This article outlines the most common MIP and valuation pitfalls encountered in mid-market transactions and offers practical insights for mitigating these risks.
Why MIPs Matter
MIPs are typically structured to ensure that management is taxed under capital gains tax (CGT) rules—currently at 24%—rather than employment income tax, which can reach 47% when including National Insurance Contributions (NICs). There is also no tax cost for companies with this structure (compared to bonus type plans which incur employer NICs and apprenticeship levies, which can total 15.5%). These rates are specific to the UK, however a similar (or even wider) delta and higher company costs can also arise in other jurisdictions.
However, if MIPs are not implemented correctly, they may both hinder shareholder value creation and trigger unexpected tax liabilities for both the company and the individual.
Employment-Related Securities (ERS) and Readily Convertible Assets (RCAs)
In the UK, when employees or directors acquire shares due to their employment, these are classified as ERS. If acquired at less than market value, the tax treatment hinges on whether the shares are considered RCAs. RCAs typically arise when:
- A trading arrangement exists or is likely to be established.
- The company is controlled by another entity (e.g., a private equity investor). Note this is often the case for mid market deals.
If shares are RCAs, the employer must withhold employment taxes (PAYE and NIC) from the individual and pay employer NIC (and potentially apprenticeship levy). Failure to do so can result in s.222 charges—grossed-up payments where taxes weren’t recouped from employees in the correct time frame, which can reduce deal value and returns to the MIP.
In other jurisdictions, there is also often the requirement to withhold (resulting in similar gross up implications) as well as potentially high employer social security costs.
These unexpected tax liabilities are often treated as debt-like items on a transaction. Buyers will typically insist that these amounts are deducted from the purchase price.
To protect themselves, buyers are likely to require that a portion of the purchase price is held in escrow to cover any potential tax liabilities that may arise post-completion or until the issues are resolved. This delays the receipt of funds by sellers and creates uncertainty which can complicate negotiations with sellers.
Such issues also cause frustration and disappointment with the management team where proceeds to the MIP are lower or slower than expected. This is likely to slow down the deal process, increase legal and advisory costs and can threaten the completion of the transaction.
Common Due Diligence Red Flags
Lack of Valuation or Inadequate Valuation
Employers must determine a “best estimate” of share value when shares are acquired. Without an appropriate valuation exercise, the valuation of the shares on acquisition is commonly challenged on due diligence exercises.
If the shares are acquired at less than their market value, the difference between the price paid and the market value will be treated as employment-related income.
Valuation of management shares is an increased focus area for both UK and International Tax Authorities. It is therefore vital to ensure that the market value of shares issued is properly considered and documented.
The lack of a valuation or use of a methodology not accepted by tax authorities makes it difficult to defend the acquisition price if challenged, increasing the risk of adverse tax consequences.
Shares Acquired Close to Exit
Acquisitions within 12–18 months of a transaction are scrutinized closely on due diligence. In particular, if exit negotiations or preparation of the exit is underway, it may be argued that the acquisition price should reflect the anticipated exit value. This can:
- result in a higher market value being attributed to the shares at acquisition, leading to a higher income tax and NICs charge at that point (and potentially s222 charge); and
- result in shares being considered RCAs resulting in a withholding requirement for the Company (even if the shares are not considered RCAs historically).
Missing s.431 Elections
In the UK, a joint s.431 election allows employees to be taxed on the Unrestricted Market Value (UMV) of shares at acquisition, avoiding future employment tax charges when restrictions fall away. Without this election, a portion of the disposal proceeds may be taxed as employment income, if the shares are subject to restrictions like forfeiture or leaver provisions. This can typically be in the region of 10%.
To ensure a s.431 election is valid it must be signed within 14 days of acquisition by both the employer and employee and kept on file for future reference
Capital Restructuring Impacts
Changes to share capital—such as share splits, changes to share rights, or new share classes—can inadvertently trigger tax consequences. Even if management’s shares are not directly involved, HMRC (or international tax authorities) may view these changes as a new acquisition or variation of rights pushing value to management’s shares, potentially leading to income tax charges under anti-avoidance rules.
Certain anti-avoidance rules apply tests on an annual basis, so while they may not be an issue when the MIP was acquired, given the shares weren’t RCAs or within these rules they must be considered over the life of the MIP to avoid potential employment tax liabilities on an exit. This means that the tax liability is not limited to the year in which the share capital change occurs but can continue for as long as the MIP is deemed to exist, potentially resulting in ongoing annual tax charges for management.
International Considerations
Cross-border MIPs are increasingly common, but a “one-size-fits-all” approach rarely works. Key challenges include:
- Differing tax treatments of equity instruments, ratchets, and vesting provisions.
- Loan-funded share acquisitions, which can be reclassified as employment income if not structured correctly.
- Varying valuation methodologies and discount tolerances across jurisdictions.
When not structured correctly, the full amount of proceeds on an exit can be reclassified as employment income in a worst-case scenario, involving withholding and reporting implications for the group as well social security charges. Our UK team works with PwC’s global network to navigate these complexities, ensuring that MIPs are tailored to local tax laws and commercial norms.
Final Thoughts
MIPs are powerful tools—but only when designed and executed with precision. Tax missteps can erode value, create friction with management, and complicate deal execution. Early planning, robust valuations, and jurisdiction-specific structuring are essential to avoid surprises and preserve value for all stakeholders.
Please contact our specialist MIP Advisory team for any questions or further discussion on the above.
Contact us
