Tax Treatment of Client Equity Stake -- second opinion Tax Treatment of Client Equity Stake -- second opinion
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    Default Tax Treatment of Client Equity Stake -- second opinion

    MyCo has been offered a client equity stake as part of a big deal we are doing. There are four employees who would be glad to have the equity stake. Please spare me the obligatory warnings of why this is a bad idea. We've weighed the risks and benefits, and judge it to be worth the risk.

    The company was valued for estate tax purposes earlier this year, due to the death of one of the principals. It is a non-EU company, privately held. There are both voting shares and non-voting shares, at a ratio of 20 non-voting to 1 voting. In all other rights the shares are equal. The shares we are being offered are non-voting shares, and contractually cannot be sold for two years.

    One shareholder owns approximately 70% of the non-voting shares but no one owns a controlling stake of the voting shares. The company has been valued at approximately £70 million. The share on offer to MyCo is just under 0.3% (around £200K, on a pro-rata basis, if the estate tax valuation is used).

    The intent is to pay out the shares as a scrip dividend to the individuals involved. The question is A) what value is used for CT purposes B) what value is used for dividend tax purposes C) what value is used for purchase price in future capital gains tax calculations and D) can the estate tax valuation be used?

    I have been told by my accountant that A=B=C, that the answer to D is yes, and that a nonmarketability discount of 75% would be appropriate, so that for tax purposes the pro-rata £200K would become approximately £50K, which would be applied to the company for CT, and prorata to the four shareholders for their dividend tax. I was told that normally this small of a percentage in a privately held company would attract a 60-70% discount but the fact that the shares are non-voting and restricted for two years justifies a larger discount. I'm not sure the voting/non-voting thing matters much for this size of a stake, anyway. But the two-year restriction seems to me to justify an extra discount.

    Without going into details, I wasn't left entirely confident that this is an area where my accountant has particular expertise, so I'm interested in the views of others. Should I go back to him and argue for a bigger discount given the restriction, or is his 75% reasonable?

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    Serious reply - contact MF about this, he's been thinking the same thing and 2 heads are better than one in this respect.

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    Quote Originally Posted by cojak View Post
    Serious reply - contact MF about this, he's been thinking the same thing and 2 heads are better than one in this respect.
    I don't think this is the same as MF's interest - he's looking at purchasing shares - in WiB's case its shares gifted to the company for services rendered.

    Given that your issue here appears to be about the level of discount and that that discount level is a potential £150,000 in taxable income / profit I would see which of the national medium sized accountancy firms can give you appropriate one off advice.

    Your typical one branch accountant won't have seen this often enough to provide an accurate answer.
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    Quote Originally Posted by eek View Post
    I don't think this is the same as MF's interest - he's looking at purchasing shares - in WiB's case its shares gifted to the company for services rendered.

    Given that your issue here appears to be about the level of discount and that that discount level is a potential £150,000 in taxable income / profit I would see which of the national medium sized accountancy firms can give you appropriate one off advice.

    Your typical one branch accountant won't have seen this often enough to provide an accurate answer.
    Oh, right you are.

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    For that sort of money I’d be going to a commercial lawyer firm not an accountant.
    It’ll cost a few k though.

    It will also help with getting the shareholder agreements right.
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    Quote Originally Posted by WordIsBond View Post
    MyCo has been offered a client equity stake as part of a big deal we are doing. There are four employees who would be glad to have the equity stake. Please spare me the obligatory warnings of why this is a bad idea. We've weighed the risks and benefits, and judge it to be worth the risk.

    The company was valued for estate tax purposes earlier this year, due to the death of one of the principals. It is a non-EU company, privately held. There are both voting shares and non-voting shares, at a ratio of 20 non-voting to 1 voting. In all other rights the shares are equal. The shares we are being offered are non-voting shares, and contractually cannot be sold for two years.

    One shareholder owns approximately 70% of the non-voting shares but no one owns a controlling stake of the voting shares. The company has been valued at approximately £70 million. The share on offer to MyCo is just under 0.3% (around £200K, on a pro-rata basis, if the estate tax valuation is used).

    The intent is to pay out the shares as a scrip dividend to the individuals involved. The question is A) what value is used for CT purposes B) what value is used for dividend tax purposes C) what value is used for purchase price in future capital gains tax calculations and D) can the estate tax valuation be used?

    I have been told by my accountant that A=B=C, that the answer to D is yes, and that a nonmarketability discount of 75% would be appropriate, so that for tax purposes the pro-rata £200K would become approximately £50K, which would be applied to the company for CT, and prorata to the four shareholders for their dividend tax. I was told that normally this small of a percentage in a privately held company would attract a 60-70% discount but the fact that the shares are non-voting and restricted for two years justifies a larger discount. I'm not sure the voting/non-voting thing matters much for this size of a stake, anyway. But the two-year restriction seems to me to justify an extra discount.

