The financial benefits to employees of growth or “flowering” shares may be reduced and unexpected income tax liabilities could arise as HM Revenue & Customs takes a harder line on the valuation of these instruments.
Growth shares are structured so that they only have any value once certain performance hurdles are achieved – typically based on an increase in the value of the company. These shares are issued directly, or as part of a tax advantaged share option plan, to incentivise employees to grow the worth of the business. If arranged correctly, any profit on the eventual realisation of the shares should be charged to Capital Gains Tax meaning that, if the employees also qualify for Entrepreneurs Relief, the effective tax rate on any gain is just 10%.
When determining the value of these growth shares it is usually argued that because they only come into value in the future once certain hurdles are achieved they have no value at the point of issue or date of grant of the option. As a result, the employee only needs to pay a small, nominal sum for the shares, but stands to make a large gain if the performance targets are met.
HMRC is now resisting this approach and takes the view that these shares must have value today. In particular, while the size and cost of the growth shares may appear relatively small, due to the nature of the investment a prudent purchaser would require information over and above what a buyer of a minority holding of ordinary shares might normally require. For example, where the value of the growth shares is dependent on the growth in the value of the company and achieving an exit then the growth prospects are intrinsic to the investment and no purchase of those shares would proceed without access to additional information such as company forecasts.
The use of forecasts when assessing the value of growth shares may imply that HMRC could look to use valuation methods such as discounted cash flow analysis or option pricing models. This will almost certainly result in some value being attributable to the growth shares at the date of issue or grant of option, and the value may well be significant. If this value is not paid for the shares then an income tax liability may be created.
For companies and their legal advisers who are considering the use of growth shares, early specialist valuation advice is now critical. It can no longer be assumed HMRC will accept that these growth shares have no value.
For further information on this subject please contact:
Head of Valuations
Burgis & Bullock Corporate Finance
T: 07831 255302