Ken Moody considers private company share structures and transactions, which can lead to significant tax problems when not thought through properly, and stresses the importance of observing formalities and getting the paperwork right.
Private companies are usually bought ‘off the peg’ from company formation agents with only one or two ‘subscriber’ shares in issue, which need to be transferred to the intended owner(s) of the company. In addition, it will usually be necessary to issue further shares to reflect the interests of each owner (if more than one) in the company’s capital. This needs to be formalised and documented properly, otherwise it may lead to problems later, which can be very difficult to resolve.
Let me tell you two stories based on a couple of recent assignments.
Share structure conundrums
Example 1 - Different share classes
A, B and C held shares in company Y, which had two classes of ordinary shares as follows:
Mr S 333 ’A’ ordinary
Mr A 333 ’B’ ordinary
Mr Q 334 ’B’ ordinary
However, the B shares had no voting or dividend rights and although only modest dividends had been paid on the A shares, those shares gave control of the company and so were on paper worth more than the B shares.
This structure had been set up some years earlier by previous advisers for reasons now unknown, but the shareholders had always considered their rights to be equal and wished to rectify the position.
It was proposed to amend the company’s articles, in effect equalising the shareholders’ rights. That may sound uncontroversial, but it was a proverbial ‘can of worms’ from a tax point of view.
Since the A shareholder had, on paper, control of the company, giving voting and dividend rights to the B shareholders caused value to flow out of the ’A’ shares and into the ‘B’ shares. That brought into play the ‘value shifting’ provisions (in TCGA 1992, s 29). The effect was that Mr S was treated as having made a CGT disposal for the amount of consideration which he could have received (at market value) for agreeing to the dilution of rights. That was not too much of a problem though, because joint ’hold over’ relief elections (under TCGA 1992, s 165) could be made by the A shareholder and each B shareholder to hold over the gain.
However, the shareholders were also directors, and therefore the shares were employment-related securities (ERS) by definition. The relevant legislation in ITEPA 2003, Pt 7 Ch 4 (‘Post-Acquisition Benefits From Securities’) applies where a person receives a ‘benefit’ in connection with ERS. ‘Benefit’ is not defined and so is capable of a very wide meaning and, since there is no motive test, whether any employment reward is intended is strictly not relevant. Tax counsel opined that there was a small but real danger that those rules could apply and therefore that the increase in value of the B shares (which was substantial) might be taxable as employment income. A practical solution was advised which hopefully minimises the B shareholders’ exposure, but which does not completely eliminate the risk.
Formation formalities
When forming a company it is very important to consider who the shareholders are going to be, but this often gets overlooked because private company shareholders, usually being also the directors, will be naturally more concerned with business matters. It might be argued that the subscriber share(s) are held in trust by the initial transferee(s) as constructive trustees for the intended shareholders, but it is far preferable to issue whatever shares are required to reflect the desired shareholdings and to complete the necessary formalities to avoid any confusion or challenge by HMRC.
For one thing, where an employee (which includes a director) pays less than market value for shares the discount is taxable as earnings (see, for example, Weight v Salmon HL 1935, 19 TC 174). However, shares issued before the company commences business or has any assets they should be worth only their nominal value, whereas if they are not issued until the company has been in business for some time they may have value and potentially a tax charge may arise.
Again, shares acquired by director shareholders are (almost invariably) ERS by definition and where more than one class of shares is contemplated, very careful consideration should be given to the rights attaching to each class to ensure that these are ‘fit for purpose’.
As can be seen, to backtrack at a later date and amend the share rights may well fall foul of the ERS rules.
Company secretarial matters
Example 2 - Formalities not completed
The company was formerly a professional practice which incorporated, taking advantage of the availability of capital gains tax entrepreneurs’ relief (now no longer possible in respect of goodwill, following Finance Act 2015). Further shares were (or purported to have been) issued, two shareholders left and sold their shares to incoming shareholders and there had also been a company purchase of own shares (PoS) in the case of two departing shareholders.
Unfortunately, stock transfer forms had not been completed*, the share transfers had not been registered in the register of members and there was some doubt as to whether the PoS was valid as the buyback resolution had not been circulated to one of the retired shareholders whose name was still in the register of members.
These issues arose as an offer had been received for the sale of the company and naturally the purchaser’s solicitors wished to ensure that good title was obtained.
*Though not required for the PoS.
It was held in National Westminster Bank plc v CIR [1994] STC 580 that shares are not issued until registered in the company’s register of members and it was unclear at first whether some shares had actually been issued, or when they had been issued, and some of the Companies House formalities had not been complied with. Stamp duty was payable on the transactions but because stock transfer forms had not been completed it had not been paid. For the PoS, Companies House form SH03 should have been filed after stamping.
Legal v beneficial ownership
The advice in Example 2 is mainly concerned with the issue of legal versus beneficial ownership. The tax system generally looks to who is the beneficial owner of an asset, as regards who is taxable on any income arising or liable to capital gains tax on disposal. For example, the legal title to a portfolio of stocks and shares managed by a bank or broker might be held by nominees, but the beneficial owner is the investor who can require that the title be transferred into their own name at any time. Another broad example would be assets held in the names of trustees.
As noted, stock transfer forms had been overlooked and the register of members had not been updated, in respect of the transfers of the shares of two retiring shareholders. However, it was nevertheless clear than the beneficial ownership of the shares was vested in the transferees who had each entered into a (albeit verbal) contract to buy the shares, had given consideration and had also been in receipt of dividends. The retired shareholders therefore merely retained the legal title as trustees for the transferees.
Fortunately, the story ended happily as the various discrepancies were rectified prior to sale, though this did require the co-operation of retired shareholders whose refusal would have caused problems. Obviously, matters would have been much more straightforward had the paperwork been properly processed at the right times (but in that case this writer’s advice would not have been needed!).
Practical Tip:
Where a company’s statutory books are maintained electronically, it may be difficult to demonstrate when share transactions have taken place (especially e.g. a spreadsheet). There are numerous software options and providers of on-line company secretarial services and so it is only possible to make the general observation that while stock transfer forms, share certificates, minutes of meetings and Companies House forms are corroborating evidence, it can be crucial to be able to verify the dates when shares are registered (e.g. for EIS/SEIS purposes), transferred, etc.
The solution adopted therefore must, in whatever way, cover that aspect to avoid any ‘accident waiting to happen’.
