This note is a response by Pett Franklin LLP to the commentary relating to growth shares by the OTS in its 2020 Report into Capital Gains Tax.
This note accepts that there are reasons historically to be concerned about growth shares but considers that the OTS Report did not take into account significant changes already made by HMRC to the tax valuation regime and other emerging concerns about the complexity of growth shares which should naturally curb their use without requiring new detailed and complex counter avoidance legislation (which may cause other harmful and unintended consequences) beyond the legislation to prevent the abuse of equity-based compensation such as the Employment Related Securities Act (Part 7 ITEPA 2003) which already exists.
Context to OTS Comments on Growth Shares
The OTS paper refers in generally unfavourable terms to growth shares (see below for information about growth shares) and in discussions with interest groups after publication of its report the OTS has suggested that it was perceived abuses of growth shares and the tax advantages they bestow of capital rather than income treatment which was the primary area of their concerns about share schemes rather than the government’s own tax advantaged share schemes, particularly those that are all employee. There appeared to be an underlying concern that growth shares had sometimes been structured as a form of complex disguised bonus arrangements where the ultimate realisation of value in a capital form for the taxpayer was only, if at all, loosely linked to real capital growth in the value of the equity of the company.
However the OTS Report did not explore growth shares in depth or their historical development and seems to have drawn heavily on fairly superficial publicly available information from some accountants’ websites. The most significant direct comment made by the OTS in the report itself is that growth shares are difficult to value.
There has been more use of growth shares over the last decade or so. They have become increasingly used by larger unquoted companies and have been used by some quoted companies. The use in the quoted sector is relatively limited because of the normal listing rules requiring a single class of shares in a quoted company and the complexity and expense of setting up arrangements over the shares in subsidiaries which can later flip up into the shares in the quoted parent company.
The main use of growth shares has been in the unquoted sector among larger companies with meaningful existing values or companies with private equity ownership and control which prevents the use of EMI options or where the number of tax advantaged awards that a senior executive requires exceeds the £250,000 EMI limits.
The use of growth shares developed as gradually share scheme lawyers became more confident of the strength of the legal analysis that if the terms of the growth shares were actually incorporated in the articles of the company, they were inherent features of the shares and not restrictions over shares, and so were not subject to the 2003 anti-avoidance restricted securities legislation which had been introduced with the intention of blocking arrangements somewhat similar to growth shares which were then often called flowering shares.
The critical issue then became the value of the growth shares at the time of their award because the award itself is a grant of an employment-related security subject to employment taxes at grant.
Growth shares started to gain use at a time when HMRC still provided as a public service a valuation agreement process whereby soon after awards had been made it was possible for the taxpayer to seek an agreement with HMRC as to the value of the shares for the purposes of PAYE best estimates or post transaction valuation checks. Valuations of considerable complexity were often presented to HMRC for agreement in a from which was difficult for HMRC to easily understand and which absorbed considerable amounts of HMRC time. At face value these awards would often appear to require significant increases in the value of the company which seemed improbable and so HMRC often agreed to nil or negligible values.
The pressure on HMRC to agree low values was considerably exacerbated by a short lived government share scheme called Employee Shareholder Status ESS which in reality was used primarily to award growth shares to senior executives and forced HMRC to agree valuations of growth shares in advance of the making of the awards.
The result was that for several years nil or nominal values were accepted by HMRC and the use of growth shares mushroomed and lawyers became tempted to design ever more complex growth shares. But HMRC started to have misgivings. They requested that valuations submitted to them should contain detailed worked examples so they could more easily review and evaluate the operation of the growth shares in different scenarios. But these worked examples were generally not provided and some valuers continued just to send HMRC lots of detailed information that was very time-consuming for HMRC to review while being difficult to understand.
HMRC announced that some nil or negligible values had been agreed by them in error. In response some valuers then attempted to find methodologies to calculate meaningful values but no single generally accepted methodology emerged. Many of those used were themselves very complex and difficult to follow as they essentially used weighted probability expectations of potential future income streams which in reality relied on highly subjective judgements of future events and probabilities. Often they were presented in a form which were very difficult for an outsider such as HMRC to understand or assess the nature and reasonableness of the judgemental assumptions being made.
Some other valuers and legal advisers who wished to retain the simplicity of a nil or nominal valuation and avoid the cost and complexity of quantifying the value of growth shares and the upfront employment taxes arising continued to argue for a nil or nominal value on the basis of a strict interpretation of the information standard. But it was significant that they lacked the self-confidence in their own arguments to seek a modern case law decision on the information standard and HMRC increasingly deployed the powerful and difficult to refute argument which was -why would a company go to all the trouble of changing its constitution to create a new class of shares intended to incentivise senior management if the expected value of the award of such a share was nil or negligible?
