Are We Bovvered?

Ken Moody points out that the employment related securities tax legislation may be of greater significance than many professional advisers consider it to be.

Introduction 

The Director of Taxation at a substantial firm recently remarked to me that he didn’t think that the employment related securities (‘ERS’) legislation was of much interest to most firms of accountants.  He may well be right about the level of interest, but what about relevance?

One fact that you can’t get away from if you are in the business of acting for private limited companies and their owner-managers, is that most of the shares they hold will be ERS – whether you like it or not.  Therefore I would say that yes, most practitioners should be interested in what the tax implications are of that, particularly in case there any potentially detrimental effects that you need to look out for and possibly do something about. 

I would accept that if you set up a company with nominal capital and with only a single or small number of shareholders it is quite likely that the ERS legislation will be of very little effect, but even so I do not think that the fact that the shares are ERS should be lost sight of and may ‘come back and bite’ when the shares are sold in some circumstances.

Form 42

For a start you need to think about the reporting requirements when ERS are acquired or any other reportable events occur.  I am referring of course to the form 42 procedure.  Most acquisitions of ERS will be reportable.  The requirements are relaxed by concession in the case of so-called founders’ shares, but this is a very narrow relaxation.  Since companies are often formed nowadays with only 1 subscriber share,  then while the transfer of the subscriber share may not be reportable the issue of further shares may be, and certainly would be once the company has started trading.  I would recommend a careful review of what the form 42 guidance says regarding founders’ shares; in some ways I find this relaxation unhelpful in the sense that it may foster a belief that founders’ shares are not ERS.  If the shareholder is a director or an employee the shares are definitely ERS with one exception – that they acquired their shares in the ‘normal course of … personal or family relationships’ (ITEPA 2003 s 421B(3)).  The Employment Shares Schemes Unit suggests that this covers the ‘plain vanilla’ situation of shares being passed down the family e.g. from father to son who also works in the business.  But this get-out is not all that it seems because of the ‘associated persons’ rules.  Suffice it to say that while it may be that the shares may not be employment-related vis a vis the son because of s421B(3) they remain ‘inside the box’ under the associated persons rules and there may be circumstances where the father would still be liable in respect of any chargeable event arising in connection with the shares.

Later acquisitions

The problems normally start if a new director-shareholder comes in at a later stage when the company is up and running and the shares have a value.  In that case if shares are acquired for less than their market value, income tax is payable on the difference.  This is of course old case law (see Weight v Salmon) and not due to the ERS rules.  Sometimes an EMI share option scheme will be appropriate, which will avoid any tax charge on acquisition of the shares when the option vests provided that the price payable for the shares under option is not less than their market value at the time the options were granted.  Even if the price were discounted, the tax charge on acquisition is only on the difference between the market value at the time of grant and the option price. 

I might note at this point that an interested professional adviser would also ensure that his clients receive a corporation tax deduction for any amount taxable as employment income on the employee, under FA 2003 Sch 23.

Restricted securities

If the shares are restricted securities, apart from any charge on acquisition there may be an additional income tax charge on the occurrence of a chargeable event such as the lifting or expiry of restrictions.  It would be an obvious way of avoiding tax if shares were issued subject to a restriction which depressed their market value and thus reduced any tax charge on acquisition; the restriction could then be lifted and the shares are suddenly worth a lot more.  The restricted securities legislation in ITEPA 2003 Part 7 Chapter 2 is designed to prevent avoidance in this way by providing that a ‘chargeable event’ would arise in such circumstances. 

HMRC appear to regard all private company shares as restricted securities in principle, though if the only restriction is the usual directors’ right to refuse to register a transfer, the shares are probably unrestricted or as near as makes no difference.  However, if the shares are subject to other transfer restrictions, pre-emption rights in the company’s articles they may be restricted; and if personal restrictions apply such as a risk of forfeiture if performance targets are not met then this is the sort of situation the legislation is aimed at.  There are complex formulae for working out the amount chargeable when a chargeable event occurs.  There is also a procedure for making an election so that any income tax charge on acquisition is by reference to what the shares would be worth if they were unrestricted, the quid pro quo being that no further income tax charges will then arise under Chapter 2 and any commercial growth in value will usually be liable only to CGT when the shares are disposed of.  If no election is made, apart from any chargeable event arising on the lifting or expiry of personal restrictions, the  disposal of restricted shares is itself a chargeable event.  While in many cases there is unlikely to be an income tax liability on disposal due to the way in which the formulae in section 428 in Chapter 2 operate, the potential for a tax charge exists and there is therefore a need for advisers to understand in what circumstances such a charge may be triggered. 

