BUSINESS ASSET DISPOSAL RELIEF - 21.05.2020

Dilution protection elections: valuing the shares

Your client is a minority shareholder in a company whose shareholding has recently been diluted to below 5%. They are considering making an election to lock in the 10% tax rate. How will the shares be valued, and what trap can you help them avoid?

Scenario

Your client is a key employee of a small but innovative family run technology company. The company has been in existence for seven years, and whilst it was loss making initially, it is now profitable.

Four years ago your client was granted share options in the company under a tax-advantaged scheme, which they exercised two years ago paying £20,000 to acquire a 7.5% stake. The business is expanding and requires further investment to meet its growth aspirations, so it recently issued shares to a member of the owners’ family in order to raise capital.

Unfortunately for your client the share issue has meant their 7.5% shareholding has been diluted down to 4%, meaning the company would no longer be classed as their personal company for business asset disposal relief (BADR) purposes. You have therefore discussed with your client the availability of the dilution election at s.169SC Taxation of Chargeable Gains Act 1992 (TCGA) .

Pro advice. We covered the election in detail in yr.6, iss.2, pg.6 (see Follow up ).

Election

In order to preserve the availability of BADR for shareholders who have had their holdings diluted, Finance Act 2019 introduced the dilution election for share issues after 6 April 2019.

Pro advice. The effect of the election is to treat your client’s shares as having been disposed of immediately before the share issue causing the dilution, and then reacquired immediately after it. The gain on the notional disposal is then available for BADR.

For detailed commentary on the dilution election

Your client would like to understand on what basis their shares are likely to be valued.

Market value

Whenever an estimated valuation is needed for tax purposes, it must be made on a market value basis.

Pro advice. Any pre-agreed method of valuing the company shares should be ignored, for example as set out in a shareholders’ agreement or in the articles of association. Any such method would only be appropriate for non-tax valuations.

The legislation defines the meaning of market value for capital gains tax (CGT) purposes as the price which assets might reasonably be expected to fetch on a sale in the open market. Ordinarily therefore as your client only has a 7.5% shareholding, it would be appropriate to discount the value of the shares to reflect the uninfluential minority shareholding that your client has.

Discount table

The Association of Chartered Certified Accountants (ACCA) publishes the following table of proposed discounts:

Shareholding Discount
>50% 5%-10%
50% 15%-25%
26%-49% 30%-40%
10%-25% 45%-55%
<10% 60%-75%

Pro advice. HMRC no longer publishes its own views but tends to quote the ACCA discounts in its correspondence.

However, the s.169SC provision containing the dilution election states that the valuation of the shares for dilution purposes should be equal to the consideration that would be apportioned to the shares if the whole of the company were sold for its market value.

Pro advice 1. By apportioning the notional market value of the company to your client’s shareholding, this effectively means no discount is allowed.

Pro advice 2. In practice, if your client were to eventually dispose of their shareholding after making a dilution election, but in a transaction that doesn’t involve the sale of the whole company, they could end up worse off even though BADR has been claimed, as the share value will most likely be discounted.

Example. The company is worth £1 million when your client makes the election, therefore the pro rata value of their 7.5% shareholding is £75,000. The shares cost them £20,000 so their gain is £55,000. CGT due with BADR is £5,500. If your client then sells their shareholding when the company is worth say £2m, the pro rata value (now just 4%) would be £80,000. If the disposal was not part of the sale of the whole company, any purchaser would be likely to push for a discount to the pro rata value. If a discount in line with ACCA’s guidance was chosen, say 70%, your client’s shareholding would be worth just £24,000. In real terms an overall gain of £4,000 will have been made, which at the main CGT rate of 20% would trigger tax of £800. However, your client would have actually paid £5,500.

Pro advice. To protect against this risk, in addition to the dilution election, an election can be made under s.169SD TCGA 1992 to defer the notional gain until an actual disposal of the shares is made. Whilst the £55,000 deferred gain would still crystallise, there would be a capital loss of £51,000 (£75,000 deemed cost less £24,000 actual proceeds) to set against it, leaving the £4,000 chargeable gain.

Valuation method

You may wish to reassure your client of the valuation they have received, as it is carried out by an independent person. Alternatively, you might be called on to carry out a valuation yourself.

The earnings basis is usually the most appropriate method of valuing an established trading company which is a going concern. The value of assets is ignored and instead the company is valued by reference to a multiple of its earnings. There are different metrics of earnings that can be used, but the current trend in private company deals is earnings before interest tax depreciation and amortisation (EBITDA), as this is a less subjective measure of profitability than other methods, e.g. discounted cash flow, and it excludes differences in the way a business is financed.

Pro advice. When calculating EBITDA it is important to obtain a normalised figure that represents a true maintainable profit. Therefore, any one-off or exceptional items need to be excluded, and so too any non-trading items. In addition, costs such as directors’ salaries would need to be included at their full market rate if the director shareholders take low salary due to remunerating themselves with dividends.

Multiple

Once a maintainable earnings figure has been calculated, a profit multiple needs to be applied in order to arrive at the capital value of the company. Typically this will be between 3 and 6, but can be more for companies in high growth industries.

If there have been no recent third-party transactions in the company shares, the multiple of a comparable listed company can be used as a basis.

Pro advice. If a suitable listed company can be found, it would be appropriate to discount that multiple to reflect, amongst other things, the difference in size of the companies. A discount anywhere between 40% to 60% is often used.

Whether or not a listed comparable company can be found, it would also be useful to ascertain whether any unlisted competitor businesses of a similar size have been sold recently. If they have, the actual multiple used in that deal could be used as a basis for the valuation multiple.

Pro advice. If an EBITDA method of valuation has been chosen, the multiple will produce an enterprise value (EV) of the business. To arrive at the EV, i.e. the value of the shares, certain adjustments should be made. Assets which are surplus to the trade and which have not contributed to the trading profit should be added to the EV, e.g. excess cash. Any debt should be deducted from the EV.

Previous article on the dilution election

The shares must be valued at market value, probably using an earnings method, ignoring any discount for minority shareholdings. If the shares are later sold at a discounted rate, more tax may be paid than necessary. To avoid this, advise your client to make a second election deferring the gain until the actual sale of the shares.

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