advance, and some of the effects have taken time to sink in. One of the big ones is the new rule that any shares you own in your employer company are "deemed to be received by reason of employment". This means that you can be charged to income tax on any profit you make when you get them, for instance by buying them cheaply in an option scheme.

If you just buy shares in the Stock Market, you won't have an income tax charge because you won't make a profit - you'll pay full value. But the new rule makes a big difference to people who have sold their business to another company in an "earn-out" deal. Typically, this involves staying on as an employee for a while, and then receiving some shares in the purchasing company once everyone is happy about the value of the target business. These "earn-out shares" have always been treated as capital gains proceeds, because they are to do with the sale of the previous business. Now, the Revenue say they could be exposed to an income tax charge, which would almost certainly be much higher.

The full effects of these rules are still unclear, and the Revenue are having to publish a longer and longer list of "frequently asked questions" (and their answers) on their website. If you have shares or share options in your employer, or are waiting for the pay-out in an earn-out, we can advise you about the issues - but it may be hard to be sure of the exact answer, because the Revenue themselves seem not to have realised what they were stirring up.

The new rules are in Schedule 22 FA 2003. There are a few articles about this already in the professional press, such as that in Taxation, 14 August 2003, p3920; there will probably be more as the year goes on. The FAQs on the Revenue's website (www.inlandrevenue.gov.uk), in particular the section on earn-outs at www.inlandrevenue.gov.uk/shareschemes/faq_emprelatedsecurity-ch5.htm#l, are very informative. However, it is difficult to get an overview of the new rules without considerable study, and it seems that the rules are still developing as experts in the area question the Revenue and guidance is developed on what the changes mean. The answers to the FAQs sometimes change as someone objects to the Revenue's first attempt. This is very unsatisfactory, because many affected clients cannot be given a categorical answer on how the new rules affect them, but it will be important to identify those affected as soon as possible and keep an eye on developments.

On earn-outs, the Revenue have promised to "be reasonable" - they will accept that the receipt is only chargeable to CGT (under the principle of Marren v Ingles) if it is clear that it only relates to the sale and valuation of the previous business. However, they reserve the right to charge it to income tax if the value of the earn-out clearly relates to work done as an employee after the deal, for example if there is no salary to pay for those duties, or the earn-out contains personal performance targets rather than business valuation issues.