Calculating the taxable value for the purposes of paying tax in these circumstances becomes more tricky if your shares are in a private company
Using past experience we guide employers and shareholders on how to approach valuing shares in private companies and payment of tax.
Valuing shares in private companies and paying tax
If you sell your shares as part of a transaction where all shares are sold at the same time establishing the value of the shares for tax purposes is fairly easy to establish. The taxable value has been fixed by the sale price. But tax charges do arise on share transactions in the form of disposals, transfers and enhancing rights where they has been no transaction involving the sale of the company and no cash has changed hands. For example:
Situations you may not have thought give rise to a tax charge
- Providing shares or options in private companies to employees or directors;
- Disposing of shares by gift;
- Enhancing the value of shares held by employees or directors by adding extra benefits such as more rights to receive proceeds of sale or better dividend rights; or
- Buying out a shareholder who wishes to exit before the entire business is sold.
Calculating the taxable value for the purposes of paying tax in these circumstances becomes more tricky if your shares are in a private company because there is no reported market value. As we explain below different circumstances can produce different values for the same shares.
HMRC have a strict tax reporting and payment regime. It is easy to overlook the requirements and find penalties as well as interest charges arises on late and or underpaid tax. We do help explain the HMRC requirements.
The background to the share transaction should be considered as this influences the taxable value of the shares. For example:
A share valuation for investment purposes will focus on the commercials and anticipated growth. Under the more formal methods of valuation the company may be worthless especially if the business has not yet gone to market – but investors are prepared to pay a premium based on the potential value.
A share valuation for the purposes of an internal transfer of shares will usually be more focused on present day value. The achieved value per share can be displaced by the identity of the purchaser and seller and their willingness to transact.
A share valuation for the purposes of agreeing with HMRC a tax liability will take a fiscal approach. A fiscal approach usually produces a lower valuation than a commercial valuation would as there is less emphasis on goodwill and hope value.
Approaches to calculating the tax due on a share transaction
There are 3 main types of business valuation used to reflect the price of a share in a private company.
The dividend basis of valuation is adopted for a shareholding where the main benefit of holding shares is the right to receive dividends. It is usually used for minority shareholders of mature businesses. The dividends basis looks at the company’s past dividends, dividend growth patterns, fluctuations and the likely dividend policy going forward.
What is examined is the dividend yield per share. There are quoted company comparisons that can be drawn and which can be helpful. The influence of the minority shareholder is not considered. However, where the majority shareholder is also a director with the power to determine if dividends are voted that level of influence should be considered as it could reduce the chances of receiving dividends.
Loss making businesses
In loss making businesses or businesses still in investment mode the dividend basis of valuation is not appropriate. Similarly, if the shares are non-dividend bearing, alternative methods of private company share valuation will need to be found.
The earnings basis of valuation is popular and often used when a business is being sold. It looks at the future profit-generating potential of the company after tax, interest and dividends are paid out (known as ‘maintainable profits’). The maintainable profits are capitalised and multiplied by a quoted company equivalent ratio to give the present value of the company.
The earnings basis is mainly used to value majority shareholdings or entire businesses where one shareholder has control over the future of the business.
The asset basis valuation is used either on company’s liquidation or where the company’s asset backing is greater than the capitalised value of dividends and earnings. It is supported by the idea that the asset backing of the business must be reflected in the share price. Investment companies such as property companies are valued on an asset basis.
Adjustments to profits
In order to arrive at the value of the shareholding the value of the business needs to be discounted to reflect commercial and legal aspects of the business. Before any discount is applied company profits often need to be adjusted to reflect the market conditions. For example, if the directors have not been paid commercial salaries company profits will have to be adjusted.
Share transactions tax – the HMRC approach
Many different considerations are applied and often a valuation is a combination of various approaches. There will be common themes HMRC will consider such as:
Size of shareholding
The importance of shareholding size is primarily in terms of control over company’s decision making. Minority shareholding discounts can range from around 5 – 90% depending upon the facts.
