How are private company shares taxed

Using our experience, we advise employers and shareholders on calculating the taxable value of shares in private companies.

Where all shares are sold at the same time, the sale price will generally establish the consideration for calculating the taxable gain. However, tax charges can also arise on transactions involving only part of a company’s share capital, and sometimes where no cash changes hands.

Situations that may give rise to a tax charge include:

• Gifting shares in private companies to employees, former employees or directors;
• Issuing new shares or transferring existing shares to employees under a share plan;
• Enhancing the value of shares held by employees or directors by granting additional rights, such as preferential sale proceeds or dividends rights;
• Exercising options, including EMI options; or
• Buying out a shareholder who wishes to exit before the entire business is sold.

Valuing private company shares for tax purposes can be complex because there is no quoted market price. Different circumstances and share rights can produce different values for the same shares. HMRC reporting and payment deadlines must also be met to avoid potential penalties and interest.

Establishing the background to the taxable value

The purpose of the transaction can influence the valuation approach. For example:

An investment valuation may reflect anticipated growth and commercial potential, even where the company’s current financial position suggests a lower value.

An internal share transfer may focus more on current value, although the relationship between buyer and seller and their willingness to transact can affect the price.

A valuation for tax purposes must follow the relevant tax valuation principles. It may differ from a commercial valuation, particularly where goodwill, future potential or the rights attached to the shares are assessed differently.

Approaches to calculating the taxable value of private company shares

Three common approaches to valuing private company shares are the dividend, earnings and asset bases. The appropriate method depends on the company and the rights attached to the shares.

Dividend basis

The dividend basis is often used for minority holdings in mature businesses where dividends are a key benefit of ownership. It considers historic dividends, growth patterns, fluctuations and expected future dividend policy.

Dividend yield and comparisons with quoted companies may assist the valuation. However, the likelihood of receiving dividends should also be considered, including where a majority shareholder can influence whether dividends are declared.

This approach is generally unsuitable for loss-making businesses, companies still investing for growth or shares that do not carry dividend rights.

Earnings basis

The earnings basis is commonly used to value profitable businesses and controlling shareholdings. It assesses maintainable profits and applies an appropriate valuation multiple to estimate the company’s value.

Adjustments may be needed to reflect the costs of running the business on a sustainable basis. For example, where founders take most of their remuneration as dividends, an appropriate salary cost may need to be reflected in maintainable profits.

Asset basis

The asset basis is often used for investment or asset-rich companies, or where the value of the underlying assets exceeds the value indicated by earnings or dividends. It may also be relevant where a company is being wound up.

What is HMRC's approach to agreeing the taxable value

HMRC considers the circumstances of the transaction and the rights attaching to the shares. A valuation may draw on more than one method and should reflect the relevant tax valuation principles. Factors include:

1. Size of shareholding

The size of a shareholding can affect its value, particularly where it determines the degree of control or influence over company decisions. A minority discount may be appropriate, but its extent depends on the facts and should not be assumed.

2. Voting rights

Voting rights can affect value by influencing company management, distributions and decisions about a sale. The number of shares held does not always determine the degree of control. The rights of other shareholders and any arrangements between connected shareholders may also be relevant.

3. The right to veto certain decisions

A shareholder with at least 25% of voting rights can generally block a special resolution, which may increase the value of the holding. Articles of association or a shareholders’ agreement may also give veto rights to shareholders with smaller holdings.

4. The right to have a director on the board

The right to appoint a director may give a shareholder greater influence and access to company information, potentially affecting the value of the shares.

5. The number of shareholders

The distribution of shareholdings can affect the influence an individual shareholder has. For example, a 20% holding may carry greater practical influence where ownership is divided equally among five shareholders than where one shareholder holds 80%. The effect on value depends on the actual voting arrangements and rights.

6. Marketability

Restrictions on share transfers, including pre-emption rights or forfeiture provisions, can reduce marketability and may affect value. The extent of any discount depends on the restrictions and the circumstances of the holding.

7. Future income potential

Expected growth in earnings or a planned IPO may affect value, particularly where there is credible evidence that future income or sale proceeds are likely to increase.

8. Strategic value

A minority holding may have additional strategic value where it can influence a business sale or provide access to important commercial opportunities. Transfer restrictions and the identity of potential buyers may also affect this value.

9. Information available

The information available to a shareholder may affect a valuation. A minority shareholder without board representation may have less access to company information, although this depends on their rights and any relevant arrangements.

10. Articles of Association/Shareholders agreement

The articles of association and shareholders’ agreement should be reviewed at the outset because they determine the rights attaching to shares and may restrict transfers. Relevant provisions include:

• Casting vote – a casting vote may determine the outcome of a deadlocked decision and affect the influence attached to a shareholding.
• Dividend rights – fixed or preferential dividend rights may affect the value of shares.
• Capital rights –the entitlement to company assets or sale proceeds can influence value.
• Transferability – restrictions on transfers may reduce marketability and affect the valuation.
• Fair value provisions – contractual valuation mechanisms may influence the price payable on a transfer, depending on their wording and application.
• Drag and tag along rights – these rights can affect a shareholder’s ability to participate in a sale and the terms on which shares can be sold.

Please contact us if you need advice on valuing private company shares for tax purposes or agreeing a valuation with HMRC.