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Key points
- The facts of the case.
- HMRC's contention of a sale for more than market value.
- The Special Commissioner's interpretation of the situation.
- Should the shareholders' agreement have affected the valuation?
- The statutory assumptions of hypothetical buyers and sellers.
- Must total sale proceeds be apportioned evenly?
I have been struggling to find any logic in the Special Commissioner's decision in Company A v HMRC [2007] STC(SCD) 466. I fully accept that there is sometimes no logic in tax, but nevertheless I do expect to understand the basis of judicial decisions.
The facts
It appears from the decision that Mr G became the managing director of Company A, a wholly owned subsidiary of Company B, during 1999/2000 on terms that, in addition to his salary, he was to be allotted shares in Company B equal to around 6.6% of the enlarged equity.
Furthermore, the two major shareholders of Company B agreed to procure that, in the event of a sale of over 50% of the company after two years, the price he would receive for his shares would be based on a formula that would give him a third of the value of the company (the 'subscription agreement').
Company B was sold in 2003/04 and the major shareholders duly procured that Mr G received a disproportionate part of the proceeds.
HMRC contended that Mr G had sold his shares for more than market value and was accordingly taxable on the excess under ITEPA 2003, s 446Y.
The Special Commissioner thought, undoubtedly correctly, that the real dispute was the market value of the shares and how that value was to be determined.
He decided that it was to be determined by taking the total sale proceeds received for the sale of the company and apportioning them rateably over all of the shares sold by all of the shareholders. That gave a market value of £26.59 per share.
The share valuation
Why do I find some difficulty in this?
First, I would expect the value of Mr G's shares to reflect his rights under the subscription agreement and the value of the shares held by the two major shareholders would be expected to reflect the fact that they had devalued their own 83.8% holding by entering into the subscription agreement.
Secondly, all that fell to be valued was Mr G's shares. Accordingly it seems to me conceptually wrong to start from a valuation of the whole company.
If, as a question of fact, the two major shareholders had accepted, and physically been paid, an artificially low price for their shares, and the purchaser was prepared to pay £6 million to acquire the entire company, I would have thought that, at a minimum, the shares held by other shareholders, including Mr G, would have a combined market value of the difference between £6 million and the price that the major shareholders had agreed to accept.
That would give a value of £55.64 per share (I think; the schedule attached to the decision does not add up; I suspect that the first figure should be £1,092,815).
Mr G actually received £98.56 per share. As he sold at arm's length and the value of a holding of shares is an estimation of what an arm's length purchaser would pay for them on the basis of certain legal assumptions then, unless the actual purchase does not reflect those assumptions, the market value ought to be the price actually paid by the arm's length purchaser.
So why did the Special Commissioner, Mr Demack, not adopt that figure? First, he said that the subscription agreement was dated subsequent to the actual subscription and should therefore be ignored.
Secondly, he felt that, even though the purchaser was aware of the existence of the subscription agreement, the purchaser should be taken to have been unconcerned about how much it paid any individual shareholder as it had a finite price that it was prepared to pay to buy all of the shares.
Neither of these contentions makes sense to me in the context of the law on valuing shares in unlisted companies.
Reflecting the agreement
I do not know what tax was levied on Mr G when he acquired his shares. I would have expected him to be taxed on the difference between their value at the time of acquisition and the price that he paid for them. I would also have expected that value to reflect the benefit of the subscription agreement.
Mr G clearly acquired his shares as part of a bargain that included entering into the subscription agreement; surely in those circumstances the value of the shares ought to reflect the benefit of the agreement.
I would have thought that it is not possible to escape the tax charge simply by deferring the signing of an agreement which enhances the value of the shares until after those shares have been issued.
Of course, if the form of the agreement had not been negotiated at the time the shares were issued, their value at that time might not reflect the true value of its terms.
However, to say that where shares are issued on terms that there would also be a shareholder agreement the contractual promise that there would be an agreement should be ignored completely if the agreement had not been signed by that date seems to me an odd suggestion.
It also raises the question of whether this works both ways and, if not, why not?
For example, if a person is issued shares on terms that he must enter into a shareholder agreement that devalues his shares should he leave within the next five years, I have always assumed that they will be restricted shares.
