By Tom Daltry, Keystone Law
Private companies, particularly those in a start-up or early stage development phase, will find it difficult to compete on salaries and benefit packages with bigger, established businesses. A key means of attracting talented individuals to work for private companies is often to offer the individual the opportunity to acquire a meaningful stake in the ownership of the company, with the potential for this to turn into a substantial monetary sum on a future exit.
The benefit of selling a shareholding on an exit will be all the more material where capital gains tax (CGT) treatment is secured; but this tax treatment should not be assumed. Employee share ownership can all too easily be caught by tax legislation which is designed to prevent employees or directors being provided with share benefits without paying income tax and national insurance contributions. As will be seen below, these rules should be considered not only where an employee is recruited with a promise of shares or an existing employee is rewarded or incentivised by a share award, but also where founders establish a new company or where a business angel invests and is to be a non-executive director.
If income tax rules apply:
- income tax at rates of up to 50% will be payable;
- employee’s national insurance contributions (NICs) at 2% may also be payable (assuming the salary payable to the individual is in excess of the maximum figure at which the full 12% rate of employee NICs is payable);
- the company may also have to pay employer’s NICs (at 13.8%);
- income tax and NIC payments will often be payable by the employer company under the PAYE system (with a need for the company to have the means for collecting relevant liabilities from the employee shareholder).
If CGT treatment is applicable:
- a higher rate taxpayer pays CGT at 28% on the gain;
- if the shareholding represents at least 5% of the company’s share capital, there is the potential for securing a 10% tax rate (by means of entrepreneurs’ relief);
- if the shareholding is of 30% or less and held by investors who are not employees or executive directors, there is the potential for an exemption from CGT under the Enterprise Investment Scheme.
- a small amount of tax exempt gains can be secured through use of the annual exemption (potentially £10,600 of gains for the individual and a further £10,600 for his/her spouse/civil partner).
So there is every reason to seek to ensure that CGT treatment will apply. We often come across situations in which the founder shareholder(s) have promised equity to a key employee but have not done anything about implementing that promise; and when they come to do this the opportunities for avoiding income tax problems have been lost.
This series of articles highlights some circumstances in which income tax liabilities can arise, either under general principles relating to the taxation of earnings or under the intricacies of the “employment related securities” (ERS) legislation. The ERS legislation is highly technical in nature and can all too easily catch situations in which no obvious tax avoidance is involved. We also make some suggestions as to how to avoid difficulties.
We provide an overview of some commonly encountered issues in this important area but do not seek to summarise all circumstances in which tax liabilities may arise. Specific advice on the facts of any particular case should be sought and is commonly invaluable for early stage businesses.
This article is based on the law in force on 1 February 2012 and refers to tax rates applicable in the tax year 2011/12.
We have written these materials to help you, but no article can address all the issues. The benefit of using an experienced lawyer is that they ask the right questions and build the solution around you. Please therefore note that these materials only provide you with general information and should not be regarded as a substitute for taking legal advice.
Tom Daltry has more than 28 years of experience as a tax lawyer and was Head of Tax at Eversheds before becoming a Consultant Lawyer. He has acted for a broad range of clients, ranging from entrepreneurs and management teams to private equity houses, large PLCs/multi-nationals and financial institutions. You can contact him
on 020 7152 6550 or by email at firstname.lastname@example.org
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