Contents

1. UK: Share Schemes and Incentives – James Paull
2. India: Vodafone International Holdings BV v Union of India – Miles Dean
3. US/UK: No one expects the hybrid mismatch rules – Andrew Parkes

1. UK: Share Schemes and Incentives

The economic and social turmoil that has resulted from the response to the Covid-19 pandemic has meant that most businesses have gone through an unprecedented period of rapid change. Many businesses are unrecognisable from the start of the year; a large number are now rebuilding or adjusting their focus and business model to deal with this.

One collateral impact of this process will be on the incentives packages that are held by employees of these businesses. Arrangements implemented in recent years which were well aligned to business strategy at the time are unlikely to remain so. This gives rise to a risk of misalignment or lack of incentivisation and retention at a time when this matters more than ever.

What are the issues?
There are a number of ways in which existing incentives arrangements could have been adversely impacted by the pandemic. Below we look at some of the more commonplace:

Performance conditions are no longer appropriate
When awards were made, it is likely that the financial projections and business strategy on which the performance targets were based were vastly different to those now in existence. It may well be that those targets are now perceived to be unachievable. Likewise, they could incentivise behaviours which are not consistent with the business strategy, creating a conflict of interests for employees.

Awards are underwater
Although equity markets have bounced back well overall, there remain many incentive plans where option strike prices or performance hurdles are currently above the market value of the relevant equity. Where employees have borrowed to invest in employer equity, the loan may be higher than the value of the equity. Again, this means that the retention effect of the incentives is likely to have been eroded, in some cases permanently. In the worst cases, concerns about their financial position could distract employee focus from the job in hand.

Underwater Exits have become more remote
Many businesses will have been working towards achieving a trade sale or IPO as a means of providing a liquidity event for employee equity holders within a specific timeframe. The pandemic may have caused a rethink of these plans; at the very least these plans could have been pushed back. This is likely to lead to the perceived value of incentive awards being discounted by recipients.

Large numbers of leavers
Some businesses will have materially reduced their workforces. Where these individuals hold equity incentives, it is likely that the terms will permit the employer to repurchase the equity held by these leavers. There will often be a prescribed process and limited time frame for doing this and any repurchase will need to be funded by the employer.

Equity now in the “wrong hands”
If the business strategy has changed, it may be that some employees who were previously seen as key to delivery of the old strategy do not remain so in the new world. On the other hand, there may be others who have now become business critical who are insufficiently incentivised. There may be a need to recruit to fill key skills gaps and again these recruits will expect to be given a competitive incentive package to convince them to join.

Misalignment with new strategy
If the business strategy has materially changed then it is possible that the structure of legacy incentive arrangements is no longer optimal. For example, employees in one division may no longer perceive value in having less strongly performing divisions contributing to their incentive pay-outs.

What structures can be used to address incentives issues?
There are a number of strategies which can be adopted to address incentives issues. There is no one size fits all answer. What is best will depend on the culture of the business and the business needs in the new world. It is important to consider any changes in this light, rather than adopting a “me too” approach and seeking to follow what competitors are doing.

Broadly, the strategies can be split into two categories: refining existing incentives and implementing completely new arrangements. There are advantages and disadvantages to each, so these should be considered carefully before acting.

Refining existing awards

This could involve one or more of the following:

Modifying performance conditions
There are a number of ways this could be done, including extending the performance period, resetting earnings targets, resetting performance hurdles, using discretion to strip out estimated Covid impact and substituting an entirely new set of conditions to reflect the revised business strategy.

Repricing options
Where the awards are underwater, consideration could be given to adjusting the strike price to strip out any adverse consequences arising from the pandemic. Alternatively, consideration could be given to granting parallel awards which will replace the existing awards if they do not pay out, but will fall away if the original arrangements recover sufficiently.

Offering liquidity
This could be considered attractive where the equity is in the wrong hands and needs to be freed up for new awards. It may be possible to do this at relatively attractive prices in the current climate.

