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Tax Bite: Disproportionate consideration – another case highlights the income tax issue

Those who advise regularly on M&A transactions will no doubt have come across situations where the shareholders of a company want to share sale proceeds otherwise than fully pro rata to their respective shareholdings and the rights attaching to the relevant share classes in the company’s Articles of Association.

Typically, the intended “advantaged” shareholder will be an employee or director (or related to an employee or director) of the company, and as a result it is highly likely that the relevant shares will be employment related securities (ERS) for tax purposes.

ERS are subject to a host of income tax charging provisions, one of which imposes a charge to income tax if ERS are sold for more than their market value. This is known as “Chapter 3D”. Where Chapter 3D bites on a sale, the excess proceeds over market value will be subject to PAYE income tax and both employee’s and employer’s NICs, so the issue is (or should be) one of concern to both the sellers and the buyer on the deal.

Perhaps surprisingly, prior to last month we were aware of only one reported case on Chapter 3D, Grays Timber Products Ltd, which went all the way to the Supreme Court. In that case, a provision in a shareholders’ agreement entitled a particular shareholder to more proceeds of sale than his shares would have entitled him to applying the rights attaching to those shares in the Articles. It was held that this personal agreement was not relevant to determining the market value of the shares for tax purposes, so the excess consideration was caught by Chapter 3D.

The recent first tier tribunal decision in CooperVision Lens Care Limited also fell in favour of HMRC. In this case, 100% of the shares in the company were sold to a third party purchaser, but certain director shareholders received around £70m more for their shares than those shares would have entitled them to on a pro rata sharing of the consideration amongst all shareholders according to the capital rights attaching to the various share classes.

The company tried, without success, a number of arguments to support the price paid for the directors’ shares being no more than market value.. A number of interesting points for advisers come out of the facts and the decision, including:

• The fact that the buyer may have been content with the shareholders not sharing the proceeds pro rata to shareholdings doesn’t mean that each “bundle” of shares was sold for market value. The arm’s length price negotiated with the buyer for 100% of the shares in the company represented the total equity value of the company, and put simply if the purchase price is £100 and there’s 100 ordinary shares in issue, the basic principle is that the market value of each share is £1. Market value for tax purposes involves an assessment of what price a hypothetical willing buyer would pay to acquire the shares in question from a hypothetical willing seller, and any agreement between sellers as to how sale proceeds are to be allocated does not have any relevance to that question.

• The company had obtained an opinion from tax advisers to support the argument that all of the shares were being sold for market value. However, that opinion was subject to various caveats and was high-level in terms of the detail provided to the advisers. The tribunal decided that the tax advisers’ report was not sufficient to show that the company had discharged its obligation to account for PAYE on a “best estimate” of the amount subject to income tax (so was still exposed for PAYE and NICs), plus the company was held to have been “careless” in relying on the report, meaning HMRC had up to 6 years after the end of the tax year of the sale to challenge the tax treatment.

• A minority of the shares held by the affected directors were accepted by the tribunal as not being ERS on the specific facts and history of the case, meaning there was no Chapter 3D charge on those shares. We suspect HMRC will appeal that aspect of the decision. Typically, it is very hard to argue (save in cases where individuals make shares available in the course of domestic and family arrangements) that shares held by employees or directors are not ERS, because the ERS definition is very wide and contains deeming provisions that typically put the question beyond doubt.

So overall this case has reinforced the message we routinely give clients and advisers, that any sharing of sale proceeds otherwise than in accordance with the respective shareholdings and the capital rights attaching to the shares is a tax “red flag”, which needs investigation and advice to determine the implications and how best to manage (and, where possible, seek to improve) the position.

One key message is that where shareholders want one or more shareholders to have a greater share of the equity than their own holding would suggest the sooner advice is taken the better. At an early stage and well before a sale process it may be possible to rebalance the shareholdings in a tax efficient way, whereas close to a sale inevitably any movement in shares or value will likely be subject to income tax and NIC.