Some growth shares became ever more complex financial instruments making them even more difficult to value and some started to resemble in their complexity the credit swap derivatives CSDs which caused the banking system in 2007 /2008 to fail when the difficulty of properly valuing complex financial instruments became belatedly and suddenly recognised.
However, HMRC started to reshape the context and risk profile in which growth shares had to be granted by withdrawing the best estimate and PTVC valuation agreement procedures with the result that companies and individuals no longer could get an early reassurance from HMRC on the valuation of the growth shares. In its place a new system is emerging whereby HMRC will select those cases for valuation review through the personal self-assessment return system or PAYE company reviews. While these look back, HMRC valuation reviews will not be able to use hindsight directly to value shares they will be well placed to challenge the objectivity and reasonableness of the foresight assumptions and probability assessments on which all growth share valuations are essentially based and it is becoming apparent that superficial and low valuations are unlikely to be resilient to look back HMRC valuation reviews.
This means that the advantageous tax valuation regime which permitted nil or negligible values and which allowed growth shares to flourish has been fundamentally changed although some advisers, lawyers and taxpayers continue to be reluctant to accept this fundamental change and alter their behaviour.
The combination of a meaningful upfront values and tax costs for the growth shares coupled with the additional costs of preparing a valuation that is likely to have sufficient resilience to withstand a future HMRC look back review is likely to moderate the use of growth shares and deter unrealistically low valuations when coupled with the continuing inherent uncertainty that taxpayers will have as a result of the self-assessment based look back review system that HMRC now apply.
There is also emerging amongst the adviser community a greater awareness of other issues concerning growth shares. The more complex structures which started to become popular are not only very difficult or impossible to fairly value but are inherently difficult to understand and model properly and their impact on other shareholders and dilution particularly when there are further funding rounds after the issue of growth shares can be difficult to understand. There are also growing concerns that the requirements to preserve the EIS status of others shares (that the companies that use growth shares often have) can be inconsistent with the terms the growth shares need to contain within their articles in order for the growth shares to be inherent rights and not merely restrictions over shares.
So although currently growth shares continue to be popular the fundamental changes in the tax valuation landscape which are starting to bed in, would seem likely to restrain their use and deter arrangements where growth shares are awarded which in reality resemble disguised bonus arrangements with little if any tethering to real and substantial growth in the value of the equity of the company, and instead only be used where they can serve a valuable and useful role in promoting real and substantial growth in the business as described below.
What are Growth Shares ?
Growth shares are a a particular class of shares which participate in value above a threshold value and are awarded to employees to incentivise them to grow the business they work in.
They are typically used by medium sized privately owned company (and often private equity owned companies which because of particular tax rules are generally excluded from government tax favoured share schemes such as EMI). They are businesses which usually already have substantial value and meaningful scale but have the potential to achieve further growth. Such companies represent a very important part of the UK’s engine for economic growth and future employment.
Growth shares have economic similarities to premium priced options over ordinary shares. But they allow a more focused and better defined bargain to be struck (between existing owners of the company and the management to incentivise them to grow the business substantially beyond its current worth) than the rather crude instrument of premium priced options allows. They also allow unlike options employees to become actual shareholders rather than merely contingent potential shareholders while protecting the existing value already built up by the owners without the general dilution of all the other shareholders which the issue of premium priced options over ordinary shares could involve.
Usually these days the hurdles in terms of the additional growth in value of the company before the growth shares participate in value are quite demanding. The hurdles can be structured to have different levels tailored to the needs of each company, a commercial structure which is very difficult to achieve other than through a special class of shares.
The award of growth shares to an employee is taxed as employment income and the sale is taxed as capital. The biggest challenge in designing a growth shares now is the valuation at the point of award and therefore the amount of employment taxes payable. Historically over a period of several years there has been confused thinking about the valuation of growth shares and historical errors have been made in their valuations including by HMRC.
But the valuation of a growth share is fundamentally challenging because it involves valuing a private company and then valuing the potential for growth in the value of the company.
Prior to 2016 it was possible to request a Post Transaction Value Check (PTVC) or best estimate from HMRC as to the taxable market value of a growth share shortly after award. Due to combination of historical precedent and administrative challenges HMRC in many cases agreed to nominal values which in many cases probably would have been in error.
Since the removal of the PTVC and best estimate agreement procedures by HMRC the tax authorities now operate a selective look back valuation review system. . This is starting to cause tax payers to adopt more defensive positions with respect to the valuation of growth shares and this is tending to mean that more tax will be paid upfront in relation to the award of growth shares or awards of growth shares will not be made.