Budget predictions. The future is tax

Pre budget speculation is always a “thing”.? But the October budget is possibly one of the more eagerly awaited events in the tax calendar.? It’s not my place to comment on what might be.? But thinking around the possible implications of a change were it to occur is always good fun.

For example, we have a mooted increase in capital gains tax to contend with.? Discussions around the impact of such a change are often very unsatisfying (there’s only so many ways one can write “pay tax at the new rate”).? It’s much more interesting to think about how a change of this nature will impact what people and organisations do.?

So, here’s the exam question for today.? If we focus on market practice in the field of reward and (more specifically) incentives, if CGT increased, what would organisations do differently??

Let’s imagine a brave new world where the rate of CGT has been increased to the highest rate that one could reasonably expect.? Which I will wildly hazard at 47%.? Would this change how we use, for example, a share plan?

I can see four angles worthy of debate.

We have precedent:? Senior executives in listed companies have been living in a world where all their incentive pay-outs have been taxed to income (and NIC) for many years.? Hence, we can see that there is hope for a world without arbitrage between CGT and income tax rates.? Again, it’s not for me to comment on whether it’s a better world, or whether people leave or stay, or work hard or relax.? All I would observe is that the use of equity incentives remains entirely standard in such organisations.? Do I mean that nothing will change?? No – but reducing the impact of tax on an incentive design makes the other considerations more important to get right.? Put simply, the reduction in the importance of tax as a driver will lead to more thoughtful incentive practice.?

More thoughtful incentive practice:? And this where things get interesting.? If tax plays a more benign part in structure or outcome, what would the portfolio of drivers looks like?? The reality is that there are four drivers of note.? Everything else is fine-tuning.? So, we should expect much greater thought around:

Driving intent:? We always say this, but the first point is to be very clear on is what it is you are trying to incentivise.? This is possibly the most important aspect of all.? Are you (for example) seeking to incentivise the team to deliver to a realisation “end point"? Or seeking to incentivise the team to deliver rolling revenue or profit or valuation targets?

You can see how the design will differ dependent upon how you answer the question.? Or differ again if the answer is “both” (be very wary of “both” – as an answer it throws up challenges as to whether it is (a) true; and (b) reasonable to expect an incentive to support two things at the same time.? Generally, “both” doesn’t work).?

Either way, securing a particular rate of tax may not exist in the driving intent box of tricks for a while – meaning the real driving intent will have a chance to breathe.?

Quantum and Grant Frequency:? How much do you want people to make from their participation?? And is this in one life enhancing chunk or regular increments over a period?? I have written at some length in previous posts about benchmarking equity awards (you can find some thoughts here) - and this is where that debate becomes relevant.? What we shall discover, as the tax driver is dialled back, is the case to grant everything in one large bet at the outset is largely a valuation driven construct – driven by (you got it) – tax.? If that doesn’t carry the weight it once did, we should expect to see plans with a more phased earnings opportunity.

Gearing:? Everyone gets tied up with structures.? Options, performance shares, growth shares, restricted stock, carried interest, promotes and the like.? These are all fascinating, in their way.? But it’s always all about the gearing.? The principle is best illustrated by way of example.? Consider the two opportunities:

(i) Deal One: The right to acquire 10 shares (for no consideration) in three years’ time conditional only upon remaining in employment.?

(ii) Deal Two:? The right to acquire 20 shares (for no consideration) in three years’ time conditional upon performance and remaining in employment

Which is best?? The answer is of course that they do different things.? So, one is not better than the other.? But in headline terms:

• If performance is poor, (an “under-performance scenario”) then Deal One provides the best employee return.

• If the performance is great (an “over-performance scenario”) then Deal Two provides the best employee return.?
• If an acceptable level of performance is hit leading to 50% vesting of the shares (“target performance”) then the economic outcomes are the same with Deal One and Two.?

People are going to spend a lot more time thinking about the desired gearing and possibly less time about the structures used to deliver the outcome.

Tax:? I’ve tricked you.? Tax will remain a key driver of incentive design whether you like it or not.? The reality is that we have an interplay between income tax, NIC and corporation tax.? We have the question as to whether rates may go down in the future (we only care about the rate of CGT when we make a disposal, after all).? An equity holding or an option may be reinvested or rolled over into other entities or structures without triggering a dry tax charge.? Dry tax is the most painful form of tax out there – so there will always be fulsome activity ensuring it does not arise. Most importantly of all, the UK is but one country.? And many employers are worrying about tax in 20 to 30 jurisdictions given their operating footprint.? A rate adjustment in the UK barely figures on the tax Richter scale (which needs creating at some point).

One final point.? If you don’t need to worry about a UK tax rate, then you can focus on some other things that should drive design but are often ignored.? Like the accounting treatment.? The accounting treatment of an incentive is the single most under considered (and advised) aspect of incentive design.? And if anything comes out of a shift in CGT rate, it may be that we start to focus an awful lot more on what an incentive costs, rather than the tax liability it attracts…

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