Tax - Flowering or growth shares - FEB 10.qxd - Pinsent Masons

Update
February 2010
Tax and Share Plans
Flowering or Growth Shares – Implications of Recent Supreme Court Decision
The Supreme Court has confirmed that an employer may be liable for PAYE and NICs on a share
sale when an employee shareholder receives more than market value for his shares.
The judgment contains interesting comments on how market value should be interpreted in the
context of personal rights relating to shares and will be relevant when structuring share
incentives in private companies especially when structuring management participation in private
equity companies.
Summary of the facts
On 3 February 2010, the Supreme Court published its
judgment in the Grays Timber case. The case concerned the
managing director of Grays Timber Products Limited, who
owned shares in the parent company. Under the terms of a
subscription agreement entered into when he acquired the
shares, the director was entitled to a specific share of the
consideration on a sale of the company. Although he owned
5% of the shares, he was entitled to 25% of the sale
proceeds – i.e., significantly more per share than the other
shareholders. The Supreme Court upheld the decision of the
Court of Session that the consideration which the director
received in excess of his pro rata share was subject to tax as
income from employment and would therefore be subject to
PAYE and NICs.
Basis for the decision
The parties accepted that the director's shares were
"employment-related securities" within Part 7 of the Income
Tax (Earnings and Pensions) Act 2003 ("ITEPA"). Chapter 3D
of Part 7 ITEPA applies where employment-related securities
are disposed of for more than market value. Where Chapter
3D applies, the disposal proceeds in excess of market value
are taxable as employment income.
In deciding whether Chapter 3D applied in this case, the
court had to determine the "market value" of the director's
shares for these purposes. Two points of controversy were
identified:
even if the rights in the subscription agreement were
treated as if set out in the articles, should they
nevertheless be disregarded in the valuation as
exclusively personal to the director in question and
worthless to anyone else?
The Court of Session had determined that the director's
special rights should be disregarded in determining the
market value of the shares for these purposes as they were
personal to him. In this case, the subscription agreement
made clear that the entitlement to additional consideration
was in recognition of his personal services as managing
director.
The Supreme Court judgment upheld the decision that the
rights were personal to the director and therefore to be
disregarded. However, the judgment goes further, and raises
a new and significant point that the conclusion would be the
same if the rights were conferred by the articles.
In other words, the right to an enhanced payment in respect
of the shares had a value to the director in question, but did
not transmit to the purchaser and was not therefore a right
to be taken into account in ascertaining the market value of
the shares.
The director had therefore received consideration for the
shares in excess of their market value and this would be
subject to PAYE pursuant to Chapter 3D. NICs would also be
due.
should the shares be valued on the basis simply of their
rights set out in the articles, or should the right to
additional consideration set out in the subscription
agreement be taken into account in the same way?
continued on reverse

What does this mean in practice?
The decision of the Supreme Court in relation to the facts of
this case, is perhaps unsurprising, as the right to enhanced
disposal proceeds seemed inextricably linked with the
director's services to the company - i.e., connected with
employment.
However, the more notable aspect of the judgment is the
discussion of whether the position would be any different in
relation to rights contained in a company's articles. The
question of whether rights in a subscription agreement or
other contractual arrangement could be said to attach to the
shares in the same way as if entrenched in the articles was
not conclusively decided. The judgment turns on the issue of
whether the share rights were of any value to a hypothetical
purchaser.
On the basis of this conclusion, it does not matter whether
or not share rights are contained in the articles – if the rights
are personal in nature and will not pass to a purchaser then
they are not rights which are relevant to the "market value"
of a share on disposal.
What can companies do now?
Companies and their advisers will need to consider the
implications of this judgement carefully in relation to
structuring going forward, as well as in reviewing existing
arrangements which may be affected.
Where there is a risk of PAYE and NICs which had not
previously been envisaged, companies may wish to consider
at an early stage who will bear the risk. PAYE and
employees' NICs, whilst a liability of the company, are
recoverable from the employee (and must be recovered to
avoid further penalty charges). Indemnities can be sought
from selling shareholders, but in many cases this may not
extend to employer's NICs.
Going forward it should still be possible to draft shares which
give an enhanced value on an exit but it is important that
the rights are drafted carefully so they are reflected in the
value of the shares acquired by the purchaser.
This conclusion will potentially impact upon the structuring
of share incentives in the form of "growth" or "flowering"
shares, as well as on the mechanisms for achieving earn-outs
and ratchet arrangements which are common in the context
of private equity deals. Many advisors had previously
thought, and it seemed implicit from the judgment of the
Court of Session, that rights contained in the articles which
were "intrinsic" to the shares would be taken into account on
valuation.
© Pinsent Masons LLP 2010
Should you have any questions please contact Liz Morgan (liz.morgan@pinsentmasons.com),
Judith Greaves (Judith.Greaves@pinsentmasons.com) or your usual Pinsent Masons adviser who will be able to assist you further.
This note does not constitute legal advice. Specific legal advice should be taken before acting on any of the topics covered.
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