This article originally featured in Tax Journal on 25 January 2013 and can also be viewed at the Tax Journal website
We act for a large private trading company where several members of the management team have been allotted partly paid shares. These are designed to provide an incentive for the individuals to participate in the equity on the ultimate sale of the company. The individuals satisfy the 5% requirements of nominal capital and voting capital to qualify for entrepreneurs’ relief. Each individual has significant unpaid capital of in excess of £100,000. What are the key tax issues on partly paid shares?
There are three main tax issues and potential pitfalls which we consider below. There is also of course a practical commercial issue in that the employee could be asked to pay up their capital if the company becomes insolvent. This risk is significant and typically the controlling shareholder may have to act as a guarantor for this debt.
Firstly it is worth mentioning that the fact that a share is partly paid should not prejudice its status for entrepreneurs’ relief purposes. The key share conditions for this relief are that 5% of nominal share capital is held and this gives rights to 5% of the votes. Nothing rests on whether the share capital is paid or unpaid for these purposes.
We have direct experience of HMRC contending that the unpaid share capital constitutes a loan to a participator and that CTA 2010 s 455 applies.
Under s 455(4) the cases where a close company is treated as making a loan to a person includes a case where ‘that person incurs a debt to the close company’. On legal advice, we successfully defended this point by responding that unpaid share capital cannot constitute ‘a debt to the close company’ until it is legally called by the company. This is consistent with the fact that the company could not sue the shareholder for the debt until it becomes due.
In practice this is a point which should be considered when the shares are structured in a company’s articles. The company should need to make a call for the unpaid capital so that no debt arises until a call has been made. It is unwise for the articles to include any provisions which require the capital to be paid at any specified dates.
We are also aware of a secondary technical argument, in the case of an individual acquiring his first shareholding in the company. The legislation requires a loan to ‘a relevant person who is a participator’, rather than a person who will become a participator, so arguably s 455 cannot apply to the first allotment.
In contrast to the ambiguity of s 455, there is specific legislation in ITEPA 2003 s 446S which treats unpaid share capital as a ‘notional loan’. e employee is subject to tax on the unpaid capital by reference to normal beneficial loan provisions (ITEPA 2003 s 175).
The provisions of ITEPA 2003 s 178 relieve the employee of the benefit charge in the circumstances where the interest would have been tax deductible had it been paid. is will usually be the case where the partly paid shares are issued to members of management in a close trading company, as they will qualify if they are involved in the management of the company. If the management condition cannot be satisfied relief can be taken on the basis that 5% of the share capital is held.
Under ITEPA 2003 s 446U the ‘notional loan’ (above) can be deemed to be discharged on a sale if the nil paid element is taken on by a third party. The aim of this legislation is to avoid value being passed to an employee if he is relieved of the obligation to repay the ‘notional loan’ on a sale.
This legislation would be relevant if a shareholder were to dispose of his partly paid shares and no longer have an obligation to pay up the capital. The problem here is that the legislation does not differentiate between cases in which partly paid shares are sold at ‘fully paid share value’ and cases in which they are sold at ‘partly paid share value’. In the former case the legislation seems fair but in the latter case it does not (as the employee receives less proceeds to account for the unpaid share capital). This provides a potential trap if a deal is not suitably structured.
HMRC has stated (we think following on logically from the legislation) that ‘where partly paid shares are sold for their market value taking into account the potential call on them, the amount of the notional loan equal to the call is still chargeable even though this obligation is taken over by the purchaser of the shares’ although they have acknowledged that ‘in theory at least, the charge could be harsh’.
In practice, the shareholders should repay the unpaid share capital as part of the transaction so as to establish that the shares were sold fully paid. This avoids the risk of HMRC challenge.
HMRC’s Employment Related Securities Manual (at ERSM 70120) explains ‘that HMRC will accept that where sale and “repayment” of the notional loan are part of one transaction, the “repayment” is treated as being made first’. Hence the partly paid shareholders should sell their shares as fully paid shares and arrange for the purchaser to deduct an amount from the proceeds to make the shares fully paid.
If shares are sold fully paid (as opposed to partly paid) both the sale proceeds and cost of the shares are increased by an equivalent amount, so the net CGT affect is nil.
Although this charge will not apply to inter-spouse transfers, these issues will still face the recipient spouse in the event of a disposal to a third party although any charge would fall on the employee.
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