In February this year, an interesting decision was made in the case of Clough Ltd v. Commissioner of Taxation (FCA 108) in the Federal Court. It has implications for companies under takeover dealing with their employees’ equity incentives.

Colvin J. ruled that the expense incurred by Clough Ltd in compensating its employees for cancelling share options and other incentives was not an expense incurred by Clough in carrying on its business – a fundamental requirement for an expense to be tax deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA). Accordingly, the income tax deduction was denied. It should be noted that the Commissioner accepted the expense was deductible over five years under the amortisation provisions of section 40-880 of the ITAA.

Some background is warranted. Clough Ltd was an ASX-listed engineering services firm that was being acquired by a South African company, Murray & Roberts Limited (M&R). The court found that Clough incurred the expenditure for the purpose of facilitating the acquisition, rather than being incurred in carrying on its business. Clough and M&R agreed through the Scheme of Implementation that the minority employee interests would be cancelled for cash compensation and they would participate in an incentive plan under M&R post the takeover.

A key determinant in the judgement was whether the cancellation payment constituted an expense to the actual carrying on of a business or whether it was intended to effect change to the shareholding structure of the company. Colvin J. found that the payments related to the latter. In the judge’s view, the true nature of making the cancellation payment was to acquire a hundred percent control of Clough, by eliminating Clough employees’ minority interests. Change of control clauses in incentive plan rules facilitated vesting of options and rights. Thus, the judge rejected the argument that the cancellation payments were a retention tool for Clough employees to remain with the new company.

There are several takeaways from this decision including:

• Ensure that equity plan rules and employee offers do not allow any unvested share rights, options or other employee equity to remain upon a change in control of less than 100%. This just adds to a non-deductible expense that reduces prospects of takeover value being fully realised for all
• Companies need to correctly assess net of tax costs taking this ruling into account before launching a takeover bid.

See the ruling HERE.

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