The GAAR advisory panel has issued a ruling clamping down on a scheme involving the extraction of cash or value from a company by its directors and shareholders using employee shareholder shares
The decision supports HMRC’s view that such tax arrangements are not a reasonable course of action and are judged to be abusive.
The latest general anti-abuse rule (GAAR) ruling relates to a number of substantially similar opinions issued on 7 August to taxpayers who had been referred by HMRC on 2 May 2019.
The arrangements under discussion involved a company which is wholly owned by the taxpayers. Each taxpayer is a director and employee of the company and also a member, with other taxpayers, of at least one of a number of partnerships.
Under the scheme, the adviser suggested a restructuring involving the extraction of value via ES C shares. These are class C shares in the company, which are entitled to the substantive economic value of the company once a performance ‘hurdle’ linked to the net asset value of the company has been met.
The restructuring involved a complex series of moves. The taxpayers gave up their interest in the partnerships, and the adviser wrote to HMRC requesting a valuation of the proposed ES C shares. A net asset value of the company was agreed, on which the share values were calculated.
Subsequently, the adviser contacted HMRC to say additional income and costs had arisen since the initial valuation and proposing the net asset value hurdle be increased. HMRC accepted this valuation based on that revised information and the new hurdle.
Then company resolutions were passed so that the existing £1 ordinary shares in the company were each sub-divided into 100 ordinary shares of £0.01 each; new articles of association were adopted; each of the taxpayers’ holding of £0.01 ordinary shares was re-designated, so that after the re-designation each held shares in two new class A and B shares; and the directors were authorised to allot Class C shares (the ES C shares).
The share rights had the effect of passing the class A and B shares into new ES C shares.
Each of the taxpayers signed an employee shareholder agreement giving up certain employment rights, recording that the ES shares were being allotted in return for entry into the employee shareholder agreement and that the taxpayer had provided no other consideration for the shares. The value of the value of the ES Shares was recorded, in each case, at less than £25,000.
Within a period of a few days ending on day 90, the effect of this arrangement was that the hurdle was met, the taxpayers resigned as directors of the company, and the company repurchased the ES C shares for an aggregate of 100 which was higher than the original one cited.
As a result, effectively all the economic value held by the taxpayers via their original shareholding moved into the ES C shares held by those same taxpayers. On the repurchase of their ES C shares each of the taxpayers received their share of the company’s accumulated and undistributed profits, those profits having been generated in the main prior to Day 0.
The GAAR advisory panel agreed with HMRC’s position that the tax advantage is that the taxpayer sought to extract their share of the 100 of value from the company without suffering income tax or capital gains tax consequences. In particular, HMRC maintained the ES shares exemption was not available on the day 90 repurchase of the taxpayer’s ES C shares.
For their part, the taxpayers sought to argue that they were entitled to the ES shares exemption on the repurchase of their ES C shares, saying they not only satisfied the ES shares conditions but that their planning was consistent with the policy objectives of the ES shares legislation.
As a result, they claimed to have an exemption from capital gains tax (CGT) and income tax on the sale proceeds they received, and that the ES C shares were subject to an income tax charge only on the difference between the agreed value of their ES C shares and £2,000.
‘Abnormal and contrived’
In agreeing with HMRC, the panel pointed to the inclusion of the hurdle in the EC shares terms, which were viewed as ‘abnormal and contrived’, while the fact the shares were only held for a short time and there was a reorganisation of the shares were both viewed as within the boundaries of normal financial planning.
The panel stated: ‘Engineering a situation in which the taxpayers give up existing economic rights, being rights on their original shareholding that accrued before the employee shareholder agreement was signed, and moving those rights into the ES C shares is a strong indicator that the arrangements are abusive.’
As to whether the abusive arrangements were the result of a failure in the drafting of the original legislation, the panel stated: ‘It is highly unusual for a company with more than four shareholders to have existing shareholders and holders of newly issued ES shares being one and the same.
‘It is probably not surprising that this particular scenario was not dealt with in the legislation. In our view, had the drafter considered this scenario we would have expected the legislation to have included an anti-value-shifting provision to bolster the ES shares £50,000 initial value limit.’
In conclusion, the panel found the scheme was not a reasonable course of action in relation to the relevant income tax and capital gains tax provisions.
The means of achieving the intended result relied on an abnormal and contrived net asset value hurdle built into the rights of the ES C shares so that effectively all current value can be passed out of the taxpayers’ original shareholding into the ES C shares held by those same taxpayers.
The arrangements exploited a shortcoming in the legislation as the particular circumstances of overlapping existing shareholders and holders of new ES Shares had not been contemplated; and the overall tax outcome is that the proceeds of sale of the ES C shares (a substantial proportion of those proceeds representing value ‘owned’ by the taxpayers before the ES C shares were issued, and indeed before they made their valuation request) were intended to be taxed in a different way to the way in which comparable transaction share repurchases were ordinarily taxed.