Tearing Up the Term Sheet: Tax Traps When Recutting Management Incentive Plans

Tearing Up the Term Sheet: Tax Traps When Recutting Management Incentive Plans

Tax in the Deal 2026

Overview

In the current economic environment, many private equity-backed companies are finding that their ordinary equity is 'underwater', as longer holding periods and the accrual of yields on prior ranking third party debt and shareholder held preferred shares or loan notes erode value that might otherwise have accrued to ordinary shares. In the context of Management Incentive Plan(s) (MIPs), this can mean that the original 'sweet equity' held by the Management in a typical UK holding company structure (see the diagram) may no longer be providing a meaningful incentive, because there is no realistic hope of them making any capital return on a future exit. 

In this context, we are seeing many private equity-backed companies looking to 'recut' their existing MIPs, so that management are realigned with the investor's objective to grow the value of the business ahead of a future exit.

This article discusses some of the different structuring options that may be available when recutting an existing MIP, together with an overview of the main tax considerations. The focus here will be on UK tax considerations, but many of the points will be similar across other jurisdictions.

Note that whilst tax structuring is key to any effective MIP recut, the need for shareholder and lender consents and issues around confidentiality can be equally important. MIP recuts are often implemented in situations where existing debt and equity have fallen in value, and holders of these instruments (who may include co-investors and former Managers) may have the ability to withhold consent or challenge arrangements later if the correct consents and approvals are not obtained. Where bonuses and subsidiary MIPs require payments from within a banking group, the requirement for lender consent should also be considered. Obtaining appropriate consents can take time and should be addressed at an early stage to avoid this becoming a barrier to implementation.

Summary

It remains the case that alternative equity arrangements in Topco (the top holding company of a group, where equity plans often sit) are the most popular option when it comes to recutting an existing MIP. This is to be expected, given that Management will already be familiar with an equity plan at this level in the group, and this structure should result in capital gains tax (CGT) treatment on a future exit, assuming that the preferred exit is a sale of Topco.

However, the feasibility of this structure will depend on the current debt and equity holdings, where value currently 'breaks' in the group, and how far away a future exit is expected to be. There is no generic, 'one-size-fits-all' solution, meaning that a careful assessment of the position will be necessary to ensure the best possible plan can be identified and implemented. For example:

  • If all the Topco equity is 'underwater', it might be difficult to make a new Topco MIP work without additional restructuring steps being taken. In these circumstances, a subsidiary MIP could be a possible option.

  • Cash bonus schemes may make more sense if an exit is expected in the near future, meaning that the upfront cost of issuing new equity might be prohibitive, or if there is a desire for simplicity and keeping costs down. Bonuses are also likely to be necessary where a new incentive plan allows Managers to share in proceeds alongside senior lenders or other holders of debt.

"There is no generic, 'one-size-fits-all' solution, meaning that a careful assessment of the position will be necessary to ensure the best possible plan can be identified and implemented."

Hannah Manning, Head of Tax

The list below provides a high-level summary of the tax advantages and disadvantages of the various options, which are then each explored in further detail.

1. New Topco Growth Shares

Advantages

  • Expected CGT treatment on exit

Disadvantages

  • Upfront cost of acquiring the shares for Managers
  • Valuation needed
  • More complexity if no value expected in Topco equity

2. Subsidiary MIP

Advantages

  • Expected CGT treatment on exit

Disadvantages

  • Upfront cost of acquiring the shares for Managers
  • Increased complexity and potential tax issues for the group to navigate
  • Valuation needed

3. Joint Share Ownership Plans (JSOPs)

Advantages

  • Expected CGT treatment on exit

Disadvantages

  • Upfront cost of acquiring the interest for Managers
  • Increased complexity (and may not be viable in some jurisdictions)
  • Valuation needed

4. Cash Bonus Scheme / Phantom MIP

Advantages

  • No upfront cost for Managers
  • Flexible and simple to administer

Disadvantages

  • Returns subject to employment taxes (meaning higher tax for Managers and a social security cost for the group)