New or additional arrangements 

The most important consideration is to ensure that the new arrangements sufficiently support the new business strategy. It is possible that arrangements that achieve tax efficiency may be available, but our recent experience is that this is now seen as a nice to have rather than a key driver. In many cases, the key consideration is to ensure that the nature and timing of tax charges is understood and that these coincide with liquidity events to avoid employees incurring a liability to tax without being able to access the funds to pay it (a so-called “dry tax charge”).

Below is a selection of the type of arrangements that could be considered:

Awards of ordinary shares

This is likely to be the simplest alternative. It could be structured as an award of shares or as an option to acquire shares in the future. In both cases this could be contingent on continued employment and/or achievement of specified performance measures. There are advantages and disadvantages to each structure and which route is best is likely to depend on the current financial position and prospects of the company, as well as the risk appetite of employees.

EMI options
This is a tax favoured option arrangement, which applies to smaller companies that meet certain conditions. If these conditions are met, then this is likely to be the arrangement that achieves the optimum balance of risk and tax efficiency. For this reason, we would always recommend considering if your company will qualify.

Special classes of shares
This type of arrangement will allow you to reward employees by reference to the performance of a specific part of the business or in relation to specific aspects of the value of the business (for example growth over a hurdle). They are capable of aligning employee interests with that of the business and are potentially tax efficient. However, they do involve the employee assuming a degree of risk of loss and are complex to implement, so are not appropriate in all circumstances.

Deferred bonuses
These can be a useful tool where there is pressure on cash and can be structured so that they pay out over a predefined vesting period. They can be subject to additional performance targets. Care should be taken to ensure that they are structured correctly to ensure enforceability from a legal perspective.

Retention awards
These should be considered where there are specific employees that are critical to the short-term welfare of the business. They are a contingent right to a cash payment if the employee stays with the business for a specified period. They are not typically subject to additional performance targets.

Conclusion
In our view, it is important that all businesses consider the impact that the pandemic has had on their incentive arrangements, even if the business has performed strongly. In all likelihood, employees will focus on how their incentives have fared through the crisis. In the absence of any comment from their employer, they will be likely to form their own views of the current situation and what should be done. It is to the employer’s advantage if it can take the lead on this issue.

At minimum, we would recommend that all businesses take the actions below:

• review existing incentives to assess the likely impact of the pandemic and whether the legacy arrangements remain fit for purpose;
• if change is considered necessary, consider the range of alternative steps that are available to assess which is likely to be optimal to address specific business needs. As part of this process, it is important to consider any tax, legal, accounting and regulatory issues which may arise to ensure that all consequences for the business and employees are understood;
• once the preferred path is selected, model the potential incentives outcome in a range of projected performance scenarios to ensure that an appropriate level of incentive is delivered and the business understands potential funding requirements; and
• communicate to employees the outcome of the exercise, even if the decision is to do nothing. This will demonstrate to employees that you have recognised the potential impact on incentives and acted to assess this. It may also head off many of the potential questions which will be in employees’ minds.

Those businesses that act now to consider whether any action needs to be taken and bring employees along with them are likely to be best placed to achieve maximum competitive advantage and optimise the value for money they get from their incentive arrangements.

For more information on share schemes and incentives in general, please contact James Paul on +44 (0)7961 118994 or james.paull@uk.Andersen.com

2. India: Vodafone International Holdings BV v Union of India 

On 25 September, it was reported by Reuters that the Permanent Court of Arbitration at the Hague (via its seat in Singapore) has ruled in favour of Vodafone in its dispute against India, initiated under the India-Netherlands Bilateral Investment Treaty (BIT). Has this case, which we have been following since the get-go, finally run its course? It would appear so, but with so much at stake and Modi’s BJP Party having such a huge majority in the Indian parliament, it would be brave to bet against there being one last-ditch roll of the dice.

Background
A (much simplified) look at the facts:

• in 2007, Vodafone International Holdings BV acquired 100% of the shares in a Cayman target company for $11.2bn from Hutchison Telecommunications International Ltd (also a Cayman company);
• the Cayman target indirectly controlled 67% of Hutchison Essar Ltd, an Indian joint venture company that owned various Indian telecom licences;
• the Indian tax authorities challenged Vodafone claiming that Indian capital gains tax of $2.5bn should have been withheld by Vodafone; and
• the Indian tax authorities based their claim on the fact that the acquisition of the Cayman target was in fact an indirect transfer of an Indian situs capital asset.

