Avoiding tax problems with employee share schemes

The question is what are the shares in a private company are worth for tax purposes? The answer depends to a large degree upon how you approach the valuation. We provide guidance.

Please do call us to discuss your position.  We are always happy to provide a scope of work and estimate.

Guide to avoiding tax problems

  • When does a tax liability arise
  • Working out market value
  • Support for employers
  • HMRC enquiries

When does tax arise if shares are provided to employees?

Tax can arise on award, exercise and sale of shares provided by the employer.  Taxable events include:

  • Exercise of options;
  • Gift of shares; and
  • If share rights are enhanced.

Basic rules

The basic tax rule is that if the employee or director is given shares for free or pays less than the market value of the shares at the time of award a charge to income tax and sometimes national insurance will arise. The tax charge will be the difference between market value and the price paid by the employee.  In most private companies the market value is unknown as the shares are not traded.  HMRC will provide a determination on market value but only after the issue or transfer of shares has been made.

Example of how a tax charge arises

Say, an employer has recently completed a successful fund raising at £10 per share and decides to award 5000 shares to a key employee to incentivise that person to stay with the company and work hard.

Assuming there is no negotiation with HMRC the position is:

  • The employee will have a tax bill of 5000 x £10 = £50,000.

Depending upon the circumstances it may be possible to negotiate a discount (discussed below) to arrive at a reduced market value.  If a discount of say 70% was achieved the position is:

  • The employee will have a tax bill of 5000 x £10 x 25/100 = £12,500

Decrease in value of the unquoted shares

If the shares decline in value after the award has been made HMRC will not refund any tax paid by the employee. Therefore the process of approaching HMRC on terms which are most likely to result in a reasonable assessment of the taxable value is important.

Similarly if the employee is forced to transfer his shares at a nominal value under good and bad leaver provisions set out in the articles there will be no refund of tax paid on acquisition.

Working out market value

Different businesses require different valuation methodologies. There is no standard approach to share valuation. HMRC apply a concept of open market value. Open market value is based on the hypothetical assumption there is a willing buyer and a willing seller.  It is assumed that the shares can be transferred freely.

Start-up companies

HMRC will accept that start ups have limited assets, and no trading history. The market value of the shares is usually agreed by HMRC to be low.

Investment rounds

If the start up has received investment, such as a SEIS Investment or EIS that will have to be disclosed to HMRC as part of the process of agreeing the taxable value of shares awarded to employees or directors. However, in many cases we secure sizeable discounts to the pricing of any investment round.

Established trading companies

For established trading companies the taxable value of shares provided to employees or directors requires analysis of a variety of different valuation methodologies. The methodology we recommend is advanced with HMRC will depend upon the business sector and the desired outcome.

Discounts applied before reaching the taxable value of unquoted shares

HMRC do accept that restrictions reduce the taxable value of unquoted shares. We consider the nature of the restriction and the commercial implications. The restrictions must be set out in the articles or shareholders agreement.

Typical restrictions relate to:

  • A requirement that an employee or director transfers his or her shares to the company and or other shareholders on leaving employment;
  • Removal of dividend or voting rights;
  • Imposition of hurdles often seen in growth shares which have to be achieved before rights arise. The most common restriction with growth shares is removal of the right to receive capital payments on sale of the shares if targets are not satisfied;
  • Discount to the taxable value for a minority shareholding.

Unless the whole shareholding is sold, the value of the shares can be discounted to reflect the degree of control over the company’s affairs.

  • HMRC does not give guidance on discount levels. The discounts have to be negotiated and agreed with HMRC on a case by case basis. Understanding how restrictions on shares in Articles of Association work in real life is instrumental in the negotiation process with HMRC.
For Example:

Company A offers EMI option over ordinary shares which are subject to pre-emption and have no voting rights. Company B offers an EMI option to employees but the shares sit after the preference shares on winding up. Both companies offer options over 10% equity.

In case of Company A – HMRC may accept the shares are worth less than the shares of Company B. The size of the discount depends on the nature of the preference given to Company B preference share holders.

Pointers for employers

We do handle the award of shares or options for employees including negotiations with HMRC. The Main areas where we help include:

HMRC procedures

In some cases elections are needed to preserve the employees ability to pay capital gains tax on disposal of his shares. Without an election there is a risk that gains are assessed to the much higher rate of income tax and national insurance.

The penalty regime enables HMRC to assess tax of up to 100% of the tax payable. HMRC operate a sliding scale based on culpability. If the employer can demonstrate it was not negligent and took appropriate advice on the taxable value of shares provided to its employees or directors the chances of a large penalty will be reduced.

HMRC and Inland Revenue Enquiries

A tax enquiry by HMRC is the process that HMRC use to check in more detail that the information reported is correct and complete. Questions may be raised about your return or HMRC might ask to review your records. Enquiries are often raised and random and therefore it is important to keep a record of documents and information used in relation to tax payments and returns.

Our specialist solicitors are able to assist with HMRC and Inland Revenue enquiries and investigations. Usually enquiries are concluded quickly through correspondence. However, HMRC can choose to look into your finances.

If you are facing an investigation or are under investigation, seek legal advice as soon as possible. By doing so, we can help you mitigate the risks of receiving a large penalty.

Communications with employees

Share awards work when employees realise how much value they are getting. However, employees often find valuation and taxation of share schemes confusing, especially the income/capital aspect. They do not want to be hit with a large tax bill and worry whether they will get their tax return right.

We draft communications for employees in a way they will understand.

Liability for employers

Employers who do not inform their employees of the full implications of the unquoted share award may be found culpable.  A recommendation to seek expert advice can be a good message to send to employees.

Investment advice

Employers need to be careful not to give investment advice to employees. There are unwanted repercussions for employers who are not authorised to provide financial advice but who break the rules.

Catherine Gannon

Catherine gets involved with thorny issues calling for her bank of practical commercial knowledge amassed over too many years of practice to count. Very good a thinking up work around solutions.

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