The tax benefits of using growth shares

In previous articles we discussed the advantages of using EMI share option schemes for your company. However if your company does not qualify it is worth considering the tax benefits of using growth shares.

Overview

Growth shares, are a special class of shares and being a popular tool for companies who wish to incentivise key employees. This may be circumstances where other tax advantaged schemes aren't appropriate.

These shares offer an opportunity to participate in the future growth of a company. Although without the upfront value usually associated with traditional shares.

Understanding the tax treatment of growth shares is crucial for both companies and employees to maximise the benefits of such schemes. In this article we'll discuss the intricacies of growth shares. Additionally, we'll outline how to implement a growth share scheme. Plus we'll focus on the tax benefits of using growth shares.

What are growth shares?

Growth shares are designed to reward employees for the increase in a company's value above a predetermined threshold. Unlike say ordinary shares, representing an immediate stake in a company's value, growth shares only provide value if this increases beyond a specific hurdle. For this reason, it makes them an attractive option for startups and growing companies.

What are the key characteristics?

Growth shares are defined by the following hallmarks:

Targeted Incentives: Firstly, growth shares are tailored to reward long-term performance. So they're aligned with your employees' interests for achieving company growth.
Customised Rights: Secondly. growth shares can be structured to include various rights and restrictions, For example voting rights, the right to a dividend, and conditions on sale or transfer .As a result, allowing you to tailor them to your company's specific needs.
Threshold Value: Lastly, the value of growth shares is reliant on your company's value exceeding a pre-determined threshold. As a result, ensuring your employees benefit from the growth they contribute towards.

Types of growth share

Growth shares

These are designed to provide a financial benefit to the shareholder. Although only if the market value of the company increases after the share issue date. So, for example if the ordinary shares are worth £5 per share when the growth shares are issued, the holder will only receive a benefit if ordinary shares are worth more than £5 on exit.

Hurdle shares

These are similar to growth shares. Although they're only designed to benefit the shareholder where the market value of the company increases beyond a set amount over and above its market value when the hurdle shares were issued. Therefore, if the market value of the company’s shares is £5 each at issue, and the hurdle is set at £10 per share, the holder will only benefit if ordinary shares are worth £10 or more on exit.

Flowering shares

These are a type of growth shares that will only benefit the shareholder if certain performance targets are met. For example where the company achieves a certain level of profits.

Tax treatment of growth shares

Issuing growth shares to employees is within the remit of HMRC's Employment-related Securities legislation. As a result, their issue is reportable to HMRC as part of their share scheme compliance reporting procedure.

However growth shares are effectively worthless when issued for reasons previously. Therefore any employee who receives them will face no immediate tax implications.

In other words, your employees won't pay Income tax when they receive their growth shares. Also, this means you won’t have to pay PAYE and National Insurance either.

The valuation of growth shares should be agreed with HMRC to ensure they reflect a fair market value. Furthermore, this value should reflect any restrictions or conditions attached to these shares. As a result, reaching agreement with HMRC can help prevent disputes over tax liabilities in the future.

Typically, if your employees sell their shares on exit, capital gains tax is payable on any growth in their value. Amy tax payable would usually be at the current rate of 20% though only after the capital gain has exceeded the annual exemption.

Implementing a growth share scheme

Establishing an accurate company valuation is vital. This is because it sets the baseline above which growth shares will start to accrue value. Therefore, any company's valuation should reflect the it's current value. It should also consider any restrictions or conditions attached to the growth shares.

Growth shares frequently have different rights in comparison to other classes of shares. Therefore, deciding on the specific rights attached to the growth shares, such as voting, dividends, and capital distribution on winding up, is a critical step in your scheme's design.

Additionally, it is prudent to obtain the other shareholders’ agreement to any amendment of your company's articles and issuing of new shares.

You will then need to amend your company’s Articles to create the growth shares and describe their rights in relation to other share classes. Additionally, this includes leaver provisions and other terms designed to protect the company and its shareholders

Once the growth share scheme is designed and the necessary documentation is in place, growth shares can be issued to eligible employees. Additionally, this process should be accompanied by clear communication to explain the benefits and potential tax implications of the shares.

Advantages of Growth share schemes

Some of the advantages of Growth share schemes are as follows:

Firstly, the growth shares have little real value when they are issued, and are a special class of share. Therefore your existing shareholdings and that of any other shareholders are not diluted financially until the value of the company exceeds the hurdle.
Secondly, they're a tax-efficient way of rewarding employees. Because of their low market value, the shares are cheap to buy. Alternatively, they only attract minimal income tax (and national insurance) charges if issued with no cost to the employee. Moreover, any subsequent increase in value after acquisition should be taxed as a capital gain
Also, you can give staff dividends, unlike share option arrangements
Finally, capital gains tax will be payable on any increase in value of the shares. These rates are generally lower than higher-paid employees’ marginal income tax rates. In some cases Business Asset Disposal Relief may even be available.

Disadvantages of growth share schemes

Some of the drawbacks of Growth share schemes are as follows:

For starters, they are usually only suitable for private limited companies able to issue different share classes. Also these companies are already successful and have a reasonable prospect for future growth
Next growth shares work best where the company can expect growth within a reasonable time. As a result this offers a substantial benefit to employees
Next, there are some administrative burdens and costs relating to growth share schemes for the company. However that would usually be the case when implementing any share scheme.
Finally, the interaction between growth shares and the Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) needs to be carefully managed

Summary

Growth shares represent a sophisticated and strategic tool if you are seeking to incentivise your key employees. This will also align their interests with the long-term success of the business.

By offering a stake in the future growth of your company, as opposed to its current value, growth shares can motivate your employees to contribute to your company's performance and increased value.

However the implementation of a growth share scheme requires careful planning and a thorough understanding of the legal and tax implications. Also from the initial valuation and structuring of share rights to compliance with HMRC's reporting requirements, each step must be meticulously managed to ensure the scheme's success and tax efficiency.

Growth shares can offer significant benefits for both companies and employees. Moreover their success hinges on a clear understanding of the tax treatment and a strategic approach to their implementation

For more useful information, check out our Ebooks here.

And if you'd like to know how we can help you with all of this, or with anything else, feel free to give us a call on 01202 048696 or email us at [email protected].

Alternatively, please feel free to complete our Business Questionnaire here.

Thanks for reading our blog post. Please now read our disclaimer here.

Spread the word!