In today’s tax tip, find out more about alphabet shares for your company.
We will cover:
- How alphabet shares work and the reliefs available
- When HMRC denies tax relief on employment share schemes
What are alphabet shares?
Firstly, alphabet shares refer to different classes of shares.
A company can choose to give shares to its directors or employees through a share scheme. This is a tax-efficient way to reward staff.
A share scheme can have different classes of shares, which are graded according to the letters of the alphabet. For example, an ordinary share scheme can have an A ordinary share, a B ordinary share, and so on.
How to set up ABC shares?
In order to set up ABC shares, you will need to register your intended share scheme with HMRC.
If a company decides to set up different classes of shares, it can also establish different sets of rights and dividends attached to each type of share.
The A share class gives shareholders a higher percentage of dividends than the B class, for example.
The board of directors or shareholders can vote to change share classes anytime.
How do share classes work?
A new share class can be set to have different rights to the existing shares. These would give different rights in respect of:
- Right to capital.
- Rights on winding up.
- Pre-emption rights.
- Rights on take-over.
Alternatively, a new share class can have the same rights as an existing class.
It’s possible to set up new share classes where each share has equal rights, but where the board has the authority to vote on different dividends. These are alphabet classes.
A company with 100 £1 ordinary shares could divide up its existing share capital into say:
50 A ordinary shares and
50 B ordinary shares.
The decision to create new classes of shares is not just a tax one, it is quite often essential when investors are brought on board, and it may be desirable to rearrange share structures if a share scheme is planned.
In the context of private companies creating new share classes, they may create various complications for existing shareholders and tax.
What are the risks?
Unfortunately, one of the pitfalls in introducing share classes is that they impact shareholder agreements and share-based transactions.
It also makes claims trickier, such as claims for Capital Gains Tax (CGT) and Business Asset Disposal Relief (BADR).
If employers do something to shares that affects or inflates their value, they will be charged additional Income Tax.
If employers award shares for free or for less than market value, Income Tax will be charged. You’ll also be charged tax if you change the rights attached to issued shares affecting their market value.
What are the reliefs available?
Business Asset Disposal Relief (BADR) applies because dividends are taxed differently from earnings.
For this reason, employers are entitled to Corporation Tax relief on the taxable value of a share award made to an employee.
Different share options for employees can also have a different tax treatment. It may be beneficial to award options under the Enterprise Management Incentive (EMI) scheme.
Business Asset Disposal Relief (BADR)
BADR is a Capital Gains Tax (CGT) relief that reduces the rate of tax you pay upon disposal of business assets where the disposal proceeds are high enough to take you into the higher tax bands.
It can apply to disposals of:
- A sole trade and its assets.
- Partnership interests and assets.
- Shares in your own company.
- Joint venture interests.
- Business assets held by a trust.
So, if disposing of shares in a trading company, companies must pass several tests to claim BADR. Learn more about them here.
Share classes for tax purposes
Employees can be taxed differently depending on their share class.
As mentioned previously, shares can be given as a reward for employees. These are called ERS, or Employment-Related Securities.
If you set up any ERS scheme, you must report to HMRC. These include one-off awards and transferring of shares.
Tax and National Insurance treatment will also depend on whether the shares can be converted readily into assets.
You will also be charged Income Tax when shares are not paid in full.
When does HMRC deny relief?
Because different share classes make valuation trickier, there’s a likelihood that HMRC may deny tax relief.
It is up to the employer to ensure that tax treatment is correct. Make sure you discount the share value to consider the effect of restrictions.
When transferring shares, Stamp Duty relief will only apply on like-for-like exchanges where the shareholdings at the end exactly mirror those before the transaction. If they don’t, HMRC may deny relief.
In the case of reorganisations and demergers, HMRC may also demand PAYE and NICs from employers if they pay dividends to employees to avoid tax on bonuses.
Dividends can be subject to Income Tax and NICs if they have the nature of an income. In PA Holdings vs HMRC, employers set up a scheme to avoid paying NICs and maximise tax relief. The company gave employees shares in a third-party company and paid dividends as a bonus.
The Court of Appeal concluded that the bonus had the character of earned income. A dividend should be taxed as a dividend and not as employment income provided it is not a disguised bonus.
Planning for different share classes
A business founder should consider reorganising their own share capital before offering shares to employees.
This ensures that profits and certain reliefs are safeguarded.
After doing this, they may attribute different share classes.
Share schemes are beneficial for encouraging hard work and participation of employees. They also ensure that dividends are paid out without being subject to PAYE or NICs with proper planning.
You should always consult a specialist before making big decisions.
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Kind regards Ilyas