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Tax Bite - Growth Shares

Tax Bite – Growth Shares

Growth shares are a popular form of equity incentive, particularly where enterprise management incentive (EMI) options are unavailable. This might be, for example, because:

• The company carries on significant “excluded” or non-trading activities for EMI purposes, so does not meet the trading status requirement;

• The incentive is to be in a subsidiary company;

• The company / group is too large for EMI (e.g. more than 250 full-time equivalent employees, or gross assets over £30m); or

• The intended participants are not full-time employees.

They can also be used with EMI options where the value of ordinary shares is too high to get within the EMI limits.

Growth shares are a class of shares that only participate in the growth in value of the company above a certain hurdle. Typically the hurdle is set at, or marginally above, the perceived value of the company at the time the shares are issued, so that any current value in the company’s equity is in effect ring-fenced for the existing shareholders.

From a tax perspective, the aim is to ensure that the growth shares have only minimal value on acquisition, and any future growth in value is subject to the (currently) more favourable capital gains tax (CGT) rates.

In principle, growth shares are very straightforward and flexible. There are however a number of issues to be aware of, and which we find are often overlooked. We have picked out some of the key ones in this Tax Bite.

• Day one value – unless the growth shares are to be acquired under an EMI option (which can be done, where all the EMI requirements can be met), the value of the shares on acquisition cannot be agreed with HMRC, whether before or after the event. We normally recommend that a robust independent valuation be undertaken by a specialist share valuer. However even where that is done, the risk of challenge cannot be eliminated. HMRC are now known to be taking a harder line on growth share valuations, arguing that the “hope value” needs to be taken into account. The participant either has to pay, or suffer income tax on, the value of the shares on acquisition (and as section 431 elections should be entered into, any income tax charge would be on the full “unrestricted” market value of the shares).

• EIS (and SEIS) companies – care needs to be taken to ensure that putting in place growth shares does not cause issues for EIS. In particular, there are prohibitions on EIS shares having any preferential rights to dividends or assets on a winding up. With careful drafting of share rights, EIS issues can usually be avoided, although we would recommend seeking confirmation from HMRC before making any changes.

• CGT rate increases? – the benefit of CGT treatment is of course only obtained if and when the shares are finally sold. It is still widely considered very likely that CGT rates will increase materially in the relatively near future, and at worst CGT rates could be aligned with income tax rates.

• Income tax risks on sale? – particularly where growth shares are in a subsidiary, participants will want some security of being able to realise the value from the shares. One way this can be done is through a put option to allow the participant to require the parent company to acquire the shares. So far as possible, any such rights should be expressed as rights attaching to the shares in the Articles. Even if that is done, however, if growth shares are sold as a one-off minority shareholding transaction rather than as part of a full exit, there is a risk of HMRC arguing that a minority discount must be applied when valuing the shares. If employment-related shares are sold for more than market value, the excess is subject to income tax.

• Risk of a wider “attack” on growth shares – over the years growth shares and other “geared growth” arrangements have been subject to various rounds of scrutiny and threats of regime reform, although to date no firm action has been taken. Most recently, in its first report on CGT published in November 2020, the Office for Tax Simplification included various commentary on growth shares, noting that they were akin to share options in some respects (in terms of the minimal up-front commitment from participants and (intended) nil or negligible initial tax charge), and that “in some cases the returns look more like rewards from labour than from capital investment”. These comments were given in the context of “boundary issues” between income and capital tax treatment, and may be something the government addresses as part of any reforms to CGT.

• Leavers – share options can be drafted with simple “lose if leave” provisions, so an employee never gets shares if he leaves. With growth shares, the shares are acquired up front and so companies need to ensure they have appropriate leaver mechanisms in place in the Articles, including whether there are to be different implications for good leavers versus bad leavers. One point that should not be forgotten in this context is that if a good leaver sells his shares back to the issuing company at a profit, the default tax position is that the proceeds above the initial subscription price are taxed as a dividend. If a series of conditions are met, a buy-back can be subject to CGT treatment, but even if CGT treatment is available in principle, the issue of minority discounts has to be considered, with any proceeds in excess of the market value of employment-related shares taxed as income.

Obviously growth shares by definition give a different commercial result to normal ordinary shares, as the recipient misses out on the value under the hurdle. In some cases where the commercial deal is that the recipient should participate “ground up” we have been able to craft creative solutions to make sure that, as long as the growth is sufficient, that commercial result can be achieved (and in a way that maintains the up-front share value at an immaterial level).

We would be happy to discuss these issues with you and your clients.