ESS was an arrangement under which employees entered into agreements to vary their employment rights in consideration for the receipt of shares, and the first £50k worth of those shares would fall within a specific tax regime. Originally any shares received in this way would benefit from an unlimited capital gains tax exemption on disposal but this benefit has been whittled away over time. For ESS agreements entered into on or after 16 March 2016 but before 1 December 2016, there was a lifetime limit of £100,000 capital gains tax exempt gains on the disposal of ESS shares. For agreements entered into on or after 1 December 2016, there is no longer a capital gains tax exemption available on the eventual disposal of the ESS shares and those shares will be subject to capital gains tax in the same way as if the shares had not been acquired under ESS.
Although ESS benefits have come to an end there are still quite a few lucky holders of pre 16 March 2016 ESS shares who will be expecting to sell their shares tax-free. These shareholders often additionally hold non-ESS shares in the company which could have been obtained through a subscription arrangement or through an option scheme.
On an acquisition of the company, management shareholders will often be asked to rollover some of their equity into the acquiring vehicle and the question arises of which shares have been sold for cash and which have been sold for shares.
Normally a particular class of shares is kept in a pool which means that shares bought at different times will be treated as being sold proportionately in the event of a part-disposal. Fortunately this is not the case for ESS shares. The technical position is set out in TCGA 1992 section 236 E and this essentially means that an ESS shareholder can decide to attribute cash consideration to ESS shares in priority to other shares.
To the extent that any ESS shares do get exchanged for shares in an acquirer then the normal paper for paper rules (whereby new shares stand in the shoes of the old shares) are disapplied and there is deemed to be a (non-taxable) capital gain. This means that the new shares take on the ESS shares’ value as their base cost and so the shareholder does ultimately access the benefit of the ESS shares’ exempt status.
John holds 18 ESS shares and 6 shares that he subscribed for. He has been advised that a disposal of ESS shares will be exempt from capital gains tax and that he will be subject to 20% tax in respect of the other shares. As part of a wider deal a private equity house will pay him £500,000 and give him £500,000 worth of shares in the acquiring vehicle. He would like to know his tax position.
Here John could deem the £500,000 receipt to be in respect of his ESS shares and therefore pay no tax on the cash part of the disposal. 6 ESS shares will therefore be rolled over, although the new shares received for these will benefit from a £250,000 tax base cost. The remaining shares in the new company will take on the base cost of the subscription shares and will probably give rise to a gain taxable at 20% on a future disposal.
These rules are difficult to access under current legislation due to the various changes to the ESS legislation but they offer valuable flexibility to an employee who is lucky enough to hold ‘old-style’ ESS shares.
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