5. Enterprise Management Incentive (EMI) Options

Advantages

  • Expected CGT treatment on exit (at lower 18% rate)
  • No upfront cost for Managers

Disadvantages

  • Unlikely to be available for most private-equity controlled companies
  • Increased complexity / risk of disqualifying event (turning options into unapproved options)

6. Unapproved Options

Advantages

  • No upfront cost for Managers

Disadvantages

  • Returns subject to employment taxes (meaning higher tax for Managers and a social security cost for the employer group)

The Available Options

1. New Topco Growth Shares

  • Topco issues a new class of growth share to Management, which sits higher in the capital waterfall than the existing ordinary equity, and is therefore more likely to have value on an exit. The new growth shares will only share in value subject to the exit value exceeding a specified hurdle, or other financial performance thresholds being met.
  • This option will typically be viable if there are preferred shares in Topco which rank ahead of the existing 'sweet equity' and are likely to have some value on a future exit, meaning that a new class of growth share can be created which 'cuts into' the preferred equity.
  • If there is insufficient value in the Topco equity (or the structure contains loan notes and the intention is for the new growth shares to cut into value alongside these loan notes), then this option can be considered in conjunction with a 'debt for equity swap', which would involve any existing shareholder loan notes being converted into new preferred equity.

Key Tax Points

  • Valuation: A valuation exercise will be essential, so that the group can evidence that market value is being paid for the shares and therefore that there should not be any employment tax liability at the time of acquisition. The hurdles can be toggled to get the balance right between having a sufficiently low upfront cost for the shares and being set at a level that is realistic for the business to achieve.
  • Funding the acquisition cost? Management might not have sufficient personal resources, or it might not be commercially desirable to require them to pay for the new growth shares, particularly if they have lost money on their original investment.

    Grossed-up bonuses could be used to assist with funding, but this could represent a substantial cost for the business, considering the high UK employment tax rates (47% on Pay As You Earn (PAYE) income tax and employee's National Insurance contributions (NIC) for the employee, plus 15.5% in employer's NIC and Apprenticeship Levy for the employer).

    More typically, we see employee loans or nil-paid shares used, with Management only required to repay the loan (or pay-up their shares) when they sell the shares in the future. There are employment tax consequences that need to be considered here, including an annual employment tax charge that may apply to the extent that Management do not pay interest at least equal to the official HM Revenue and Customs (HMRC) rate (3.75% per annum for the 2026–27 tax year). In addition, the loans to participators tax regime may apply, which can result in a 35.75% corporation tax charge for the group on the amount of the loan. The charge should be recoverable from HMRC when the loan is repaid (and so should just represent a cash flow cost to the group). It is also worth noting here that incurring additional borrowing to acquire shares may carry financial risks for Management and so this will generally only be the preferred approach where the cost of new shares is relatively modest.
  • Debt for equity swap: If a 'debt for equity swap' is required to create additional equity value at the Topco level, then the complexity of the structuring is increased. There are various potential tax pitfalls to navigate, one of the key points being to ensure that there is no corporation tax liability for the Finco (that is, the issuer of loan notes to the investor) in the group structure on the release of the loan note indebtedness. In practice, if all the holders of shareholder debt are holding on the same basis and are aligned, it is usually possible to effect a 'debt for equity swap' on a tax neutral basis for all parties.
  • Managing tax risks:
    • From a group perspective, obtaining formal tax advice and valuation advice is essential. In addition to ensuring compliance from a payroll tax perspective, this should reduce the risk of any issues being flagged as part of due diligence on a future exit.
    • Typically, Management will be expected to indemnify the group for:
      • any employee tax that may arise in respect of the new shares; and
      • any employee tax that may arise in respect of any employee loan.

      However, these indemnities would not cover employer NIC or the Apprenticeship Levy, which would remain a risk for the group.
    • Section 431 tax elections will generally be entered into so as to disapply the charging provisions of the 'restricted securities regime' from applying to the shares, particularly on an exit.

