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Giving employees and directors shares in their employing company has long been regarded as a sensible means of aligning their interests with those of the company’s shareholders. 

There are, however, complications from a commercial and tax perspective.

On the one hand, the employee or director may agree to pay a market value purchase price for the shares and in such cases consideration will need to be given as to how the employee or director will fund that purchase price.

On the other hand, the company and employee may agree that the shares will be issued for below market value consideration.  In such circumstances, the difference between the market value of the shares and the price paid (if any) by the employee will be taxable in his or her hands as employment income in the tax year of acquisition.  This will trigger an income tax liability at rates of up to 45% which the employee or director will ordinarily be liable to  pay over to HMRC under the Self-Assessment tax return regime.  PAYE and NIC considerations will come into play where the shares acquired are shares in the unquoted subsidiary of another unquoted company, or in a quoted company or in a company where trading arrangements are in place for the shares.  In such cases, the shares will be “readily convertible assets” and the employing company must account for the income tax due under the PAYE system as well as pay over Class 1 NIC (both employer’s and employee’s). Furthermore, where the employing company does not recoup the PAYE paid over to HMRC from the employee or director concerned within time limits, further income tax and Class 1 NIC charges will arise. 

The tax cost of issuing shares to directors and employees in established, profitable companies may be sufficiently high as to act as a disincentive for the company to bring those individuals on board as shareholders.

Moreover, existing shareholders may not wish incoming director and employee shareholders to share in the historic value of the company, and may only wish them to benefit from a share of the future capital growth.

A further consideration to be taken into account is the profit extraction policy of the existing shareholders.  Where a single class of ordinary share is in issue and the current shareholders extract profits by way of dividend they may not be content for new employee or director shareholders to share in those dividends on a pro rata basis.

What can be done in such circumstances?  One potential solution is for the company to issue what are known as “growth shares” to directors and employees.

Growth shares – a potential solution

In very broad terms, the company would create a new class of, say, B ordinary shares.

The B ordinary shares would typically have similar voting and dividend rights to the existing ordinary shares but so far as their capital rights are concerned they would only share in capital over and above the current market valuation of the company (which would need to be determined).

The company would issue the B ordinary shares to the employees.

The purchase price of the shares would ordinarily be set at their market value as determined by a share valuation exercise.  The market value of the new B ordinary “growth shares” should be significantly lower than the market value of the shares with normal capital rights.  (It should be noted that HMRC would be likely to contend that the growth shares did have some value at the point of issue and they would be unlikely to accept that they had nominal value only for employment income tax purposes).

Once the B ordinary shares had been issued, and subject to the company’s cash and distributable reserves position, the company could pay dividends on the B ordinary shares to the employees and directors quite independently of the dividend policy in place in relation to the ordinary shares held by the founder shareholders.

Other legal and tax considerations

Given that the planning involves the actual issue of shares to directors and employees (as opposed to the grant of share options) consideration would need to be given to the inclusion of appropriate “leaver” provisions in the Articles of Association. These provisions would regulate how the B ordinary shares would be dealt with in the event that a director or employee shareholder ceased office or employment.

From an income tax perspective, the growth shares would in all likelihood be regarded as employment-related “restricted securities” for income tax purposes.  Consideration would need to be given as to whether the company and each employee or director should sign a joint election under Section 431(1) Income Tax (Earnings & Pensions) Act 2003 within 14 days of the date of acquisition of the shares.  The benefit of making such an election is that any future growth in value will then fall within the beneficial capital gains tax regime and no part of the ultimate sale consideration will be taxable as employment income subject to PAYE and NIC under the restricted securities income tax legislation.  The quid pro quo is that the director or employee is treated as acquiring the shares at their unrestricted market value (i.e. their value disregarding any restrictions) when determining whether any employment income tax charge arises on acquisition.

From a Capital Gains Tax (“CGT”) perspective, consideration should be given as to whether each employee or director is issued with shares amounting to at least 5% of the ordinary share capital (measured by nominal value) and which entitle the holder to exercise at least 5% of the votes.  Such a shareholding would put the individual in a position to be entitled to claim CGT Entrepreneurs’ Relief on a future gain made on sale of the shares, once at least 12 months had elapsed from the date of issue.  Entitlement to claim CGT Entrepreneurs’ Relief is, of course, dependent upon other conditions being met such as the company whose shares are being issued being either a trading company or a member of a trading group.

Conclusion

The use of growth shares to bring employees and directors on board as shareholders is becoming increasingly popular given the ability to structure arrangements tax efficiently and without major funding considerations.  In addition, growth shares are suitable for use by companies that for various reasons may not be eligible to use certain “approved” share schemes, for example, a house-building company whose trade precludes it from granting Enterprise Management Incentives (“EMI”) options.  

For further information, please contact me or your usual Thomas Westcott office.