Many countries impose capital gains tax on the sale of shares that derive their value from real estate (France, Spain, the US, Australia, the UK and so on), but generally the sale of ‘regular’ shares (i.e. those that do not derive their value from real estate) can be made without deduction of tax at source.  An unusual feature of the Indian tax system is that it is the purchaser, in this case Vodafone, that is obliged to withhold the seller’s capital gain. A non-resident entity obliged to withhold tax on behalf of another non-resident entity raises a number of sticky cross-border enforcement issues, particularly where the asset being bought/sold has no Indian nexus!

In the first instance, the Bombay High Court held that the transaction was a transfer of a capital asset situated in India and that the tax authorities had jurisdiction. The matter was then referred to the Supreme Court which duly reversed the decision holding that Vodafone was not liable to pay any tax.

Following the decision of the Supreme Court, the then government introduced retrospective legislation in Finance Bill 2012 that allowed it to continue to pursue Vodafone for the tax, penalties and interest.

In 2012, Vodafone initiated proceedings under the India-Netherlands BIT arguing that the use of retrospective legislation was in breach of the principles of equitable and fair treatment per Article 4.1, which includes an obligation to ensure a stable and predictable regulatory environment. Vodafone argued that by failing to abide by the most senior Court’s ruling and introducing legislation specifically designed to thwart a decision of that court, the Government created an unstable and unpredictable business environment.

In 2014, Vodafone initiated further proceedings, this time under the India-UK BIT. The Government sought an anti-arbitration injunction which was initially granted by the High Court in Delhi, but was subsequently dismissed as being an abuse of process in May 2018. What’s the point in signing up to BITs if you intend to railroad them when used against you? The answer to this question is that you terminate those BITs you don’t like and start negotiating BITs that contain very restrictive arbitration provisions (the recent Brazil-India BIT expressly provides that a tribunal cannot award compensation, it can only interpret the BIT or order conformity of any non-complying measure).

The Award
The Court of Arbitration found the Indian government in violation of the fair and equitable treatment standard under Article 4(1) of the India-Netherlands BIT and directed India to pay $5.5mn to Vodafone as compensation for its legal costs.

Interestingly, the Indian government can still approach the High Court of Singapore (where the arbitration was held) requesting it to set aside the award and in this vein the Indian Ministry of Finance has said “the government will consider all options and take a decision on further course of action including legal remedies” suggesting it might just appeal.

Our thoughts
The Supreme Court, when deciding the case in favour of Vodafone, commented as follows:

‘Foreign Direct Investment flows towards the location with a strong governance infrastructure which includes enactment of laws and how well the legal system works. Certainty is integral to rule of law. Certainty and stability form the basic foundation of any fiscal system.’

Since the days of Adam Smith, it has generally been accepted that for an economy to grow there needs to be strong protection of property rights. If you cannot be certain you own something, you will not spend money improving it in case it is taken away and someone else benefits from your expenditure. Nor can you use it as collateral for a loan to improve something else. A bank will not lend against an asset you may not own.

This makes you wonder why India undermined property rights by enacting and enforcing retrospective legislation, particularly because of the damage it would do to foreign direct investment and investor confidence.  Vodafone isn’t alone, however. As often happens, once legislation is on the books the tax authority will try to use it which is what they did when Cairn Energy undertook an internal reorganisation in 2006 to allow it to make an initial public offering of its Indian subsidiary. It even received the Indian Tax Authority’s blessing that no Indian tax was due. That, as they say, wasn’t worth the paper it was printed on, as the Indian Tax Authority used its new power to raise a $1.5bn, plus interest, assessment on Cairn in respect of the transactions within the reorganisation.

The Cairn arbitration decision is still pending but expected before Christmas.

For further information on the above and cross-border tax matters generally, please contact Miles Dean on +44 (0)7785 770 431 or miles.dean@uk.Andersen.com

3. US/UK: No one expects the hybrid mismatch rules 

Recently we were asked to confirm that a minority equity investment by a US entity into a UK one, followed by an arm’s length loan, was not within the hybrid mismatch rules.

