An Unquoted Private Company

PC Tech Limited is a private limited company, resident, registered and incorporated in the U.K.  It is a high-tech company, specialising in the development of Internet communication systems.  The company is projecting a period of strong growth for the next two years and anticipates selling out to a third party acquiring company in the next two to five years.  The company’s constitution limits the opportunity to issue new shares to support employee share scheme arrangements.

There are five shareholders, all individuals.  70% of the shareholding is concentrated in the hands of the two founder shareholders who each own 35%.  The company pays a low dividend.  The company has one wholly-owned subsidiary that employs the 25 employees in the U.K. and another wholly-owned subsidiary that employs 35 employees in the U.S.A.  The company wishes to involve its two non-executive directors in its share scheme arrangements.

The intention is to grant options to all employees following the completion of the final accounts for the financial year to 31st December, 2002 but at a level for each employee that is agreed by the board of directors.  The gross assets are £2,500,000 and the share valuation of the group is £7,400,000.  This comparatively low share valuation surprised the existing shareholders, particularly when another company that they own, completely separate from the PC Tech Group, a company called Computer Sales Limited that trades through the purchase and sale of computer equipment, is valued at £15,400,000.

Computer Sales Limited has promised each of its 30 employees a share incentive over 1% of the issued share capital of the company.  The company has paid a healthy dividend for many years but is not regarded as being in strong growth mode.  Computer Sales Limited has a 60% stake in Photocopy Sales Limited.

The questions that the company directors asked to be addressed were as follows:-

What share scheme(s) would be appropriate for PC Tech Limited?

The approach is to devise a scheme or schemes that support the corporate objectives and then to introduce the most tax-advantageous schemes possible.  The company’s objectives are geared to strong growth over a comparatively short period of time.  The incentive must encourage strong performance over that concentrated period.  By examining the most tax-advantageous scheme first, the company does qualify as a qualifying company and the U.K. employees do qualify as eligible employees for EMI.  The company chose to introduce EMI on an all-employee basis even though statutorily it is a discretionary arrangement.  Using EMI, rather than the statutory all-employee schemes of SIP or ShareSave, the company was able to determine the level of share involvement for each employee while at the same time honouring its commitment to all-employee involvement.  The exercisable events were linked exclusively to possible exit positions of takeover, stock exchange listing and management buy-out.  For the U.S. based employees the company introduced a general tax-unapproved share option scheme that did not qualify the U.S. resident employees for any tax advantages.  The company rejected the opportunity to introduce a scheme that was tax efficient under the U.S. legislation for the U.S. resident employees although the directors did clearly understand that it is the residence of the employees that determines the availability of employee tax reliefs.

What share scheme(s) would be appropriate for Computer Sales Limited?

Computer Sales Limited is a standalone company, separate from PC Tech Limited.  The common shareholding with PC Tech Limited does not cause the company to fail the EMI Independence Test.  However, its 60% ownership of Photocopy Sales Limited at an ownership of less than 75% causes it to fail the EMI Trading Subsidiaries Requirement which applied at the time but has since been abolished for grants after 16th March, 2004.  Computer Sales Limited wanted to grant an option over a value in excess of £100,000 to each employee.  If it had passed all the EMI tests it could have operated EMI for each employee up to £100,000 with the excess dealt with under a tax-unapproved version.  However, failing as an EMI qualifying company it chose to grant options under a tax-unapproved scheme to all employees with exercisable events linked exclusively to exit positions.

Will all the employee share arrangements be “schemes”?

All the schemes were bona fide employee share schemes under section 743 of the Companies Act 1985, allowing exemptions from the legislative requirements for share issues, financial assistance and financial services.  The financial assistance exemption was particularly important given that the company had chosen to grant the options over existing shares that were purchased from the existing shareholders by an employee share trust funded by cash contributions from the company.

Can the existing shareholders be granted share options?

