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Tax issues of underwater ordinary shares held by management on sale

We are seeing an increasing number of company sales where the sale proceeds are insufficient to pay out the full preference stack, such that the ordinary shareholders, often including management, would receive nothing or very little from the sale.

It is not uncommon in this scenario for all parties to want ordinary shareholders to receive something. This may be partly so that everyone cooperates on the deal, but also possibly, in the case of management, in order to ensure that their shares deliver some value so that they are not disincentivised going forwards.

The issue is that if this is dealt with at the time of completion (possibly through share transfers, amendments to preference amounts or allocating consideration other than in accordance with the Articles), there will almost certainly be a PAYE/NIC charge on any additional value which management benefits from (in whichever way this is delivered). In that case, it becomes a question of working out a way of delivering that value in the most efficient way (recognising that there will be a PAYE/NIC cost). For example:-

• if the management have some, but not enough, value from the ordinary shares, any bonus paid to them would dilute their own value (and so reduce their actual sale proceeds further), so it might be better for the other shareholders to transfer shares to management;

• transferring shares might also deliver a better corporation tax outcome in that a corporation tax deduction is more likely to be available than for a bonus;

• we would also want to make sure we produced the best CGT outcome for any other shareholders involved in transferring shares.

There might be some cases where it is at least possible to argue that there is no PAYE/NIC charge, for example, if all ordinary shareholders benefit from any increase in value and there is a high proportion of non-employee ordinary shareholders and clearly no employment motive (so this would not work where the whole point is to get value to management but may work if there are other reasons e.g. compensating EIS investors who are selling in the 3 years EIS period). This will very much depend on the facts and any argument put forward may not be accepted by a buyer (which would have the liability to account for any PAYE/NICs as the new owner of the employer company).

The key message to take from this is that this is something that should be looked at well in advance of a sale when it might be possible to do something tax efficiently (i.e. get more value into capital gains treatment such that it is taxed at rates of up to 24% versus income tax and employee NICs of up to 47% plus employer NICs of 15%). This would possibly involve EMI options (if sufficiently in advance of a sale) and/or growth shares. The closer you get to a sale the harder it will be to do anything tax efficiently and leaving it until a sale will likely make it a case of just doing the best we can, as set out above.