Have you heard? How venture capital backed companies can maximise their tax advantages

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1 Have you heard? How venture capital backed companies can maximise their tax advantages Optimising the Tax Position of Founders and Employee Shareholders The importance of equity incentives Being able to offer tax efficient equity incentives is crucial to enable small and growing enterprises to compete with much larger companies in the recruitment and retention of key individuals. The current economic climate only increases the importance of these incentives. The income tax risk for founders or employees who acquire shares Founders and senior management will often acquire shares at an early stage, rather than relying solely on option entitlements. Whenever founders or employees (including directors) acquire shares, they will be exposed to a risk of an immediate income tax charge. However this risk can be mitigated to a significant extent by careful planning and documentation. Risk of income tax/nics on the increase in share value Both the company and founder/employee shareholders will wish to ensure that any growth in the value of their shares is taxed as a capital gain (maximum 18% rate) and is not, inadvertently, taxed as employment income (40% income tax, 1% employee NICs and 12.8% employer NICs). However, it is not uncommon for employment income treatment to apply to all or part of their growth in value. This can result from the nature of the legal documentation or because of the failure to make appropriate tax elections at the time of acquisition. Careful management of the company's affairs should ensure that these problems are avoided. "Being able to offer tax efficient equity incentives is crucial to enable small and growing enterprises to compete with much larger companies in the recruitment and retention of key individuals." Reducing the tax bill to 10% - Entrepreneurs' Relief Founders or other employees should also consider whether they can qualify for Entrepreneurs' Relief which was introduced in For those who qualify, it reduces the rate of CGT to 10% (from 18%) on the first 1m of any growth in the value of their shareholding.

2 Who qualifies for Entrepreneurs' Relief? To qualify for Entrepreneurs Relief on the sale of shares, individuals have to: hold shares in a trading company, hold those shares for at least one year prior to their sale, and hold at least 5% of the shares in the company. To meet the 5% test: the shares must form at least 5% of the total nominal value of shares in issue. Where there are different share classes, an individual can fall beneath the 5% threshold under this test even if he holds more than 5% of the total number of shares in issue, the shares must carry at least 5% of the voting rights, and the shares must be held by the individual directly so that spouse/trust holdings do not count. We can advise on how you can meet the 5% test and how you can manage voting rights. What is happening to equity incentives in the current economic climate? The current economic climate is leading to a re-evaluation of existing equity structures. Common issues include: whether the existing equity structure is an adequate incentive for current participants - for example, is equity now underwater with no prospect of recovery in the foreseeable future? "The current economic climate is leading to a reevaluation of existing equity structures." whether the current economic climate provides an opportunity to introduce new participants at an affordable price, and whether existing participants should be offered the opportunity of a partial exit or whether equity value should be re-apportioned, i.e. are the right people being incentivised to take the company forward? These commercial objectives can all be achieved with some planning, but care needs to be taken to avoid crystallising unfunded tax charges for existing participants and to ensure that new participants can acquire their shares in a way that is both affordable and taxefficient. Could your company grant options which qualify for Enterprise Management Incentive ("EMI") reliefs? Many companies wish to grant equity incentives to employees in the form of options. The EMI scheme enables this to be done in a tax efficient way.