Voting rights in shares have inherent value because voting power offers influence over how profit is enjoyed, whether assets (including the business) are sold, how the company is managed and how the internal market in the shares is operated. However, voting power is only indicative of control and does not need to correspond to the number of shares held. If it can be shown that a majority shareholder has no effective control over the company it will be taken into account. 51% + shareholders are presumed to have control over the company’s affairs.
If shareholders are connected it is fair to assume that they will join together and their combined voting power can be considered.
The right to veto certain decisions
Typically, a minority shareholder who holds 25% or more voting rights can block a special resolution of shareholders which means that he can veto certain decisions of the majority shareholder. However, a shareholders’ agreement or articles of association can also provide that a shareholder with an even smaller than 25% shareholding can veto decisions in which case the value of his shares increases. Therefore, the constitutional documentation is important.
The right to have a director on the board
Being able to appoint a director gives a shareholder insight into everyday running of the company. It offers control over directors meetings and influence over board meetings. Not many minority shareholders have a right to appoint a director unless they are director-shareholders themselves with power to influence the board.
The number of shareholders
The division of ownership of shares has an impact on the impact shareholders can exert. If there are two shareholders with the 80%-20% split, the minority shares have a ‘nuisance value’. If however there are five shareholder holding 20% each then the minority shareholder has greater control and the value of his will increase.
The marketability of the shares plays a role in valuation. How easily can the shares be sold? Are there any restrictions on the sale of shares in the corporate documentation? The degree of influence depends upon a range of factors, both legal and economic and can vary significantly from company to company. For example, one company may permit shares to be transferred to non-members while another may impose restrictions on transfer. Any restrictions on transfer decrease the value of shares as marketability of shares is low.
Future income potential
Future ability to increase earnings, e.g. when an IPO is planned or imminent, will impact the value of the shareholding.
There might be reasons why a minority stake might be particularly valuable. Minority shareholding can have strategic value when it can prevent a business sale or when mere possession of a single share can ensure access to the customer base. The strategic value is enhanced when there are no transfer restrictions on minority shares in the articles of association because shares can be transferred to e.g. a strategic investor or competitor.
Small minorities are generally assumed to have limited access to unpublished information and no guarantee of board representation. However, this may not be so if the shareholding has some strategic significance. Directors should not disclose confidential information without board consent. Therefore, unless special circumstances exist no knowledge about additional facts will be presumed.
Articles of Association/Shareholders agreement
Articles of Association set out the rights attaching to shares as well as restrictions on the transfer of shares. A review of Articles of Association is one of the first steps in share valuation.
Matters to look out for impacting on the taxable value of the shares
In addition to point set out above you may need to consider:
- Casting vote – a casting vote swings an otherwise deadlocked vote. A casting vote gives control to a shareholder in a 50-50% share split and can carry a premium.
- Dividend rights attaching to shares. Dividend entitlement which is fixed, e.g. preference shares, increases the value of shares.
- Capital rights – as with voting rights the greater entitlement to the company’s capital the higher value of shares.
- Transferability – Articles often specify who the shares can and can’t be transferred to which impact marketability of shares. Restrictions increase the discount and lower their value.
- Fair value provisions – Articles or a shareholders’ agreement often provide mechanisms explaining how company shares should be valued upon transfer. This can work for or against a higher valuation depending upon the wording and actual circumstances.
- Drag and tag along rights – the rights to allow a minority shareholder to benefit from the same rights and protections as the majority shareholder on business sale. If the company only has standard articles downloaded upon incorporation drag and tag rights will not be present. This will decrease the private company share valuation for a seller.
Share transaction disputes
If the parties cannot agree on the private company share valuation, which is often the case, appointing a joint expert can be the way forward. The benefit of a joint expert is only one expert is used and this manages costs. Appointing the expert requires some thought.
Terms of appointment
Terms of appoint for the expert are up to the parties to agree. Typical points to think about include:
- How will the costs be determined – is the company paying or the shareholders and if so in what proportion?
- What type of valuation should be commissioned – commercial or fiscal?
- Will discounts be made for minority shareholdings?
- What information should be presented and can the parties make representations personally?
Dual-qualified in the UK and USA and a qualified solicitor since 1998, Helen is a partner and heads up the corporate team, advising start-ups, SME companies, partnerships, entrepreneurs, investors and shareholders.