Valuation insights: Selling shares for more (or less) than market value

We have recently seen a number of instances where shareholders’ agreements contain a different method for allocating sale proceeds to shareholders from the Articles of Association. Such arrangements may expose shareholders and the company to substantial tax liabilities.

There are often good commercial reasons why some shareholders should receive a larger proportion of the proceeds on a sale than they are entitled to under their actual percentage shareholding. Ratchet arrangements are common in private equity backed companies. However, family owned businesses may also want to use such arrangements, for example, to incentivise certain managers in the business. Where the shareholders are also employees their shares come under the “employment related securities” legislation and particular care must be taken when enhancing the rights and entitlements of these shareholders.

A gray area

The key case is that of Grays Timber Products Limited v HMRC, 2010. Under the terms of a 1999 shareholder’s agreement the managing director was given the right to receive a much larger proportion of the proceeds on any sale of the company than he would have been entitled to with his 6.6% shareholding. In 2003 the company was sold and the director received the additional consideration. However, because the shares were employment related securities an income tax charge arose on the amount of the consideration received over the market value of the shares (Chapter 3D of Part 7 of Income Tax (Earnings and Pensions) Act 2003). Also, because the shares were deemed to be readily convertible assets the liability fell on the employer under PAYE.

The Supreme Court held that the right to the additional consideration was personal to the director and of no value to any purchaser. Accordingly, such rights could not be taken into account when determining the market value of the shares. Therefore, the extra consideration received was in excess of market value, classified as employment income, and subject to an income tax charge under ITEPA. As the sale of the company was in prospect, the shares were also deemed to be readily convertible assets, and so national insurance contributions were also due.

In some circumstances a sale price differential can be justified because shareholders are selling their shares on significantly different terms, for example, one set of sellers may give extensive warranties and indemnities while the other sellers do not. Particular care needs to be given to earn-outs, which may only be payable to employee shareholders.

A class act

While certain issues from the case remain unresolved, the safest course of action is always to ensure all share rights are included as class rights in the Articles of Association. To the extent that such class rights increase the market value of those shares on issue compared with other classes of shares it may be necessary for subscribers to pay a higher subscription price to reflect the full market value of those shares.

For further information about this subject please contact:

Simon Chapman

Corporate Finance Partner

M: 07831 255302


Anne Rose

Head of Tax

M: 07932 743266


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