3 The tax benefits Under an EMI scheme, reliefs are available on options granted to employees, provided that no single employee receives an option over shares with a value of more than 120k and that the total value of all employee EMI options does not exceed 3m. EMI options offer the following benefits: no funding requirement when the option is acquired, (usually) no income tax or NICs charge on grant or exercise of option (provided that the option is granted at market value), and CGT at 18% on the sale of the shares. This contrasts with non-emi options on which a 40% income tax rate and 1% employee and 12.8% employer NICs would be payable by higher rate taxpayers on the option gain realised at the time of exercise. Which companies qualify? The reliefs are generally available to companies that: are "independent", have gross assets of less than 30m, have less than 250 full time employees, and who carry on a qualifying trading activity. Attracting Investment: Enterprise Investment Scheme ("EIS") Reliefs and Venture Capital Trust ("VCT") Reliefs "A company will be better placed to secure external investment if it can offer tax reliefs to its investors." Why do VCT and EIS reliefs matter? A company will be better placed to secure external investment if it can offer tax reliefs to its investors. In particular, business angels who are considering investing in your company will want confirmation that their investment can qualify for EIS reliefs. Who benefits from EIS tax reliefs and what are they? EIS is designed to encourage investment by business angels in smaller companies. Where EIS reliefs are available, the business angel qualifies for the following tax breaks: 20% income tax relief on up to 500k of investment per year, exemption from CGT on disposal of shares after 3 years, loss relief, and unlimited CGT deferral on amount reinvested in EIS shares.

4 What are VCTs and what are the relevant tax reliefs? A VCT is designed to enable individuals to invest in small unquoted companies through the medium of a quoted vehicle. The shareholders in the quoted vehicle qualify for various wide ranging tax benefits. Which companies will be able to qualify for EIS/VCT status? Companies will only qualify if they meet the following conditions: have gross assets of not more than 7m pre-investment, have fewer than 50 employees, are "independent", and carry on a qualifying trade. Whilst these rules are deceptively simple, there are many traps for the unwary and many companies inadvertently fail to meet the qualifying criteria, as highlighted in the Court of Appeal's recent judgment in the case of Blackburn and another v Revenue and Customs Commissioner [2008]. Subsequent loss of reliefs Both EIS and VCT reliefs can be lost after the initial investment unless the company continues to satisfy the relevant conditions. EIS relief can be lost or clawed back in a number of circumstances within 3 years of acquisition of the shares. Some examples of this are: sale of EIS shares, the investor receiving value from the company where e.g. loans are made or assets are sold at less than full value, "The loss of qualifying status can have very serious repercussions for both investors and VCTs. Monitoring the day to day running of the company to ensure that these reliefs are not inadvertently lost is crucial." the company ceasing to trade wholly or mainly in the UK, the investor increasing his proportionate holding of shares or loan capital such that he becomes connected with the company, and the nature of the share rights changing so that they cease to be eligible shares. The loss of qualifying status can have very serious repercussions for both investors and VCTs. Monitoring the day to day running of the company to ensure that these reliefs are not inadvertently lost is crucial.

5 Travers Smith, is an award-winning full-service law firm with 63 partners and approximately 250 lawyers. It is an acknowledged market leader in private equity and also has leading practices in employee incentives and tax. "Providing the 'highest standard' of work, Travers Smith LLP has outstanding private equity expertise" The Legal 500 (2008) (Tax) "Seamlessly juggles employment, tax and employee share schemes issues.the group is extremely client focussed" The Chambers and Partners UK Guide How to find out more If you have any questions or would like to know more about how these issues may be relevant to you, please contact: Travers Smith LLP 10 Snow Hill London EC1A 2AL T +44 (0) F +44 (0) Hannah Manning hannah.manning@traverssmith.com +44 (0) Victoria Nicholl victoria.nicholl@traverssmith.com +44 (0) Kathleen Russ kathleen.russ@traverssmith.com +44 (0) Simon Skinner simon.skinner@traverssmtih.com +44 (0) Mahesh Varia mahesh.varia@traverssmith.com +44 (0) Russell Warren russell.warren@traverssmith.com +44 (0) The information contained in this guide is based on information available at the time of publication. Readers should always obtain professional advice before taking any action. The firm is regulated by the Law Society of England and Wales. We are not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Law Society. We can provide these services if they are an incidental part of the professional services we have been engaged to provide. Travers Smith LLP is a limited liability partnership registered in England and Wales under number OC and is regulated by the Solicitors Regulation Authority. The word "partner" is used to refer to a member of Travers Smith LLP. A list of the members of Travers Smith LLP is open to inspection at our registered office and principal place of business: 10 Snow Hill, London, EC1A 2AL.