Valuing restricted shares impact of decision of First-tier Tribunal

The valuation of private company shares acquired by, and disposed of by, employees is a complex field which has frequently caused confusion and misunderstanding.

There are several different share valuation methods which can be adopted for tax purposes. Which one will apply in a particular case will depend on the circumstances of the event giving rise to the tax charge.

Since 2003, the tax treatment for restricted shares has been governed by Chapter 2 of Part 7 of the Income Tax (Earnings and Pensions) Act 2003. This legislation is fairly complex, but to date, few cases on its interpretation have been heard by the tax tribunals. One reason for this might be that companies and employees have frequently entered into section 431 elections (see below), even if only on a protective basis, in order to opt out of the Part 7 regime.

However, share valuation issues were relevant in the recent case of Sjumarken v HMRC [2015] UKFTT 375 (TC). The taxpayer had an interest in more than one of his employer’s incentive plans, but the one which is of particular relevance from the valuation viewpoint was his interest in his employer’s share plan (Share Plan).

After the taxpayer had been made redundant by his employer, certain shares deriving from the Share Plan were allocated to the benefit of the taxpayer.

At the time, these shares appear to have been valued for tax purposes by the employer without reference to any restrictions (resulting in a higher valuation and therefore more tax payable), although the taxpayer was informed by his employer that restrictions continued to apply to at least some of the shares. Evidently, there was some confusion over the extent to which (if any) restrictions continued to apply, and, if so, how this would affect the valuation process. The tribunal concluded that the relevant provisions in the Share Plan were unclear, and that, in practice, the shares were subject to restrictions and should therefore be valued on that basis.

This case is instructive on the following points:

1.       It is crucial that share scheme documents should be clear and unambiguous, and that individual arrangements for particular employees should be communicated fully and clearly to participants, so as to avoid lengthy and time-consuming arguments further down the line.

2.       Similarly, careful records should be kept by the employer regarding the individual arrangements for particular employees, and, in particular, the basis on which valuations are made.

3.       Where restricted shares are involved, a section 431 election might usefully be considered in order to disapply the Part 7 regime. Such an election can sometimes result in a higher upfront tax charge, but it does normally secure greater certainty of tax treatment.

Employee Share Plans in Growth Companies

14th July 2014

New research on how UK-based companies with ambitions to grow are using equity as an incentive and reward for key employees.

Postlethwaite has recently carried out research into how a broad range of UK-based companies are using equity to incentivise and reward their key employees. The research covers tax-advantaged arrangements, such as Enterprise Management Incentives and Company Share Option Plans, as well as non-tax-advantaged arrangements such as growth shares, partly-paid shares and restricted shares.

The trends emerging from this research will be of interest to entrepreneurs and their financial backers, as well as the SME sector generally and their advisers.

A report summarising the findings from this research is now available on our website by clicking here

If you or your clients would like to discuss any aspect of the report or of the research underlying it, please contact:

Robert Postlethwaite rmp@postlethwaiteco.com
David Reuben dgr@postlethwaiteco.com
Stephen Chater spc@postlethwaiteco.com
Judith Harris jdh@postlethwaiteco.com
or call us on 020 7470 8805

New tax reliefs for employee-owned companies

10th April 2014

Finance Bill 2014 confirms two new tax reliefs designed to encourage and support the creation and growth of employee-owned companies.

Employee ownership can take the form of direct ownership (where employees hold shares in their employing company), indirect ownership (where shares are held collectively on behalf of employees, often through an employee benefit trust (EBT)), or some combination of the two.

Existing tax-advantaged share plans encourage employees to make direct acquisitions of shares in their employer company on an individual basis, rather than encouraging the holding of shares indirectly on behalf of employees.

Under the first new tax relief, the sale of a controlling interest in a business to an indirect employee ownership structure (to be known as an “employee ownership trust”) will be entirely free from capital gains tax (CGT).  

An employee ownership trust (EOT) must meet certain requirements:

  • The company whose shares are transferred must be a trading company or, where there is a group, the principal company of a trading group.
  • The EOT must meet the “all-employee benefit requirement”.
  • The EOT must not hold a controlling interest in the company before the disposal, but must do so at the end of the tax year in which the disposal takes place.
  • Where the transferor has an interest of more than 5% in the company in the 12 months before the disposal, the ratio of employees who are participators to employees generally must not exceed 2/5.

The all-employee benefit requirement means, in the main, that if the EOT provides benefits (such as cash or shares) to individual employees, it must generally do so in favour of all eligible employees on the same terms (the “equality requirement”). The EOT cannot, therefore, skew benefits to the advantage of particular employees, although it can allocate benefits of differing amounts by reference to factors such as salary, length of service or hours worked.

In the course of consultation, the Government accepted that it could be difficult for existing EBTs to satisfy the all-employee benefit requirement without significant changes to their constitutional documents. It has, therefore, introduced deeming provisions to the Finance Bill whereby an existing EBT can be deemed to meet the all-employee benefit requirement, if, broadly, the way in which it operates is consistent with the all-employee benefit requirement, it had at least a 10% shareholding in the underlying company at 10 December 2013 and subsequently obtains control of it.

The new relief is available for disposals on or after 6 April 2014.

Comment: Ownership succession by selling to an employee trust has grown in popularity in recent years, but is not yet widely understood and has so far been chosen by only a small proportion of companies. However, it is generally no more complex than a trade sale and is often simpler. It is particularly well-suited to companies whose value largely derives from the talents of its employees. This new relief is intended to encourage more business owners to go down this route. The important practical point is that a seller or sellers wishing to benefit from full CGT relief will need to ensure that the EOT receives a 100% holding in a single tax year.

