With entrepreneurs relief ("ER") now worth up to £900,000, we look at an example of how we used growth shares to enable key management of a venture backed company to qualify...
Individuals who qualify for ER pay tax at 10% on the first £5 million of lifetime gains. With the top CGT rate at 28%, the 18% differential is now worth up to £900,000. The tax savings have only recently become significant following the increase in the top rate of CGT on 23 June 2010 and two successive increases in the ER limit in the Budgets of 2010.
In the context of shares sold by an individual, for a period of one year prior to disposal:
- the company must be an individuals "personal company" and either a trading company or the holding company of a trading group; and
- the individual must be an officer or employee of the company or any group company.
A company is an individual's personal company if:
- he holds at least 5% of the ordinary share capital when tested by nominal value; and
- at least 5% of the voting rights are exercised by the individual by virtue of that holding.
These conditions are not always straight-forward to meet! The most obvious issue is that the individual has to hold at least 5% of the voting rights. The Quoted Companies Alliance (and other organisations) are lobbying the Government to remove the 5% threshold. It seems anomalous particularly as there is no similar threshold for disposals of business assets.
The 5% test does not relate to the economic rights attaching to the shares so it is possible, for example, to create special classes of shares with economic rights of less than 5% which are structured so as to satisfy the tests.
In a stand-alone win for the employee incentives team we replaced a big four accountancy firm as incentives advisers to a venture backed company in the healthcare sector. We implemented growth shares to allow four key members of the management team to qualify for ER and to allow other employees to participate tax efficiently.
The venture investor held over 90% of the voting rights in the company and several classes of preference shares. After some negotiation the investor agreed to the dilution of its voting rights to 80% to allow the four key members of the management team to qualify for ER.
We created five classes of growth shares, four with entrenched voting rights of 5% per class and a fifth non-voting class for employees. The growth shares were entitled to a specified percentage of exit consideration achieved above a threshold - the percentage increased on the achievement of higher thresholds.
The commercial intention was for management to share in different proportions of the sale consideration achieved so this case the number of shares issued to each determined their proportion of the "pot".
The 5% by nominal value test requires a careful analysis of what constitutes "ordinary share capital". In this case the preference shares were not ordinary share capital for these purposes as they were only entitled to dividends at a fixed rate. This allowed us to set the nominal value of the four classes of voting shares at a relatively low level so management did not have to pay much cash to subscribe for the shares.
By structuring the arrangement using growth shares we achieved the commercial objective of rewarding management on for increases in value and will be able to argue the up front value is no more than par to avoid an income tax charge on the acquisition of the shares.
There are even more sophisticated arrangements which have appeared since we advised on this particular structure. These allow employees to benefit from ER without each shareholder being entitled to 5%. Please contact us for details.