This article is the first in a series designed to bring readers up to speed with share scheme basics and the taxation of employment-related securities.
Share schemes sound scary, and many of us make a conscious effort to steer well clear of them. Unfortunately, every advisor needs to have a basic understanding of the rules. Almost any share transaction between individuals is likely to be construed, according to the legislation, as being part of an unapproved share scheme, and if it is part of a scheme, then there are employment tax issues to consider as well as capital ones.
The rules for employment related securities are in place to tax shares and securities as if they were employment income. They were created because shares and securities have been used in the past to create tax-efficient employee remuneration, and HMRC decided to put a stop to this form of tax planning. The provisions are found in Part 7 of ITEPA 2003, and need consideration whenever a company grants options or allots shares (or any other security to which the legislation applied) to any individual. The rules also can apply whenever any individual buys, sells or gifts any shares or securities from or to another individual.
The legislation is aimed at big companies engaging in complicated tax planning schemes, and an unfortunate side-effect is that it also affects really, really small companies.
For example:
Fred set up his own company Amityville Limited, with two shares allotted to him. One year on and he needs to expand the business. Burt, an old friend comes by, and he happens to have exactly the right talents. Fred suggests that Burt joins him and he likes what he sees. He realises that there is considerable risk at stake, and so suggests that Fred might like to give him a part of the business, and they could then proceed as equal shareholder-directors.
"Fine" says Fred, "Lets see an accountant to set this up".
The perfectly reasonably action of asking someone to "come on board" and also become a shareholder brings with it an incredible number of problems:
Capital gains:
Value shifting rules – s.29(2) TCGA 1992 dictates that Fred is making a part disposal of his shareholding. This applies even when new shares are allotted, as Fred's percentage shareholding is diluted and that means that he has "shifted" some of their value.
He could sell a share to Burt and he will have some cash with which to pay the CGT bill which is calculated after giving one year of business taper relief (we assume that Fred’s business constitutes a trade for taper purposes).
If Burt is being allotted new shares or given existing shares, the pair can make an election under s.165 TCGA 1993 to hold over the gain, though the gain held over is not tapered.
The capital value of new shares in Burt's hands depend largely on their income tax treatment – and this is where the 'fun' really begins.
Income tax
Let us assume that the company issues shares to Burt for no payment.
The chapters in Part 7 which are of particular interest to SME owners and advisors are the ones which can tax unapproved share schemes - Chapters 2 to 4 and 5. Chapter 4a deals with Research Spin-off companies, and so can safely be ignored by many practitioners!
The Enterprise Management Initiative is not a proper approved scheme, but like approved schemes has many tax advantages over unapproved schemes. This is dealt with on its own in Chapter 9.
Potential directors and office holders are deemed from the outset to have acquired employment-related securities. S 5 ITEPA 2003 says that all office holders are deemed to be employees. There is no exemption for subscriber or founder shares within the legislation. Burt has therefore acquired employment-related securities.
Shares are taxed on the money's worth principle established in the case of Weight v Salmon [1935] 19 TC 174, which means that they need to be valued. At this stage it is important to examine the rights, restrictions and conditions attaching to the shares in question. Any share which has different rights to those contained in Table A of the Companies Act may be a restricted share of one sort of another.
I will examine restrictions, conditions and rights in more detail in a further article. What needs to be established is whether Burt's shares would have a different value were it not for anything that affects them. Let us assume that the company’s Articles of Association follow Table A, in these circumstances, HMRC treat them as unrestricted securities.
A valuation of the new shares is agreed and Form CG34, "post-transaction valuation check", is submitted to HMRC’s Shares Valuation.
If the shares were found to be restricted, then Burt could, by making an election under s 431 ITEPA 2003, ask to be taxed on their unrestricted market value on acquisition. This would be a higher value, but it would ensure that any growth in the shares would be taxed as capital. For simplicity, Burt's shares are unrestricted securities in this example.
The next question is whether or not the share are Readily Convertible Assets (RCAs) or not. RCAs are taxed as notional salary payments directly through the payroll and PAYE and NICs are payable as a result. For a share to be an RCA, it must have some form of trading arrangement in place, or disregarding all ideas of trading, a share will be an RCA if it is one issued by employing company's subsidiary.
Burt's new shares in Amityville Limited are not RCAs, there is no means in place by which he can dispose of his shares. The articles of Amityville Limited say that an exiting shareholder must offer his shares first to other shareholders, but nothing says that they must buy them. He puts the value of his new shares on his tax return and suffers income tax on them at 31st January next.
Sch 23 FA 2003 produces a corporation tax deduction for Amityville Limited which mirrors the amount assessed on the employee for income tax.
This is subject to s.34 ITTOIA 2005, the "wholly and exclusively" rule. There is no guidance from HMRC so far to indicate whether s.34 might prevent a corporation tax deduction when additional shares are issued to directors in these circumstances.
Form 42 needs to be completed by Amityville Limited at the end of the tax year to record the transaction in securities, but there are some exemptions from the legislation when friends and family are given shares (s 431(3)B).
Burt may be able to claim this exemption if Fred is willing to help prove that he was only given a share because he is an old friend. The exemption is not really (judging by the guidance on offer) meant to be used in these circumstances, but it could be worth the claim as it will immediately take Burt shares outside Part 7 ITEPA 2003, and the advantages in terms of red tape removal alone are even better than any tax benefits.
In summary
1. Burt has been given some shares in what turns out to be an unapproved share scheme.
2. As a director/prospective office holder/employee he is automatically deemed to have acquired shares for an employment-related reason, they are therefore employment-related securities
3. He suffers an income tax charge on acquisition, and may suffer later charges depending on the restrictions, conditions and rights attaching to his shares. This is subject to making the appropriate elections on time.
4. He may be able to opt out of income tax charges by claiming an exemption for friends and family.
5. Assuming no claim for friends and family, the company, Amityville Limited will need to file form 42 and make the entries in its accounts for the Sch 23 deduction for value of the shares.
6. A S.431 election is a sensible idea. This is signed by Amityville Limited and Burt within 14 dates of the share allotment and kept in the company's safe should it ever need to be inspected.
7. A share valuation has been prepared and submitted by the accountant.
8. Burt must declare the shares' value on his tax return.
9. Fred will need to complete CGT pages on his SA return.
Fred wonders what on earth he has set in place - he has created a house of horrors! He had absolutely no idea of the number of issues and their tax consequences. He might have considered granting Burt share options, different classes of share, or nil paid shares instead. I will explore these in the articles which follow in this series.
