The Supreme Court has recently provided the final word on a long-running tax dispute which centres on whether personal rights and rights outside the articles of association can be taken into account when working out the market value of shares for employees.

The significance of this dispute is that if shares are acquired from employees for more than their market value (eg on a sale of a private equity company), then that excess amount is subject to income tax and National Insurance contributions (NICs) (which needs to be accounted for by the employer under PAYE) rather than the more favourable capital gains tax regime.

In Grays Timber Products Ltd v HMRC, an employee acquired shares in a company. A shareholders' agreement signed more or less simultaneously by the majority of the shareholders gave him a right to receive a disproportionately large amount of any sale proceeds if certain targets were met and he remained in employment. This was in contrast to his entitlement under the articles, which would just have given him a pro rata amount based on the number of shares he held compared with the number of shares other shareholders held. A sale duly occurred and the employee received the larger amount of proceeds. The Revenue subsequently challenged the tax treatment of his gain.

The employee repeatedly argued throughout all the proceedings that his rights in the shareholders' agreement should be treated as if they attached to the shares and were included in the articles, and so contributed to the shares' market value. However, the Supreme Court upheld the rulings of the lower courts in the proceedings in agreeing that market value meant the value of the shares and rights which passed to a prospective buyer. External rights (in shareholders' agreements, for example) or personal rights, which did not affect the buyer or the intrinsic value of the shares, could not affect the market value of the shares. Accordingly, the shares' market value remained the pro rata amount the employee was entitled to under the articles (some £450,000) and not the enhanced amount (some £1.5 million).

This meant an income tax and NIC charge on the excess amount, which was payable under PAYE. In this case, the excess amount was over £1 million. Fortunately, however, the buyer of the company had operated a retention and so it was able to cover at least some of the amount sought by the Revenue from that sum rather than having to go against the employee to recover its PAYE liability – which, as the sale occurred in late 2003, would now be difficult.

While not a surprising result, the case acts as a timely reminder, as capital gains tax schemes become more important, of the need for properly drafted arrangements to give employees additional rights on exits or achievements of targets.

Crucially, these rights should be included in the articles rather than being expressed as personal rights. The downside of this can be that the employee shares can have a slightly higher value on acquisition than their pro rata value, but this is hope value and so should not normally amount to any significant premium. In the Grays Timber case, had the employee's full rights been included in the articles up-front, it is likely that, while he might have had to pay a little more to acquire his shares, his full £1.5 million would have been subject to capital gains tax after all and so he would have saved some £300,000 in tax.

To view our earlier email please click here (www.law-now.com/law-now/2007/enhgaformanprico0407.htm).

For a link to the Supreme Court case report please click here (www.bailii.org/scot/cases/ScotCS/2009/2009CSIH11.html).

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

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The original publication date for this article was 12/02/2010.