Facebook's initial public offering (IPO), which launched on 18 May 2012, has certainly captured the imagination of the media with news of the transaction dominating headlines all over the world.
Much has been made of the incredible valuation the IPO has placed on Facebook (even after the dip in the share price in the first few days of trading). As has been widely reported, the opening price of $38 a share valued the business at $104 billion - or 100 times its 2011 profits. What strikes us as more remarkable, however, is the fact that, due to the huge gains that some employees will make from the exercise of share options prior to or as part of the float, Facebook will obtain such vast corporation tax deductions that it may avoid paying any US corporate income tax for many years. Indeed, these deductions have been estimated by Facebook in its prospectus to be approximately $17 billion.
In the UK, a similar form of corporation tax relief is available, also relating to gains made by employees in relation to the exercise of share options.
As well as on an IPO, share options are also usually exercisable when a company (whether private or public) is the subject of an acquisition. Where a UK target company has granted to its employees share options which will become exercisable as part of a proposed sale, the company may be able to obtain a UK corporation tax deduction. This tax relief will be equal to the amount by which the market value of the shares acquired exceeds the aggregate amount paid to exercise the option (in other words, the amount on which the employee optionholder will be subject to tax, assuming the options are not approved by HM Revenue & Customs).
Discussions over which party will take the benefit of this relief (and how and when such benefit can be enjoyed) should therefore be considered early in the transaction process and form part of the deal negotiations. In the right context, this issue can become a key bargaining chip or even lead to a price adjustment.
However, the UK legislation contains traps for the unwary. If not properly considered, these can mean that a company will not be able to obtain this potentially valuable tax relief, which could see selling shareholders leaving value on the table.
One of the requirements that companies are most likely to fall foul of relates to the status of the target company at the point at which the options are exercised. In order for a target company (or, more specifically, the relevant employing group company) to be eligible for UK corporation tax relief, employees must acquire shares in the company at a time when it is either:
(a) not under the control of another company;
(b) controlled by a listed company; or
(c) itself listed on a recognised stock exchange.
Where, on the facts, a target company will not satisfy either limb (b) or (c), the first limb of this test must be carefully considered. This is because if employee share options are exercised immediately after the target company is acquired, at the point of exercise of the options, the target will already have become "controlled" by the purchaser and will therefore be ineligible for the relief.
To ensure that a target company does not fail to meet limb (a), both the mechanics of the employee option exercises and the transaction documentation need to be carefully structured so that options are exercised immediately prior to the point at which the acquisition takes place. A frequent issue is that when the target company's share options were granted, the availability of corporation tax relief on an exit was not properly considered. If this is the case, the terms of the options may also need to be amended prior to exercise. In cases where employees have been granted options under UK "approved" share plans, great care must be taken when amending such terms after grant in order to ensure that the tax-efficient status of the options is not prejudiced.
Both Olswang's Corporate and Employee Incentives teams have extensive expertise in dealing with these issues across the whole spectrum of corporate transactions. While we cannot guarantee to replicate the scale of the tax deductions expected to be available in Facebook's case (!), we can help our clients utilise the availability of UK corporation tax relief in the context of deal negotiations, as well as ensure that nothing contemplated as part of any potential acquisition will prejudice the availability of such relief.
For further information about any of the above, please contact Rob Willis for Corporate/M&A aspects and Michael Deeks for Employee Incentives aspects.