    Without going into details, I wasn't left entirely confident that this is an area where my accountant has particular expertise, so I'm interested in the views of others. Should I go back to him and argue for a bigger discount given the restriction, or is his 75% reasonable?
    How about a few more facts about the valuation:

    1. What price is the company paying for the shares?

    2. Why is the company paying that price?

    3. What price have other people bought shares for recently?

    4. What price are other people offering to buy the shares for?

    5. What do you think the shares are worth?

    6. Why do you think that the shares are worth this amount? Why not more? Why not less?

    7. What was the value of the shares that were valued for estate duty purposes? (i.e. not the £70m value for the company but the value of the shares).

    8. What was the size of this stake?

    9. What country's tax system was the valuation done for?

    10. What basis does that country use to value the shares?

    11. Did the tax authorities question that value? If so, what was the outcome of that?

    12. Do you have a copy of the valuation report?

    13. When was the valuation done?

    14. What has happened since (e.g. profits different to expectations, dividends paid, takeover offer, etc)?

    15. How is the non-sale right to be documented? (e.g. in articles applying to all shareholders, in a personal agreement?)

    16. What dividends do you expect will be paid on the shares over the next five to ten years?

    17. Who owns the other shares?

    18. What is the expectations around there being a capital event?

    19. What price is expected to received on such an event?

    You mention dividends, do all the people who are going to receive the shares hold exactly the same class of share in your company? Will they receive the shares in proportion to their shareholding?

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    I'll just copy the questions with my answer following:
    How about a few more facts about the valuation:

    1. What price is the company paying for the shares?
    We are negotiating a fixed price for a project. It’s part of a cash and shares deal. The cash portion is £500K. I would probably bid the job somewhere between £550-600K if it were all cash. So I guess we're paying somewhere between £50-100K, but it's not strictly defined. In a project this size at a fixed price there are obviously significant margins and uncertainties.

    2. Why is the company paying that price?

    The project has the potential to significantly increase the value of the client co.

    3. What price have other people bought shares for recently?

    No shares have changed hands for over a year.

    4. What price are other people offering to buy the shares for?

    I’ve not been given any information on this. I do not know if there is any market for them at all.

    5. What do you think the shares are worth?

    As noted above, probably somewhere between £50-100K. Probably closer to £100K, but I'm an optimist.

    6. Why do you think that the shares are worth this amount? Why not more? Why not less?

    Why not more: non-marketability, all the known risks of minority shareholding, currency risks. Why not less: current dividend yield of 3-6% if value is £50-100K, potential significant upside.

    7. What was the value of the shares that were valued for estate duty purposes? (i.e. not the £70m value for the company but the value of the shares).
    8. What was the size of this stake?

    30% of voting shares and 70% of non-voting shares. Valued at approximately £40M, to which a nonmarketability discount of 25% was applied, for total value near £30M.

    9. What country's tax system was the valuation done for?

    USA

    10. What basis does that country use to value the shares?

    I do not know.

    11. Did the tax authorities question that value? If so, what was the outcome of that?

    Not challenged to date. The valuer is reputable and has a long track record with the IRS.

    12. Do you have a copy of the valuation report?

    I have been promised one.

    13. When was the valuation done?

    March 31 2019

    14. What has happened since (e.g. profits different to expectations, dividends paid, takeover offer, etc)?

    No profits reported since then, quarterly dividends as before, no takeover offer. Company paid approx. £3 million (cash) two months ago to acquire a key supplier. This was a defensive acquisition to protect against it being purchased by a hostile entity. The valuer was informed of the likelihood of this acquisition and presumably factored it in.

    15. How is the non-sale right to be documented? (e.g. in articles applying to all shareholders, in a personal agreement?)
    An agreement between ClientCo and MyCo to which any acquirers of the shares (me and other shareholders) must agree.

    16. What dividends do you expect will be paid on the shares over the next five to ten years?

    Based on history, £3K / year increasing to perhaps £4-5K / year 10 years from now. Based on my view, that this project will open key markets to Client Co, I anticipate dividends could easily increase to £8-12K / year, but that’s speculative.

    17. Who owns the other shares?

    45% voting shares held by a trust controlled by children of a former majority shareholder. 30% voting shares and 70% non-voting held by spouse of deceased. 10% (voting and non-voting) held by former CEO, now chairman. Remainder, in varying amounts, held by about 45 employees / former employees and 5-10 of ClientCo's key clients and suppliers.

    18. What is the expectations around there being a capital event?

    There may be a share buyback offer in December to which we could not be participants, as per agreement.

    Due to emotional / family reasons involving the founder's 'vision', the makeup of the trust, and the relationship with the shareholder who holds 30% of voting shares, the company is very, very unlikely to be sold for at least a decade. Their goal is to distribute dividends rather than sell the company.

    19. What price is expected to received on such an event?
    I have no knowledge, if there is a buyback, of what price it would be.

