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 are a popular tool for companies who wish to incentivise key employees where other tax advantaged schemes aren't appropriate.
These shares offer an opportunity to participate in the future growth of a company, though 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, outlining how to implement a growth share scheme and focus on the tax benefits of using growth shares.
What are growth shares?
Growth shares are a class of share expressly designed to reward employees for the increase in a company's value above a predetermined threshold. Unlike say ordinary shares, which represent 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:
Types of growth share
Growth shares
These are designed to provide a financial benefit to the shareholder only if the market value of the company increases after the date the shares are issued. So, for example if the ordinary shares are worth £5 per share when the growth shares are issued, then 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 though only designed to benefit the holder if the market value of the company increases beyond a set amount over and above its market value at the point 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. An example of this would be if the company achieves a certain level of profits.
Tax treatment of growth shares
The issue of growth shares to your employees is potentially within the remit of HMRC's Employment-related Securities legislation. Therefore the issuing of growth shares to your employees is reportable to HMRC as part of their share scheme compliance reporting procedure.
However because growth shares are effectively worthless at the time of issue for reasons stated above, 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 – which 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, taking into account any restrictions or conditions attached to these shares. This 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 may be payable on any growth in the value of their shares. This 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
Determining an accurate company valuation is vital as it sets the baseline above which growth shares will start to accrue value. Your company's valuation should reflect the company's current value and consider any restrictions or conditions attached to the growth shares.
Growth shares frequently have different rights in comparison to other classes of shares. 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.
It is therefore prudent to obtain your other shareholders’ agreement to the 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, including 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. 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:
Disadvantages of growth share schemes
Some of the drawbacks of Growth share schemes are as follows:
Summary
Growth shares represent a sophisticated and strategic tool if you are seeking to incentivise your key employees and 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. 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.
While growth shares can offer significant benefits for both companies and employees, their success hinges on a clear understanding of the tax treatment and a strategic approach to their implementation
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