Chapter 3D and ‘fair’ market value

A specific area of difficulty is the possibility of an income tax charge arising under Chapter 3D of Part 7 where shares are disposed of at ‘fair market value’, or that is certainly the view of HMRC (see ERSM 80110).  Fair market value usually means pro-rata to the value of the whole company without applying the usual minority discounting.  Where pre-emption rights exist in a company’s articles of association, a shareholder who is a ‘good leaver’ will often be required to offer their shares to other shareholders at fair market value.  A good leaver will usually be someone who leaves the company’s employment through death, ill-health or retirement.  However, what Chapter 3D says is that if you dispose of shares for more than their open market value (applying minority discounting) the excess is taxable as employment income.  The charge under Chapter 3D was considered by a (single) Special Commissioner in the case of Company A v HMRC SpC 602 in relation to the sale of the whole of the share capital in the parent company of Company A to a third party.  The MD of Company A (Mr G) received a greater than pro-rata share of the proceeds under an agreement (The Subscription Agreement) entered into some two years earlier when Mr G joined Company A.  The Special Commissioner agreed with HMRC that PAYE/NIC was due from Company A under Chapter 3D in respect of the excess over what Mr G would have received for his shares on a pro-rata basis.  Mr Michael Sherry argued unsuccessfully that The Subscription Agreement took precedence over Company A’s articles of association and therefore that the open market value of Mr G’s shares should take account of his rights under that agreement.  This begs the question that if pre-emption rights are contained in a company’s articles which prescribe fair market valuation in certain circumstances, does the Company A decision imply that market value for CGT purposes is the same as fair market value?  We may have to await a further precedent to enable that question to be answered conclusively, however this demonstrates that this is a ‘live’ issue and that the HMRC guidance is not necessarily correct.

Chapter 4 – dividends assessable as employment income?

Another ‘live’ issue is whether private company dividends may be regarded as disguised remuneration under Chapter 4 of Part 7 (Post Acquisition Benefits From Securities).  Until F(No 2)A 2005, section 447 in Chapter 4 stated that if income were assessable under other provisions of the Taxes Acts Chapter 4 would not apply.  As a result of a F(No 2)A 2005 amendment this now only applies provided nothing has been done which affects the shares as part of arrangements to avoid tax.  The argument thus runs that in paying themselves nominal salaries and drawing large dividend payments, proprietors of small companies are avoiding (mainly) national insurance.  There is still some doubt as to whether s447 can apply to company dividends properly declared and recorded – Andrew Thornhill QC has reportedly described Chapter 4 as a ‘damp squib’.  There is also to my mind the objection that the fact that dividends do not attract NICs is a facet of the company form in the same way that the shareholders do not pay income tax on monies left in the company (unlike a sole trader or members of a partnership).  However, it must be said that the usual dividend/salary strategy will indeed often be motivated by a desire to avoid NICs and that may be sufficient for the legislation to apply.  I have recently been consulted in a case where a number of classes of ordinary shares were in issue.  One class was, if you like, the ‘equity’ shares while the other classes were individual share classes A, B, C etc.  These were used to pay differential rates of dividend and had few other rights attaching, though the holders of the individual classes were also the equity shareholders.  HMRC were arguing that the dividends on the individual share classes reflected personal performance and were thus disguised remuneration.  The inspector was threatening to raise assessments under Chapter 4, though it would appear that HMRC’s preferred course, normally, is to proceed on the basis that the dividends should be assessed as general earnings under section 62 ITEPA 2003.  The enquiry has still to run its course and needless to say the inspectors’ arguments are not accepted.  It may also be the case that the inspector would be overruled since any decision to proceed under Chapter 4 may be a matter of policy.  However, while the direction of this particular enquiry may be down to an overzealous inspector, it is clearly not safe to assume that the dividend v salary question is a non-issue and if there is a change of HMRC policy it will be of concern to all private company owner-managers.

So, to answer my own question: should professional advisers to private company OMBs be interested in ERS matters, I would say most certainly they should!

Employment Related Securities and The Private Company

Ken Moody is author of 'Employment Related Securities and The Private Company', which is available via TaxBookShop. For further details and to order a copy from TaxBookShop, click here.    

Article Added Friday, 19 September 2008

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