Catriona: Hello everyone, as we’re working through the implications and repercussions of the current crisis, we have begun to get quite a few questions about whether and how businesses should be thinking about restructuring. Some, I think are from a defensive perspective obviously, but others are looking more to the future. So today Graeme Blair, our head of business tax is here to talk through some of the issues. So Graeme, can you give us a flavour of the sorts of questions people are asking?
Graeme: Hi, there are three general areas that people are looking at, at the moment. The first is gifting shares throughout the family generations. The second is incentivising employees through share schemes and the third is restructuring for trade and asset protection or financing purposes.
Is now the right time to gift shares in my family business?
Catriona: Okay. So there’s quite a lot of different things going on there. You mentioned gifting shares. Why would people be thinking about that now?
Graeme: It’s always been possible to gift shares in family trading businesses. However, there’s more than one tax to consider when gifting shares. The interaction of tax reliefs makes gifting of shares between the generations tax efficient for trading businesses. However, there are many companies which look like they’re trading but aren’t able to rely on these reliefs. Typically these are successful trading companies which use surplus monies to reinvest often in property.
What the shareholders may not have appreciated is the investments they’ve made the company non-trading in the eyes of the tax law. They might be trading commercially, but in the eyes of the tax law, they are non-trading. The investments don’t have to be large for this to become a problem. And the impact is that there can be a tax charge when shares are gifted.
Catriona: And presumably low interest rates are making alternative investments even more attractive at the moment, for those that are lucky enough to have assets to invest.
Graeme: With low interest rates, people are starting to consider cash balances and thinking about other areas to use their spare cash. And this can only perpetuate any problems about having non-trading assets on the balance sheet.
There’s also the thought that tax rates may rise in the future and so people are considering the possibility of gifting under known current reliefs rather than running the risk of doing nothing now and considering gifting in the future on uncertain tax regimes.
Catriona: Okay. So can you expand a bit more on what taxes you’re talking about?
Graeme: When there are gifts, there are two taxes that need to be considered. The first is capital gains tax, which is payable by the donor and the second is inheritance tax. The capital gains tax costs are difficult to overcome and this has led to an increased interest in gifting at this time while share prices are depressed, effectively it’s an opportunity to minimise a tax charge, which is determined with reference to a company’s open market value.
As companies struggle in the current economic climate their values are depressed and the tax costs associated with gifting are reduced. I’ve already highlighted that these tax costs arise when you have a non-trading company.
There are techniques such as demergers which we’ll come to in due course which may be able to protect against the tax consequences for non-trading businesses. They do this by converting a business into a trading business and allow them to access the tax free gifting rules.
How can I incentivise staff when cashflow is a problem?
Catriona: You mentioned that we’re getting a lot of calls from employers who are understandably concerned and upset about the fact that they’re having to make cost cutting and indeed reduction of wages and the impact that that’s having on their staff. What could they be doing that could incentivise staff or go some way to helping those people that wouldn’t be an in upfront salary costs?
Graeme: Cash is king here. The reason that salaries might be cut or bonuses deferred is to save the business cash and therefore the solution would be to offer staff non-cash consideration as part of their package. Shares would be an obvious example of a non-cash payment that could be part of the salary package.
Of course, what I’m considering here is a commercial business which is not already employee controlled. Therefore, I’m not describing a business which has, for example, a John Lewis model. I’m describing the situation with the vast, vast majority of UK businesses where employees are not necessarily shareholders.
The issue that needs to be overcome is that if an employee simply received shares in the business for less than their market value, for example, they are given shares in the business, then there’s a tax charge. It would be reasonable to assume that the employee would go to the employer and say, please provide me the funds to pay the tax charge.
Of course, if you’re trying to save cash, that is not really an effective mechanism to do so and therefore what we’re finding is we’re entering into conversations about share option schemes because they bridge the gap between providing the employee with a package that incentivises them and the employer saving cash.
Catriona: Okay. Thank you. So what sorts of share option schemes are there?
Graeme: In the UK there are three share option schemes that one looks to adopt for private businesses. They are enterprise management incentive, sometimes called EMI, Company Share Option Plan, sometimes called (CSOP) or the unapproved share option plan. Unapproved in this instance does not mean anything other than they don’t come with any special tax breaks.