2. Subsidiary MIP

  • Shares are issued in a group company lower down the holding company stack, at a level where there is some equity value. This may need to be at a level below any shareholder loan notes, and in some cases, senior debt. The shares can be drafted as growth shares, so that they only share in value subject to certain hurdles being met, and to keep the initial acquisition value relatively low.
  • In this scenario, it is necessary to give thought to how a future exit might be structured because having a Subsidiary MIP in place will involve having shareholders sitting at two different levels in the structure. Typically, put and call options will be put in place to ensure that the group can buy in (and Management can sell) any Subsidiary MIP shareholdings on a Topco exit.

Key Tax Points

  • Valuation: The same valuation considerations apply at the time of acquisition as outlined above in respect of Topco growth shares. In addition, the question of valuation will come under greater scrutiny at the time of an exit.
  • Sale of shares: In the case of a Subsidiary MIP, typically it will be a group company that acquires the shares, rather than a third-party purchaser. This introduces an additional technical question as to whether the shares could be being sold for more than their market value, which would lead to an employment tax liability on the amount of any overvalue. Whilst the risk here can be effectively mitigated by proper implementation, there may be greater scrutiny of the arrangements as part of a future exit due diligence process.
  • Funding the acquisition cost? The same points apply as set out above for the Topco Growth Shares Option (see New Topco Growth Shares, Key Tax Points, Funding the acquisition cost? section above.
  • Tax grouping: In our experience, special care needs to be taken to avoid breaking any tax group as a result of the issue of new shares to Management. For example, if Management were to be issued shares in Midco (that is, the company held by Finco, and holding Bidco, in a typical structure) then it is possible that Finco and Topco would no longer be treated as part of the same corporation tax group as the rest of the group (because Finco might no longer hold a sufficiently large shareholding in Midco). This could trigger immediate tax de-grouping charges and/or prevent the surrender of tax losses between group companies.
  • Managing tax risks: The same points apply as set out above for the New Topco Growth Shares (see New Topco Growth Shares, Key Tax Points, Managing tax risks section above).

3. Joint Share Ownership Plans (JSOPs)

  • Very broadly, JSOPs involve having the Management jointly own shares (or loan notes) via a contractual joint ownership agreement with an employee benefit trust or institutional investor. The Management's interest entitles them to share in sale proceeds above a certain hurdle. In the same way as growth shares, the hurdle can be set so that the initial market value of the JSOP interest should be low, and any growth in value in the JSOP interest should in principle be subject to capital gains tax.
  • For many private equity-backed companies, it will be preferable to introduce a new class of share, rather than implementing a JSOP structure. JSOPs typically mean greater complexity and more documents, and they may be less likely to work for Managers resident in other jurisdictions outside the UK. However, there are circumstances where JSOPs may provide a more attractive solution, including where there are commercial reasons why introducing a new share class may not be viable. For example, it may not be possible to introduce growth shares into a structure because the consent of a minority investor is required. Instead, the lead investor could implement a JSOP in respect of existing shares or loan notes that it holds.

Key Tax Points

  • Broadly similar valuation and tax considerations arise in respect of an acquisition of a JSOP interest as in the case of the acquisition of growth shares (see New Topco Growth Shares, Key Tax Points section above). Conducting a robust valuation exercise is particularly important for JSOPs.

4. Cash Bonus Scheme / Phantom MIP

  • Cash bonus schemes (including 'phantom' MIPs) provide the greatest flexibility in their terms, with the lowest implementation costs. Typically, such schemes are designed so that they pay out on a future exit, potentially linked to financial performance. A contractual bonus can generally 'cut-in' at any level in the proceeds waterfall, subject to agreement from relevant shareholders or lenders. Such schemes can be structured as 'phantom' equity or units if that is the commercial preference, but the UK tax treatment should be the same as a bonus.
  • Any warehoused management shares (including shares held by an employee benefit trust) can be used to fund these bonuses. Otherwise, the cost (including any associated employer social security) will be borne by the group, reducing the exit proceeds for the shareholders.
  • A key advantage to a bonus scheme as compared to the equity plans outlined above is that there is no upfront cost to Management. This makes bonuses particularly attractive if an exit is expected in the near future, which might make equity too expensive for Management to acquire.