    You mention dividends, do all the people who are going to receive the shares hold exactly the same class of share in your company? Will they receive the shares in proportion to their shareholding?

    MyCo does have more than one class of shares. Shares in ClientCo will be issued to MyCo shareholders, for each relevant class of shares, proportionally to the shareholding of the shareholders for that class of shares. The number of shares issued to Class A will not be the same as the number issued to Class B, and Class C will receive no shares of ClientCo.

    We have also considered just having employees of MyCo purchase the shares from MyCo at the price used for tax purposes, rather than issuing them as scrip dividends. If that's cleaner we could do that but I don't think it makes any difference.

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    Quote Originally Posted by eek View Post
    Given that your issue here appears to be about the level of discount and that that discount level is a potential £150,000 in taxable income / profit I would see which of the national medium sized accountancy firms can give you appropriate one off advice.

    Your typical one branch accountant won't have seen this often enough to provide an accurate answer.
    That's certainly appropriate if my accountant's answer is not generally correct.

    If we're talking about whether a discount of 70 or 80% applies, then we're talking about a difference in taxable income of perhaps £20K, which is tax of less than £5K.

    If that's the range and my accountant hit the middle of it then, shrug. If his discount numbers are significantly high or significantly low then it is time to pay an expert.

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    Quote Originally Posted by Lance View Post
    It will also help with getting the shareholder agreements right.
    I have a US lawyer on this part of it, but he's not much help with UK tax.

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    1. Everything I write is not worth the paper it is not written on.

    2. I know nothing about VAT so make sure you get proper advice on that.

    3. Company on acquisition: value of shares should be included in turnover, so increasing accounting and taxable profits. There is no tax rule saying what the value should be. From an accounting perspective, you probably should use what you would have received if you'd been paid in cash rather than shares (technically, the issuer has a rebuttable presumption that this should be used and it makes sense for the provider of the service to use the same). You might want to check what the issuer will use as its accounting expense as if you say it is £50,000 to £100,000 and they use £1m then HMRC may think that is strange. Same if the buyback is for £1m and yourco says that they are worth £100,000. Spreading the income may be relevant depending on when your co provides the services (similar basis to cash).

    4. Company dividend in specie: It's not a scrip dividend but a dividend in specie. The company will pay CT on the deemed market value on disposal less the deemed market value on acquisition. Let's come back to what the "market value" (a tax definition) is likely to be later. The market value on acquisition can be different to the value you include in turnover. But that's unlikely to make a difference from a tax perspective (if the shares are distributed soon after acquisition and the amount included in turnover is not in excess of market value). It's a non-UK company so SD is not relevant.

    5. Dividend received by shareholder: Ignoring employment income tax stuff for now, "market value" of shares is taxed as dividend (so rates up to 38.1%). This amount will be the base cost on a future disposal.

    6. So what is "market value"? This is basically the price that a hypothetical purchaser would pay for the shares. A US valuation report is good evidence as to the valuation. But you'd want to update it for the last nine months. A 25% minority discounts seem to have already been taken into account. You can try to apply some more but don't over-egg it. A further 75% discount would be over-egging. The expected dividend yield makes sense (but may be a bit on the low side). The lack of any likely exit suggests that focusing on dividend yield makes more sense. What's an appropriate yield? No idea but I'd probably want closer to 10% than 3%. The December buy-back price (even if happens shortly after you get the shares) is likely to influence the market value (you say that they are worth £100,000 but a week later, when nothing else has happened, the company buys similar shares back for £1m is likely to be indicitive of what the value was a week before).

    7. There is then the question about how the in ability to sell the shares for two years comes into the valuation. I'd say very little if you don't expect a market for the shares anyway (as a hypothetical buyer would also be expected to hold the shares a long time). If it is a personal agreement (i.e. does not apply to all shareholders) then I'd argue it does not reduce the value but HMRC challenge that for employment taxes purposes.

    8. You do need to think about employment taxes. Why do the "employees" get the shares from your co? If it's really because they are employees then the market value of the shares is subject to PAYE/NIC. A section 431 election should be made. That means you would ignore the two year holding period in valuing the shares but prevents their being an employment income tax charge at the end of their two years. It looks like you have 'alphabet' shares and so there must be a risk that HMRC would say that it is related to the employment. If HMRC succesfully argue this and your co doesn't operate PAYE then HMRC will persue yourco for it. There will also be a penal tax charge under s222 if the employees don't reimburse the PAYE promptly. So you need to think carefully about the PAYE/NIC liability being on the company and the s222 risk.

    9. If you do go down the employment income tax route then your co should recognise an expense for the value of the shares in the accounts (i.e. reduce the company's profits) then your co is likely to get a CT deduction for the expense (there is case in the Court of Appeal that might change that). There won't be a deduction if it is taxed as a dividend.

    10. The shares need to be reported by yourco on the online version of form 42 (since they are made available by their employer) regardless of whether they are taxed as dividends or as employment income.

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