Piece of cake, you would think. The US company is taking a 35% stake in a UK business. It is a purely arm’s length transaction between unconnected parties. But, no, this is the UK’s hybrid mismatch legislation which we only wish was Pythonesque in its similarity to the Spanish Inquisition.

We can at least dispense with the majority of the rules as the UK company has not “checked the box” for US purposes and so remains a taxable entity for both UK and US purposes. There are no Permanent Establishment issues and the loan made as part of the deal is a plain vanilla one, money has been lent for a specific period of time, interest will be charged and then the capital repaid. No funny business or conversion conditions.

However, that is not the end of the matter. As might be expected, the US investor is a limited liability company that has not checked the box for US purposes and has two members. It is, therefore, a partnership for US purposes, but a company for the UK. It is a HYBRID!!!

This means we still have to consider the Hybrid Payee rules in Chapter 7 and being the hybrid mismatch rules there are five conditions to be met. The first three are fairly easy to consider:

a. Is there a payment or quasi payment under an arrangement? Well there is a payment of interest under a loan agreement, so yes.

b. Is a payee a hybrid entity? The money has been paid to the US LLC so they are a payee and it is regarded as a distinct and separate entity for UK tax purposes but it is not for US tax, therefore it is a hybrid entity.

c. Is the payer within the charge to UK corporation tax (CT)? The borrower is a UK incorporated company and not tax resident elsewhere so it is within UK CT. (There are other ways a company can come within this condition but we don’t need to consider those here).

The next two, not so much.
Condition D sounds quite straightforward when you decipher it: is it reasonable to suppose that if the hybrid mismatch rules did not exist, the UK company would be able to claim a deduction whilst no-one would be taxable upon the income? Here, we have a US LLC and it would normally not be taxable upon the interest income, but the UK company will not know this or about the structure above the LLC. However, as this is an article about the hybrid mismatch legislation (which would end here if it was unreasonable to suppose etc), we will say it is reasonable to make this assumption.

Condition E – that the payer and the hybrid payee (or an investor in the hybrid payee) are in the same control group, or there is a structured arrangement – goes to the heart of this article.

With a 35% shareholding, the two companies are not in the same control group, but there is the question of whether the two entities are part of a structured arrangement. This is where it is reasonable to suppose (again) that the arrangement is designed to secure that the UK company has a deduction, whilst no-one is taxable upon the income or that the users share the economic benefit of the mismatch.

The legislation is also clear that the transaction can still fall within the rules, even if there are commercial reasons for it, but it was structured to obtain the mismatch. In our particular case, the US LLC was the main trading entity of the group and all the commercial activity, both “foreign and domestic”, went through it.  All previous transactions for the group involved the LLC and there was nothing special about this one. The structure had not been designed to secure any deduction/non-inclusion mismatch, it had been designed without a thought to the UK side of things – the US did not know or really care if the UK got a deduction or not, whilst the UK was not aware (and, again, not interested) of the US tax treatment. There was simply no question of the transaction being made in any other way. It was not designed to secure any mismatch and nothing was being shared between the parties.

This time the legislation does not apply, but you can see how easily it could, even with a minority shareholding. For instance, if the LLC had been a special purpose vehicle set up for the transaction, it suggests the tax treatment might be an important consideration. If the UK entity is asked to check the box by the investor, again that suggests a tax motivation, or if the structure is altered subsequent to a discussion about tax. All of this is highly subjective and made more difficult due to the minority investment and the incomplete knowledge between the two parties. I say “incomplete” as there will likely be some knowledge, but that could be more dangerous than total ignorance here (for instance, if you assume there is no check the box election when there actually is, was it reasonable of you not to ask?).

To go back to the title of the article, you can be happily sitting in the meeting room having secured a minority investment from a US group and out pops Michael Palin and co. to ask if anyone has considered if Part 6A Taxation (International and Other Provisions) Act 2010 applies? Not something that will win the best joke at the Edinburgh Festival Fringe, but may cause a sharp intake of breath.

For more information please contact Andrew Parkes on +44 (0)7522 229 589 or andrew.parkes@uk.Andersen.com