What are growth shares?


What are growth shares?

This page was last updated on May 25, 2023
Often popular with start-ups and young businesses, growth shares offer a way to incentivise and retain key employees when other share option routes are not suited to the company or individual.

This article explains what growth shares are and their tax implications for those receiving them.

Why are growth shares popular?

Growth shares are a type of share designed to allow employees to gain from the growth in the value of the company. They are often favoured by start-ups, where there tends to be more of a culture of equity ownership for employees – particularly if the long-term plan is to participate in a funding round or sell to a venture capital company.

Another reason for their popularity is that they help young companies create an attractive remuneration package where they can’t currently afford competitive bonuses.

Often businesses will use EMI share option schemes or unapproved share options in this way; however, not all companies will qualify or suit the criteria of those approaches. For example, an EMI Scheme is only for people who work 25 hours a week in the business. This doesn’t then suit the likes of contractors or non-exec directors.

With unapproved share options, the employee faces income tax on the profits their shares generate, which can be a sizeable tax amount – particularly if they are a higher-rate taxpayer. Unapproved share options are also often subject to national insurance contributions. 

How growth shares work

Growth shares allow recipients to benefit only from the growth in value of their company’s shares, rather than the value at the time the shares were granted. The gains on a growth share are then subject to Capital Gains Tax (CGT). The employee pays CGT on the increase in value between when the shares were issued, and when they eventually sell them.

To ensure it is indeed CGT (and not income tax) that the employee faces, companies have to change their Articles of Association to record the growth shares as a new class of B or C shares. That record must make it clear that the growth shares only participate if the company shares’ value rises above a specific value threshold. This threshold is known as the Growth Hurdle.

For example, if the company market value is £100,000, the business could create a new class of share – a “B Ordinary” share in the company. This share would only receive value above the current company value of £100,000 or a higher level “growth hurdle”.  So, on issue of the new B share to the employee, the growth hurdle would imply that the new B Ordinary share would have little or no value. However, for any future growth of the company, the value of that B Ordinary share will increase.

Growth shares, therefore, help to both incentivise/retain employees and preserve value for the principal shareholders to a certain amount when the business sells. Growth shareholders only gain on the value in growth since their shares were issued over the growth hurdle.

To avoid falling foul of rules such as the Restricted Securities Rules, which would mean the shares incur income tax rather than CGT, it is imperative that Growth Shares are documented in the company’s Article Associations. The Grays Timber case shows why.

Grays Timber

The Managing Director of Grays Timber Products Ltd had entered into an agreement which entitled him to extra proceeds in the event of a sale of the company. This was, however, on the condition that the sale was for more than a specified amount. The company only had one class of shares though, so this right was not set out in its Articles of Association. Instead, the right was contained in a subscription agreement.

HMRC challenged this and sought an income tax payment. The case then revolved around whether the excess payment ultimately received by the Managing Director (taxpayer) meant he had sold his shares for more than their “market value.”

HMRC argued that the market value of the shares should be determined by the price that would be paid for the shares by a hypothetical purchaser. Therefore, only intrinsic rights attached to the shares should be taken into account for tax purposes. Intrinsic rights would be set out as rights attached to a class of shares in the company’s Articles of Association.

As the taxpayer’s rights to extra proceeds were set out in a subscription agreement, they were extrinsic, and so of no value to the purchaser. They represented a payment in excess of the market value of the shares.

The Supreme Court held that the more important determinant was whether or not rights giving rise to an extra payment were “personal” or not. In this case, the rights were personal to the taxpayer and therefore it would have made no difference whether they were intrinsic or extrinsic. They would not be of value to the hypothetical purchaser and should not be considered when determining market value. The Supreme Court also held that extrinsic rights could be considered when determining the market.

Where growth shares are recorded as a separate class of shares created in the relevant Company’s Articles of Association, the growth hurdle will be intrinsic to that share class. This means the growth hurdle will not be personal to the holder of the shares. Market value should therefore take these factors into account. This is key to ensure exercising growth shares attracts capital gains tax rather than income tax.

Seek specialist advice

While growth shares aren’t new, it is essential to document and value their issuing correctly to achieve all the benefits young companies seek when using them.

Specialist advice is recommended. At Shipleys, we advise and help businesses to put in place the proper share framework to achieve their growth ambitions and comply with the tax obligations of that approach.

For more information, please talk with your Shipleys’ contact or our specialist shown on this page.

Specific advice should be obtained before taking action, or refraining from taking action, in relation to this summary. If you would like advice or further information, please speak to your usual Shipleys contact.

Copyright © Shipleys LLP 2023

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