The two founder employee shareholders of PC Tech Limited were not eligible for EMI given that they owned more than 30% of the shares at the date of grant.  As it happens, with more than 10% each of the shares they would not have been eligible for CSOP either.  The final decision was that they chose not to participate in even a tax-unapproved employee share scheme, even though they would be eligible, taking the view that their remaining shareholding, after the sale of some of their shares to the employee share trust, was to all intents and purposes their share scheme.  They took the same view in relation to their shareholding in Computer Sales Limited.

Why is the share valuation of PC Tech Limited so low?

The company was projecting a period of strong growth for the next two years.  This is exactly the situation in which the Shares Valuation Division of the Inland Revenue (“the SVD”) recognises hyper-growth for which they will typically assume a higher cost base for the next two years and mark down the share valuation accordingly.  Additionally, PC Tech Limited had not paid a dividend ever, a factor that will ensure that the dividend-generated premium is not attached to the share value.  The share valuation was prepared by an independent share valuer who submitted his workings to the SVD for agreement.

Why is the share valuation of Computer Sales Limited so high?

This surprised the directors of the two companies as they considered PC Tech Limited to be the more valuable company.  In reality, for share valuation purposes Computer Sales Limited was the converse of PC Tech Limited.  Its cost base could not be assumed higher for the reason that it was not regarded as being in strong growth mode.  It had, though, consistently paid a healthy dividend, enhancing the value of even a small minority shareholding in the business.  Again, the share valuation was prepared by an independent share valuer whose share valuation was relied upon for purposes of the grant of options.  As a tax-unapproved scheme the SVD would not have given an agreement for the share valuation although the Inland Revenue could raise questions about the shareholding on the basis of entries on the self assessment returns.

How will the options be satisfied?

Although the constitution of PC Tech Limited did not give the opportunity to issue new shares to support employee share schemes it was the desire of the existing shareholders to realise cash for the sale of some of their shares under the capital gains tax regime that finalised the decision to grant over new issue shares.  For this reason it was agreed that the exercise of the options would be satisfied by the transfer of existing shares from the employee share trust to the employees.  This transfer would be on the basis of an operating agreement between PC Tech Limited and the trustees of the employee share trust under which the employee share trust agreed to assist the company in the operation to satisfy the exercise of options.  For Computer Sales Limited there was no such limitation on the use of new issue shares to satisfy the exercise of options and the existing shareholders were prepared to wait until the exit position to realise a cash value for their shares.  It was established, therefore, that the exercise of the options would be satisfied through the issue of new issue shares directly to the employees at the time of exercise.

Can the existing shareholders have granted to them a put option by the trust? 

The shareholders accepted the advice that to have a put option under which the trust had to buy their PC Tech Limited shares at their request would undermine the independence of the trust, especially as they controlled the company.  The independence of the trust is crucial in establishing that the scheme arrangement does not represent a pre-ordained series of transactions entered into with the express purpose of tax avoidance.  If it did then the potential would be there for the Inland Revenue to treat the structure as though it had never been established in the first place with the resultant effect of significant tax exposure for the founder shareholders.  Rather than enter into a put option arrangement the directors accepted the advice given to them as existing shareholders to grant a call option to the employee share trust for the trust to have the right to call upon the shareholders for delivery of the shares as and when the trust required them.  This call option feature of the arrangement strengthened still further the independence of the trust.

What communications are required with the Inland Revenue?

The Small Company Enterprise Centre of the Inland Revenue was notified about the grants of option under EMI.  The Shares Valuation Division of the Inland Revenue  was involved in agreeing the share valuation for purposes of the EMI grants.  The Employee Share Schemes Unit of the Inland Revenue was notified of grants under the tax-unapproved share option schemes.

What arrangement should be introduced for the non-executive directors?

Neither the non-executive directors of PC Tech Limited nor the non-executive directors of Computer Sales Limited were employees.  If they were to be involved in the employee share schemes then the status of the schemes as bona fide employee share schemes would be contaminated.  Each of the two companies chose to grant options to the non-executive directors through separate schemes specifically for non-executives.