Catriona: So how would anyone know which one to choose?
Graeme: In the private company arena, EMI is always looked at first. In fact, EMI is often described as the gold standard of share option scheme. If EMI is not possible, then CSOP is generally considered next. If CSOP is not possible, then employers look unapproved share option schemes.
Catriona: So if EMI is the gold standard, why wouldn’t that be the one that everyone would go for?
Graeme: Not all companies could issue EMI options. There are certain tests about the eligibility of the employing company. These tests include tests of size and activities. Only trading companies can issue EMI options. I’ve already referred to the differentials between some of the tax reliefs between trading and non-trading companies and this is another example where there are differences. If EMI is not possible, then one looks to CSOP, this is because the range of companies which can issue CSOP options are broader than the range which can issue EMI options.
Catriona: Okay, so you’ve explained clearly the benefits to the employer, but what’s in it for their employees?
Graeme: Certainly for CSOP and EMI, there are special tax rules that give them benefit if they receive an exercise share options. If the employer grants options to the employee which are exercised at the current market value of the company, then as long as the employee pays that sum, when they exercise the option, there’s no tax charged to them for receiving the shares. So for example, if the business is worth £1 per share today and options are granted and the exercise price of £1, then it doesn’t matter that the individual exercises the options say in five years’ time when the shares are worth £10 each.
The employee would only pay £1 for the shares, but they would receive shares worth £10. Both EMI and CSOP, therefore give an incentive for the individual to work hard and grow the value of the company. Reverting back to the comments made earlier about the depressed economic climate, company shared values are more likely to be lower at the moment and therefore the price at which the individual can be granted shares is lower, and if those shares do grow in value in the next few years, then the gain to the employee is greater.
Catriona: Lovely, thank you. So that sounds like certainly something to consider for those who’ve got a robust plan for the longer term. Is there a limit to the value of the shares that can be transferred to employees?
Graeme: Generally, companies can issue more EMI options to their employees than CSOP options. Again, it’s another reason why you look at EMI first.
Catriona: What are the differences to the employees when they get the shares?
Graeme: Again, there’s a difference between EMI and the other share option plans. Entrepreneurs’ relief is the lowest rate of tax in the UK. It’s a 10% rate and an EMI option can allow the individual to obtain entrepreneur’s relief when they sell the shares.
In my experience, this 10% rate of tax is rarely available when shares are rising under either CSOP or unapproved share options. This differential was deliberately introduced by the government to enhance the attractiveness of EMI.
I’ve given you a little insight into some of the conditions for the share option schemes. There are others and tailored advice should be sought based on the specific circumstances of the employing company.
Catriona: So to sum up you’ve highlighted some of the benefits to employers, but obviously this sounds like something that the employers could be looking at. Are there any other benefits you would flag?
Graeme: There is one other benefit that’s regularly highlighted and that’s the corporation tax relief available to the employing company. Going back to my earlier example where options were granted for £1 and exercised at the time when the shares are worth £10, the £9, as I’ve already highlighted is tax-free for the employee, the employing company gets tax relief on this £9 even though there’s no tax on the employee.
This is a great benefit to the employing company as it doesn’t have to spend money paying staff and yet it gets tax relief on the shares which were issued to staff. Again, this is deliberate to make EMI share option planning attractive.
If we reflect on discussions to date, the trading company status of the company is paramount. There are differences between gifting shares on trading and non-trading companies and EMI share options require the company to be a trading company.
Catriona: And you mentioned in the introduction that people can accidentally find themselves in a position of not being a trading company. If companies find themselves in that position, what can they do then?
Graeme: That’s absolutely right and yes, it’s possible to take a company or a group and separate it out into its component parts so that you separate the trading activities from the non-trading activities. So let’s use an example of a single company with a trading section, but over years it’s used its spare cash to start investments, perhaps property investment. It’s then possible to split that company into two new structures. One, its trading activity and the other, the investment activity. It’s then possible to incentivise employees through, for example, EMI share options on the trading activity. These separations are called demergers.
Is there anything I can do to protect key assets in my business?
Catriona: I know you’ve been doing a lot of demerger work already grown long before the Covid crisis. So before we get into why they might be useful particularly now, can you just give us some examples of why people might want to demerge?