Key Tax Points

  • For UK Managers, any bonus payment (or payment under a phantom MIP) will be subject to employment taxes (up to 47%), which is obviously less attractive than capital gains tax rates (up to 24%). However, there should be no upfront cost or tax liability for Managers, in contrast to some of the other options.
  • For the group there will also be a liability to employer NIC and (potentially) the Apprenticeship Levy (together totalling 15.5%). The group may be able to obtain a corporation tax deduction in respect of the payment of the bonus and the employer taxes, although this will need to be considered on a case-by-case basis. In an M&A context, whether this potential tax saving is reflected in the sale price on a future exit will depend on the availability of other reliefs and the parties' respective bargaining power.
  • It is important to ensure that any employment tax liability should only be triggered when any bonuses are actually being paid to Managers. This should generally be the case, but there can be circumstances in which the tax point can arise earlier.

5. Enterprise Management Incentive (EMI) Options

  • Private equity-owned companies will generally not qualify for any tax-advantaged options, including EMI options, unless the private equity investor holds a minority stake. There are also other conditions that restrict the availability of EMI from applying in many cases, including businesses undertaking any of a long list of 'excluded activities', including financial services, legal and accountancy services and various property related businesses. There are additional restrictions linked to the gross assets and number of employees of the business. Accordingly, we do not commonly see EMI options being used by private equity-backed companies when it comes to recutting an existing MIP.

Key Tax Points

  • If EMI options are a possibility, then they are certainly worth considering as an incentivisation tool. The key tax advantages of qualifying EMI options are:
    • no employment taxes at the time of grant or exercise of the options, provided that they are granted at a strike price equal to the market value of the shares at the time of the option grant; and
    • Business Asset Disposal Relief (BADR) automatically applies to the shares (albeit that the BADR CGT rate has risen to 18% (since 6 April 2026), as compared to the main 24% rate, meaning that BADR is no longer as advantageous as it was).
  • EMI option schemes bring with them a lot of complexity, with the potential for issues to arise on a future exit. In our experience, issues are routinely flagged as part of tax due diligence, although some changes in law have been made recently which are designed to reduce certain compliance errors. Beyond this, one of the main areas of complexity is whether any 'disqualifying event' has taken place, which would have the effect of turning the EMI options into unapproved options (see Unapproved options section immediately below). This can be difficult if the terms of options need to be amended to address unforeseen events or if certain discretions need to be exercised in relation to the option plan.

6. Unapproved Options

  • Employment taxes are triggered on the exercise of unapproved options, meaning that returns are effectively taxed in the same way as a bonus. Accordingly, there are unlikely to be any material tax advantages to unapproved options as compared to bonus schemes and phantom MIPs (as outlined in the Cash Bonus Scheme / Phantom MIP section above), and bonus schemes arguably offer more flexibility and simplicity. As a result, we do not typically see unapproved option schemes being used.

Key Tax Points

  • One marginal tax advantage of an unapproved option scheme is that a statutory corporation tax deduction might be available. This, arguably, offers greater certainty than the position in respect of bonuses, which will rely on the general 'wholly and exclusively' test being satisfied for there to be a corporation tax deduction. However, in practice, there is unlikely to be any material difference on the corporation tax position.
  • Unapproved options also offer employers an opportunity to agree with option holders that they will bear the employer national insurance on the exercise of the options – this is not possible where shares are acquired or bonuses paid (although bonuses can be calculated in such a way that a similar effect is achieved).

Typical UK Holding Company Structure

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Joseph Sheldrick

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