Enterprise Management Incentives - New HMRC guidance on swamping rights and impact on private equity backed companies

The grant of EMI options is often seen as a tax efficient way to incentivise employees of a trading company. As such, EMI options (along with other incentives) are often granted during a private equity investment life cycle of a company. 

The Issue

For a company to be a qualifying company for EMI purposes, it must satisfy the “independence requirement” which requires that:

1. the company must not be controlled by another corporate; and
2. there must not be any arrangements for the trading company to become controlled by another corporate.

Where private equity firms take a minority stake in the company, the first condition above is satisfied. However, in order to protect its investment, the investor will often require that their shares carry enhanced voting rights (sometimes called “swamping rights”) on certain events of underperformance which will allow it to obtain a majority of the voting rights in the company. 

An interpretation of the law exists where such rights breach the second part of the independence condition above on the basis that the enhanced voting right provisions are an “arrangement” for the private equity firm to obtain control of the trading company in the future. 

HMRC guidance has long been silent on this point. This has led to ambiguity and at times exits being frustrated.

HMRC’s current approach

HMRC’s new guidance now states that enhanced voting rights (or “swamping rights”) will not breach the independence requirement if the enhanced voting rights are only triggered on certain events of genuine financial distress such as:

1. failure to redeem any loan notes;
2. breach of banking covenants; or
3. proposed liquidation (other than voluntary liquidation).

However, each case will be dependent on the facts and HMRC will look closely at the wording of such provisions. Any provisions which trigger the enhanced voting rights merely due to general underperformance, regulatory issues or management team issues will most likely be challenged. 

How we can help

Ultimately, the issues above require both tax advice and careful legal drafting.  As a full-service law firm, Freeths can provide EMI tax advice and produce the legal documents to put the EMI scheme in place. We can also advise private equity firms on the EMI implications of their investments into trading companies as part of a PE investment instruction.