Graeme: There are a variety of reasons why demergers occur. They allow gifting through generations or option planning are adjust two examples. It’s not unreasonable to see demergers occur prior to management buyout, prior to retirement, prior to seeking external funding or as a mechanism to allow different shareholders to grow the businesses in different directions.
Looking at each of these in turn. A demerger could allow family business to separate into a trading arm and the investment arm with a view that the younger generation are gifted shares in the trading arm tax-free and using the gifting reliefs while the older generation retain the investment side and that becomes a quasi-pension pot for them to finance their retirement.
Alternatively, the business might be looking for external funding and a demerger allows funders to take security on investment assets in a ring-fenced manner.
I’ve come across situations where the family have brought in non-family members who are senior management and don’t want those management to participate in the growth of the value of the company that simply arises from its investment portfolio. A demerger allows management to take a stake in the trading arm of the business, potentially through EMI. Whilst the investment side is wholly retained by the family to finance their lifestyle.
If the business was, say, a manufacturing concern and it owned its factory or an advisory business and it owned its office block, then those property assets could be transferred with the investment assets and the family rent the business to the trading company at market rent. If the trading business failed at some time during the future, for example, as a result of Covid-19 or the actions of the external management, then the family still have the rental business to generate future income.
Another example of where a demerger has been appropriate is when a shareholder dispute occurs, because some shareholders want to take a business down one direction, whilst other shareholders want to concentrate on a separate business stream. The demerger allows the shareholders to separate the businesses amongst themselves and they can develop each business stream in the way that they wish.
Catriona: And that also happens in family businesses when you’ve got two subsequent generations and they’ve just got to the point they just wanted to go in two different directions. So it can happen for positive reason too?
Graeme: Oh, absolutely.
Catriona: So all of those examples involve trading activity. But what about people whose entire business is investment? For example, property investors.
Graeme: Demergers are equally appropriate in those scenarios. For example, in the last couple of years I’ve dealt with a number of families who own property investment businesses and looking to separate those businesses. For example, one situation was two families each own 50% in the shares in a group which had numerous residential properties. The family’s finances were therefore intertwined and they wanted to unlock their financial dependence on each other. What we did was to separate the properties into two separate businesses with one family taking one business and the other family taking the other business.
In another situation the relationship between a brother and sister deteriorated. In order to allow them to lead separate lives, they demerged their investment business with the brother taking some of the property assets and the sister taking the rest.
A further example is a family which had a dispute about the future of a particularly valuable piece of land, one sibling wants to spend time and money on that land seeking property development opportunities. Whilst the other siblings wanted to concentrate on the rental income that other properties were generating. Again, the siblings split the company, so the individual who wanted the development site was able to take it and do what he wished with it whilst the other siblings took the remaining properties and continue to make rental profits from them.
Finally, there’s the common situation in which families need to offer security for borrowing. This is not security for company borrowing. It’s security for private borrowing. It might be security to help finance a separate business in which they have an interest or security to allow them to buy an asset such as a family home.
A demerger can occur to take the valuable asset out of a trading company into a separate company and allow that separate company to be offered as security without any impact on the day to day activities of the trading company.
Catriona: And are you seeing an increase in interest in demergers as a defensive reaction to the situation we’re in now?
Graeme: I’m certainly seeing many conversations about demergers. No two demergers are the same and they have to be structured in accordance with the specific facts of the business and the commercial wishes of the shareholders.
With share values falling and incomes falling I’m entering into more conversations about their use as a mechanism to allow families to achieve their objectives and protect the wealth in a way that’s appropriate for each separate family member.
Catriona: You’ve talked a lot about family businesses, are demergers appropriate for enterprises that are not owned by families?
Graeme: I’ve already hinted that demergers are appropriate as a structuring for a management buyout, and that same principle applies to other situations where there may be external investment into existing businesses, and so the answer is yes.
Catriona: Thank you very much, Graeme.
I hope you all enjoyed that. We are obviously trying to share the issues as they happen, but everything is happening really fast at the moment. So always check our website, which is goodmanjones.com for up-to-date information. But if you have any questions you’d like to put to Graeme or anyone else, do please get in touch either by the website or through LinkedIn or Twitter. Thanks very much.
The information in this article was correct at the date it was first published.
However it is of a generic nature and cannot constitute advice. Specific advice should be sought before any action taken.
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