What's it worth? When private company shares must be valued
Many private companies are still unaware of the substantial tax and cash flow benefits that can be obtained from employee share schemes. But as part of the process of introducing a scheme it is usually necessary to agree a tax valuation with HM Revenue & Customs. This provides a baseline from which any subsequent tax charges can be calculated.
When HMRC is helpful
In some circumstances HMRC can be surprisingly helpful. For example, if you are considering offering share options under the government sponsored Enterprise Management Incentive (EMI) scheme, HMRC will discuss the valuation of the shares with you before the options are awarded, or even before the scheme documentation has been drawn up. This allows you to judge the tax consequences for the recipient. If the options are granted with an exercise price which HMRC considers to equate to fair value, all the gains realised when the options are exercised and the shares sold will be within the capital gains tax regime. This is much better than income tax and substantially increases the benefit to the recipient. It also means that the company will save on the NICs which would be payable on unapproved awards or cash payments.
Under an EMI scheme you don't have to grant the options with an exercise price equal to fair value. You can set the price higher or lower than this. Companies often promise options to their key people but don't get around to issuing them for some time. If the value of the shares has increased over this period, the directors may decide to compensate for this by setting the exercise price at less than current value. In this case, the difference between the two will be subject to income tax and possibly NICs at the date of exercise but the rest of the gains will still be subject to CGT only.
Reverting to type
HMRC is less helpful when it comes to other schemes. In relation to Company Share Option Plans (CSOPs), another type of government sponsored option scheme, or Share Incentive Plans (SIPs), HMRC will not discuss valuation until the scheme documentation has been fully drawn up and approved by HMRC, a process that can take months.
HMRC is even more unhelpful when it comes to other schemes, such as share purchase schemes or unapproved share options. In these cases the officials will not discuss valuation until after the awards have been made. This means that the company effectively has to guess what value will be acceptable to HMRC before making the awards.
Take the case of a share purchase plan. An increasing number of companies these days are offering employees the opportunity to purchase shares in their employers, but paying only a nominal amount up front. The rest is usually payable on an exit event such as sale or flotation. Any gains will normally be subject to capital gains tax, not income tax, although the employee may also be subject to investment risk. From a tax point of view, however, the problem is that if, after the transaction has taken place, HMRC decides that the total purchase price (including the deferred element) was less than fair value at the date of purchase, there will be a charge to income tax on the difference.
Getting it checked
It is generally worth having a conversation with HMRC about value as soon as possible after the transaction has taken place. There are two main reasons for this: firstly, that if the company subsequently does well, HMRC may be tempted to use the benefit of hindsight to argue for a share valuation higher than the deal price, which will trigger the income tax charge just mentioned. The second reason is that, in some circumstances, any income tax due must be collected via PAYE. This must be recovered from employee income within 90 days of the transaction taking place, otherwise the amount is treated as a benefit in kind to the employee and taxed again. This tax is irrecoverable even if the employee later pays back the unpaid PAYE. Therefore, a company could unwittingly incur a PAYE liability and find that, since it was not paid within the prescribed period, there is double tax to pay. It is likely also that penalties and interest would apply.
This latter scenario would apply if the shares are what is known as "readily convertible assets" (RCAs). Shares fall into this category if they are quoted, since the shares can be sold for cash. Private companies who allow employees to buy and sell shares via internal market arrangements will also find that their shares are classed as RCAs. There is a further trap for the unwary, however: shares in subsidiaries of private companies are automatically classed as RCAs whether or not they can be traded. This is an anti-avoidance measure designed to stop companies providing advantage to employee by manipulating the shares of subsidiary companies.
For this reason it is vital to (i) have your valuation prepared, or at least looked at, by a professional valuer such as the RM2 Partnership, that understands HMRC custom and practice and (ii) draft the documentation for the transaction so that there is the possibility of adjustment to the price if HMRC decides to be stubborn. It may be preferable to agree to pay a higher price at a later date rather than income tax for the current tax year. In some cases it may be necessary to allow for the transaction to be reversed completely if HMRC takes an unreasonable view, although thankfully in practice it is rare that transactions have to be completely reversed.
If you would like to discuss any of the issues raised in this article, please call us on 020 949 5522 and ask to speak to one of our advisers.