Share ownership can give employees a vested interest in the success of the employing company, aligning the long-term goals of the company and the staff as well as helping to retain and reward them. However, valuing shares in a private company is often difficult, so it is important to ensure businesses, and employees, do not fall foul of the tax rules.
In private companies, estimating the value of employees’ shares is a fundamental aspect of the success of the share award. When shares are acquired or disposed of by employees, their market value for tax purposes needs to be considered or agreed with HMRC to ensure that any associated tax is properly calculated and paid.
Enterprise Management Incentives (EMI) and other tax-advantaged share schemes
EMI schemes are attractive as they are generally income tax free and employment income tax is only payable, if at all, on the date of exercise on any difference between the value of the underlying shares at the date of the grant of the options and the exercise price, if less.
EMI schemes tend to be very popular with SMEs, as employees can be granted options over shares up to a value of £250,000 per individual (up to a total of £3million in aggregate).
Another benefit of tax-advantaged share schemes such as EMI (as well as others such as CSOP, SAYE and SIP) is that the value of the scheme shares can be agreed with HMRC in advance of the award and we strongly recommend that this is done for unlisted companies.
In practical terms, valuations for EMI are considered with a lighter touch by HMRC than other valuations for income tax purposes; indeed, HMRC usually undertakes reviews of most EMI valuations within a matter of weeks and without detailed examination.
As a result, employers should be careful about relying on EMI valuations for other purposes, for example, the acquisition or disposal of employee shares outside of EMI, as HMRC will consider itself within its rights to seek to agree different methodologies and different values if it deems it appropriate.
Employers should also consider whether they are overstating the value of the shares, meaning that they may award fewer shares under the relevant limits and awarding employees with options with a higher exercise price than would necessarily be required – HMRC will not inform the taxpayer if it considers the values are too high.
Agreeing values with HMRC
Outside of EMI and tax-advantaged schemes, it is no longer possible to approach HMRC directly to agree the values of employee shares for employment income tax purposes. This means that employers should take care to ensure that the market value of any shares acquired or disposed of by employees has been considered and documented in case of any future enquiry by HMRC.
This is particularly relevant where the employer has an obligation to operate Pay As You Earn (PAYE) on any employment taxes arising from the sale or disposal of shares (generally, when the shares are considered to be readily convertible assets). The employer has a statutory duty to make the best reasonable estimate of the value for PAYE.
Certain types of highly-geared shares are often referred to as ‘growth shares’. Growth shares (sometimes known as ‘hurdle’ or ‘flowering’ shares) are only capable of delivering a return to the holder if the value of the company increases above a pre-determined ‘hurdle’ which is commonly set at a premium to the current value of the company. This means they are commonly used as a means of aligning employee reward with the long-term growth of a business.
Following an evolution in approach over the last few years, HMRC will, in almost all cases, expect the market value of such shares to be considered by reference to a ‘forward-looking’ methodology that takes into account the expected returns to the growth shares based on the forecast growth of the company and the likely date of a sale or other capital realisation.
This approach is somewhat contentious as, underpinned by past tax cases, methodologies relating to the valuation of minority shareholdings permitted by that case law suggest that there should be a limit to the amount of forecast financial information available to be used in the valuation.
In addition, undertaking a forward-looking approach, which could involve estimating the future performance of a business, can be complex and will require careful thought and consideration.
Check your working
We have increasingly seen share scheme valuations challenged by HMRC; particularly, those that fall outside EMI and other tax-advantaged schemes. This can sometimes result in a large tax bill for both the person with the shares and the business involved.
The benefits of ensuring the long-term investment in key staff through share schemes and share ownership should not be underestimated, but businesses need to take care that they are correctly structured, through appropriate advice where necessary.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.