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Spotlight On…Growth Shares: Tax-efficient investment opportunities for UK employees and directors

Welcome to the latest edition of our ‘Spotlight on’ series. In this edition Simonne Inarejos and Tim Shaw provide an overview of how growth shares work and how they are treated for tax purposes.

For a UK company, awarding growth shares to employees or directors can be a tax-efficient way to give them the opportunity to invest in the company and participate in its future growth, often above a specified hurdle.

This hurdle is set by the company and is often linked to the future growth of the business. Once the hurdle is passed, participating directors and employees will likely want to realise their growth value on an exit and sell their shares, making growth shares ideal exit-based incentives.

What are growth shares?

Unlike share option plans where shares are available to employees at a later date once certain vesting conditions are met, growth shares are a separate class of shares awarded to employees on a given date. The company can choose who to award these shares to, making them more flexible than ‘all employee’ incentive plans. Often, they are awarded to key employees who are tasked with growing the business. It is common for growth shares to be subject to restrictions on transfer or forfeited if an employee ceases their employment.

How do they work?

An independent professional valuation should be carried out to first establish the value of the company before any growth shares are created. Existing holders of ordinary shares will not see their current value diluted by the issue of these growth shares which would have happened if ordinary shares were issued instead. It is therefore important to establish what the market value of the company is.

The company can then create a new class of shares called ‘growth shares‘. These shares typically may not carry any voting or dividend rights and the shares only have material value once the set hurdle has been met. There is no guarantee that this targeted future growth will be achieved, therefore growth shares typically have a lower initial value in comparison to ordinary shares of the company. This lower value makes growth shares more attractive and affordable for key employees to buy. Growth shares provide holders with an additional incentive to generate future growth of the business, especially where hurdles are set. This can help align the interests of the existing shareholders and key employees.

Growth shares can work independently or alongside other share option schemes such as the Enterprise Management Incentive where individual limits have already been reached.

Who are they relevant to?

Growth shares are especially relevant to maximise the long-term incentivisation of key employees. Growth shares are also often used by companies where tax efficient share option plans, such as the Enterprise Management Scheme, cannot be used, say, because the company cannot meet the statutory requirements of such schemes. In the absence of growth share arrangements, such companies may struggle to provide competitive retention packages.

Growth shares are especially relevant to maximise the long-term incentivisation of key employees.

How are they treated for tax purposes?

There will be no Income Tax or National Insurance Contributions to pay on the issue of shares as long as the employees pay full market value for the shares on acquisition. Growth shares usually have a low initial market value due to uncertainties about the hurdle being met, so this should be affordable. The growth in value of the shares should be subject to Capital Gains Tax (CGT) rather than Income Tax. The rate of CGT is currently 20%; much lower than the highest rate of Income Tax which is 45%.

Growth shares issued to employees are Employment Related Securities which are often likely to be restricted securities. This means that part of the growth in value could be subject to Income Tax instead of CGT. There are two ways to avoid this happening:

  • The employee pays full market value on the acquisition of the shares or
  • A joint election (a ‘s.431 election’) is made by the company and employee within 14 days of the acquisition of the growth shares.

What should you do next?

Companies considering implementing growth share plans should consider how, for example, they would set the hurdle above current market value

Professional advice should be taken before a growth share plan is implemented and the tax effectiveness of growth shares will often depend upon the robustness of the company valuation used, and there being genuine commercial uncertainty as to whether the hurdle can be met.

Companies considering implementing growth share plans should consider how, for example, they would set the hurdle above current market value, how they would use this to incentivise appropriate employees and how they would go about communicating the benefits of growth shares to such employees.

Should you require further information, please get in touch with your usual Blick Rothenberg contact or Simonne Inerajos or Tim Shaw using the details on this page.