Under the second tax relief, bonuses up to £3600 per tax year paid to employees of companies controlled by an EOT benefit from an income tax (but not National Insurance) exemption.

The key requirements for the new relief are:

  • The employer company must be a trading company or a member of a trading group.
  • A controlling interest in the company or, in a group situation, the principal company of the group, must be held by an EOT.
  • Provisions very similar to the equality requirement for the CGT exemption also apply to the income tax exemption.
  • The company should not have a ratio of more than 2/5 for office holders and directors to employees.
  • The payment must not consist of normal salary, must not be made by a service company and must be made under an arrangement under which:
  • all employees of the company, or, where there is a group, any group company must be eligible to participate in any award (although employees with continuous service of less than 12 months can be excluded); and
  • all employees participating in the arrangement must do so on equal terms (although awards can be determined by reference to pay, length of service or hours worked).

The new relief will apply to payments on or after 1 October 2014.

Comment:  Any company which is or becomes majority owned by an EOT should investigate this new relief further. It doesn’t prevent bonuses also being paid on a discretionary basis to selected employees, although these will not benefit from the tax exemption.

New Research on the Performance Impact of Employee Ownership

15th January 2014

The Cass Business School has recently published the findings of a study into the comparative resilience of employee-owned businesses (EOBs) during periods of both recession and economic growth.

The research finds that, when compared with non-employee-owned businesses (non-EOBs), EOBs show:

• Significantly higher growth in sales turnover during recession
• Significantly higher growth in employee numbers during recession
• Similar sales turnover per employee to non-EOBs despite maintaining higher employment levels during recession
• Superior employee contribution to profitability despite maintaining higher employment levels during recession

The study is based on data obtained from 38 EOBs and 239 non-EOBs for the period 2009-2011, and extends the findings of a similar analysis conducted in 2010 for the period 2005-2009. For the purposes of the Cass study, EOBs are businesses which are majority-owned by employees.

The most striking finding is the significant and steady decline in turnover of non-EOBs between 2005 and 2011, while EOBs showed positive growth in turnover, even as the recession deepened. The survey found that, while EOBs are not immune from recessionary pressures, they appear to be better able to withstand the downturn.

Although the study indicates a general slowdown in the growth in numbers of employees during the period, the impact of the recession seems to have been less severe for EOBs than for non-EOBs who, as a group, dropped into negative growth figures on employment.

For more information, please go to: http://tinyurl.com/q6cmuko

 UK Employee Share Ownership Index (EOI)

The Cass study coincides with the publication of separate research which finds that UK companies which are viewed as encouraging employee share ownership have delivered substantially better returns for their investors than their listed peers last year.

The EOI measures the share price performance of FTSE-All Share companies in which employees own at least 3% of the equity. During 2013, shares in the 69 companies which satisfied this ownership condition produced an average total return (share price plus dividends) of 53.3% as against an average total return of 20.9% achieved by the other 623 companies in the All-Share index.

Among the companies making up the EOI are support service companies such as Atkins and Mitie, financial services companies such as Brewin Dolphin and Admiral, the insurance broker. Employee share ownership was, of course, an important feature of the privatisation of Royal Mail, which was the largest London flotation in 2013.

For more information, please go to: http://tinyurl.com/non3c5a

These two studies seem to provide strong evidence to support the Government’s declared view that employee ownership is beneficial to the UK economy as a whole. Details of the most recent tax incentives announced by the Government to assist employee ownership can be found on our website by clicking on the following link: http://tinyurl.com/qzb6sh2

Employee Ownership: Connecting the Parts

29th August 2012

How does a business with employee shareholders encourage them to think and act like owners?

The Government has said it wants to see more businesses become employee-owned, wholly or partly. This includes encouraging public sector workers to assume control of the delivery of public services through the formation of mutual enterprises owned by employees, and encouraging existing businesses to allow employees to acquire an ownership stake. However, how should a culture of ownership be created among employees? In what ways can employees be educated in how a business operates and how to identify targets and measure performance?

One approach, originally pioneered in the USA, is the concept of “open-book management”. The promoters of this idea take the view that changing the culture requires more than simply granting shares or share options to employees, paying them bonuses or creating some kind of employee benefit trust. What is required is a change in attitude and a process of continuing education. Employees should learn that they have a direct role to play in creating the kind of company they want, and that an ownership culture is built on mutual trust and respect. In order to do this, employees need to be initiated into the ways in which business owners and entrepreneurs think by being guided through a business’s strategic plan and its management accounts.

These ideas are discussed in greater detail in “A Stake in the Outcome” by Jack Stack and Bo Burlingham, published by Currency Books.

The authors advocate providing informal business training to employees throughout the organisation and maintaining a focus on creating the kind of company that its owners want. Their approach is to treat it as what they describe as a “business game” with discussions about targets linked to defined awards, regular progress reviews and business performance reports. An example might be weighing up the relative merits of paying a dividend to shareholders as opposed to making a reinvestment in the business.

What will work in a specific situation will depend on the precise circumstances of a particular business, but the essential ingredients are openness, transparency and mutual trust and respect.

The challenges are significant but, judging by the examples cited in “A Stake in the Outcome”, so are the potential rewards.

It’s all about encouraging employees to behave like owners. If wider employee ownership is to prosper in the UK, these issues, and the ways in which they might be approached, will become familiar challenges to employers, employees and professional advisers alike.