Is that wrong and can the restrictions imposed by the agreement be ignored if it is not entered into until after the shares have been issued
Willing buyers and sellers
Turning to the sale, the statutory assumptions are that the market value of Mr G's shares is the price that would be paid by a hypothetical willing buyer to a hypothetical willing seller on a sale of the real shares in a hypothetical open market.
However, the hypothetical willing seller steps into the shoes of the real transferor in the sense that the hypothetical sale must be 'a sale of the property which [Mr G] had in the shares at the time [of his sale], that is of the entire legal and equitable interest therein' (Attorney-General v Jameson 1904 2 IR 644).
Why was the subscription agreement not part of the equitable interest that Mr G had in his shares? After all, its purpose and effect was to enhance the value of those shares.
Because, said Mr Demack, although it was a collateral agreement between shareholders, not all of the shareholders were bound by it. But why should it then be ignored? It nevertheless affects the value not only of Mr G's shares, but also of those of the shareholders who were bound by it.
Hoffmann LJ, as he then was, said in CIR v Gray [1994] STC 360: 'Certain things are necessarily entailed by the statutory hypothesis. The property must be assumed to have been capable of sale in the open market even if in fact it was inherently unassignable or held subject to restrictions on sale. The question is what a purchaser in the open market would have paid to enjoy whatever rights attached to the property at the relevant date'.
Surely the rights attaching to Mr G's shares would include those under the subscription agreement? Admittedly that agreement was non-assignable, but the statutory hypothesis that assumes the hypothetical vendor would step into Mr G's shoes surely also assumes that he would take the benefit of that agreement, but could not himself assign it.
Why would a willing seller with the benefit of an agreement that significantly enhances the value of his shares be prepared to sell them at a price that ignores the benefit of that agreement?
Mr Demack thought that 'Company C could not have acquired the benefit of the subscription agreement ... Even had Company C been able, and wanted, to step into Mr G's shoes under the subscription agreement by paying more for his shares than for those of other shareholders, it would simply have been paying itself for the privilege of doing so — an event so unlikely that I may discount it'.
The importance of the agreement
I have two problems with the Special Commissioner's statement above.
First, although Company C, the actual purchaser, is clearly a participant in the hypothetical open market it is not the only participant. There could well have been someone else in the hypothetical market, such as a competitor of Company C, that would pay more than Company C in order to block the sale of the company.
It is likely that if the major shareholders could deliver only 93.4% of the company, Company C would have walked away.
Of course, as the holding is under 10% it could be acquired compulsorily, but it seems improbable that Company C would be prepared to incur the costs of doing so.
Furthermore, surely the two major shareholders are also potential participants in the hypothetical market. It is possible that they would buy the shares at a price that reflects the rights under the subscription agreement in order to facilitate the sale of their own shares.
After all, by entering into the subscription agreement they have effectively already agreed to do something that would achieve the same effect.
The willing seller would be crazy if he were willing to sell at a price that ignores his rights under the subscription agreement and thus throw away the major element in the value of his shares. To assume otherwise seems to me to assume an unwilling seller, which is not what the statutory hypothesis requires.
Secondly, whilst it might have been unlikely that Company C would have paid itself for the privilege of stepping into Mr G's shoes, it is by no means unlikely that it would have been prepared to buy the remaining 93.4% of the shares for £4.55 million conditional on it being able to acquire Mr G's shares for £1.45 million.
After all, in the real world it was prepared to enter into a purchase agreement to acquire the whole company and to allocate £1.45 million of its purchase price to Mr G's shares.
In the real world, a prospective purchaser may well be prepared to pay only a finite price to acquire 100% of a company, but it should not care what price it pays for individual holdings provided that its total cost does not exceed that price.
Accordingly, it would be expected to respect the terms of whatever agreements shareholders may have entered into between themselves, provided that doing so did not affect its overall cost. Why should it be any different in the hypothetical world?
Conclusion
The money involved looks big enough for the case to go to appeal. I hope that it does, as the implications of the decision seem to me potentially very far-reaching. Sadly, as the decision is anonymised Mr G may, however, feel that he would rather pay the tax than court the publicity of an appeal.
