Private companies, particularly those which are private equity backed, sometimes use so-called “growth shares”, to allow senior managers to benefit from Entrepreneurs Relief (ER) on the increase in value of those shares. Recent regulatory changes mean these structures risk inadvertently triggering a reporting obligation, to the effect that they constitute tax avoidance.
What are growth shares?
Growth shares are shares with class rights designed to allow participation in the value of the company (for example on a sale) only above a pre-determined ‘hurdle value’. The hurdle value is typically set at a premium to the current value of the shares when they are acquired by the manager. This reduces the up-front value of the shares, making them more affordable, while incentivising the recipient by reference to the growth in value of the company.
Growth shares implemented by private equity backed companies have commonly been structured to allow a small number of senior managers to benefit from ER.
What is the impact of the Disclosure of Tax Avoidance Schemes (“DOTAS”) regulations on growth shares?
The new DOTAS ‘Financial Products Hallmark’ (see Further Information section below) potentially covers growth share arrangements. The application of DOTAS usually turns on whether it would be reasonable for an informed observer to conclude that the main benefit of including the particular features of the growth shares was to obtain a tax advantage. DOTAS requires certain transactions to be notified to HM Revenue and Customs (“HMRC”) where HMRC considers that part of the rationale for the transaction is the avoidance of tax – a finding which companies generally prefer to avoid.
Why does this matter?
Although such a notification does not imply unlawful conduct, many companies prefer to avoid labelling themselves to HMRC as a “tax avoider”. Potential reputational impact may be a particular concern for some businesses. Others may be less concerned about this label. However, most companies prefer not to flag their activities to HMRC, in order to avoid increased HMRC scrutiny of the company’s tax affairs more generally. In addition, any DOTAS notification is an invitation to HMRC to apply the General Anti- Avoidance Rule (”GAAR”) and seek to deny Entrepreneur’s Relief.
Failure to report a scheme to which DOTAS applies can lead to penalties for the company using the scheme and for the adviser involved in designing the arrangements. Advisers will also be alive to the legislation expected to be enacted after the June 2017 general election whereby advisers who are found to be ‘enablers’ of defeated tax avoidance schemes may be subject to additional penalties.
What does this mean for growth-share incentive structures?
Companies and their advisors must consider carefully whether or not a DOTAS notification is required. The aims and context of the overall structure of which the growth shares form a part are critical, as this is likely to indicate the level of exposure to a DOTAS reporting obligation. We can help with this assessment, and advise how to mitigate any risk, as well as on alternative structures for share-based incentive schemes.
For further information please contact Alasdair Friend, Partner (Compensation & Benefits), on +44 203 051 5711, or email us at firstname.lastname@example.org.
Further information about entrepreneur“s relief (ER) and DOTAS
What is ER?
ER is a relief which applies a lower rate of capital gains tax to chargeable gains, provided certain conditions are satisfied. Gains which qualify for ER are taxed at 10%, rather than the usual 20% rate which applies where an individual has total income and gains in a tax year in excess of the threshold for the higher rate of income tax. ER is available for the first £10 million of qualifying lifetime gains.
How do shares qualify ER on sale?
Broadly, for shares to be eligible for ER on sale, it is necessary that:
- throughout the period of at least one year ending on the date the shares are sold the shares have been shares in a trading company or the holding company of a trading group;
- the selling shareholder has been an employee or director of the company or another company in the same group as the company, and
- the company must have been the employee’s ‘personal company’. (The company is the employee’s ‘personal company’ if the seller has held shares carrying at least 5% of the voting rights in the company and representing at least 5% of the aggregate nominal value of all shares in the company).
What are the four hallmarks under the DOTAS Financial Products hallmark?
See table below. There are four conditions for the application of DOTAS which will apply provided condition 1 and condition 2 (which usually apply in growth share structures) and either of conditions 3 or 4 are satisfied.
|Condition 1||the arrangement includes a Financial Product (‘Financial Product’ is defined to include shares, so this condition will be satisfied).||Must apply|
|Condition 2||an informed observer could reasonably conclude that the main benefit of including a specified financial product is to achieve a tax advantage||Must apply|
|Condition 3||a specified financial product included in the arrangements contains at least one term which would not have been included but for the tax advantage||Either 3 or 4 must apply|
|Condition 4||the arrangement involves contrived or abnormal steps without which the tax advantage could not be obtained|
HMRC has published guidance which recognises that there are circumstances in which the use of shares carrying the types of rights typical of growth shares would not satisfy condition 2. For example, where such shares are used as part of a large scheme or arrangement to further the commercial interests of the company, an informed observer might conclude that obtaining a tax advantage would not be a main benefit of including this type of shares into the overall arrangements.
Why are 3 or 4 likely to apply to these scenarios?
Arguably, enshrining a right to 5% of votes, or setting the nominal value of the shares such that a particular employee’s holding will have a nominal value of at least 5% of the total nominal value of the company’s shares would satisfy Condition 3 or 4 – there may be no reason for including these rights or setting the nominal value at this level other than to make the shares eligible for ER, and the purpose of making the shares eligible for ER is to reduce the amount of capital gains tax ultimately payable.
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