Tax opportunities arising from lower business valuations

Our corporate finance and tax teams outline the possible tax opportunities business owners could avail of if the value of their business has been reduced due to COVID-19. 

The COVID-19 pandemic continues to have a significant impact on both individuals and businesses, with lockdown and restrictions severely effecting consumer sentiment, business activity and investment appetite across many business sectors. Given the nature of the pandemic, it’s global effect, the sharpness of the economic decline and the ongoing uncertainty around what the future holds, it is likely that many businesses, in particular SMEs, will see a reduction in value.

While such reductions may be seen as a negative where a business is seeking finance or trying to maximise value through a merger or acquisition, the reduction in value also presents some opportunities for business owners to consider.

Below we examine the rationale for why a business valuation may have fallen significantly due to the impact of COVID-19 and how businesses might be able to take advantage of such reduction in certain circumstances. 

The areas we have focused on here are:

1. The opportunity to provide equity participation in a company to key employees with a reduced tax impact and possibly reducing the cash cost for companies of rewarding key staff; and
2. The opportunity to transfer shares in closely or family-held businesses to the next generation at reduced tax cost. 

Factors influencing business valuation

If, as a business owner, you have to answer yes to some of the below questions, it is likely that the value of your business has decreased in recent months:

• Business continuity – has your business had to close stores, facilities or offices resulting in a material loss of revenue?
• Supply chain – has your supply chain been disrupted making it more difficult to fulfil orders or bring product to market. Does your business supply into a trade that has been severely affected by the pandemic (e.g. hospitality, aviation industries)?
• Future revenue – is there a significant risk or uncertainty around significant revenue-generating contracts held by the business? 
• Liquidity – does your business have short or medium-term debt repayment commitments that the business will struggle to meet? Is there difficulty in meeting ongoing payments to trade creditors?
• Working capital – is the business’s working capital tied up in stock and debtors? Is there a recoverability concern around existing debtors?
• Business model – has there been a change in business model that has negatively affected revenue / profitability? Customer preferences, route to market and regulatory changes may all result in a business revisiting its business model.
• Key staff – has the business lost key staff as a result of a reduction in their remuneration package?

When valuing your business, a detailed review considering many of above issues (but not limited to) together with accounts and projections showing past, present and future performance will need to be considered by a skilled independent expert.

Using the lower valuation to your advantage

If your business has been impacted and its value reduced, there may be some opportunity to take advantage of the situation. 

We have considered two scenarios by way of example:

1. Share participation by employees
The first area to consider is providing equity / share participation in your business to key employees. 

At a time where protecting cash is vitally important, it may be beneficial to look at rewarding key employees with equity in your company. This would provide a number of benefits including incentivising and rewarding your star employees, reducing the cash outlay of the company by replacing future bonus / cash payments with shares, and also reducing the tax impact on the employee significantly due to reduced business valuation. 

Why is this now an opportunity? 

The tax treatment of most share awards is fundamentally based on the valuation of shares in the company, so a reduced business valuation will mean a lower deemed benefit being taken by the employee and thus a lower or eliminated tax cost. 

Let’s look at some examples. 

Growth / flowering shares
A growth share scheme (sometimes referred to as a flowering share scheme) is typically used to try to engage and retain key employees to help build the future value of a business. This is done by creating a new class of share in the company which has limited rights (e.g. no dividend or voting rights) but is entitled to participate in future capital growth over a specified hurdle value. 

Where that hurdle value is set at the present day value of the company, it is typically possible to grant the shares to the relevant employees with no tax cost where the value of the share granted is nominal. 

In a situation where a company has grown considerably and is at perceived “max value” the benefit in such shares may be considered limited by the employees. However, where the business has incurred a drop in valuation due to COVID-19 and has the opportunity to rebound and grow, the intrinsic value of the growth share to the employee may be significantly higher than it would otherwise have been. 

Share options 
There are a number of share option schemes that could be used to provide employees with a future benefit on the growth and / or sale of a business. 

The taxable event for share options is when the option is exercised in the future by the option holder. Typically, the option will be granted at no or nominal cost, and the exercise price set at a discount on the current market value. The benefit for the employee is the potential growth in value. Once exercised the employee will pay income tax on the difference between the market value at sale and the exercise price paid by them. 

There is a specific share option plan called the Key Employee Engagement Programme (KEEP), which provides for capital gains tax treatment on that future gain rather than income tax, where certain conditions are fulfilled. 

In either scenario, the employee being granted the option will see much more value to the option if the exercise price, based on a discount on current market value, is as low as possible. While this would in a way represent a loss of future value to the existing shareholders it would also represent a zero cash means of rewarding and retaining key employees. 

For example, an employee was granted an option in 2019 to buy shares in 2022 at €4 per share, and the company had a market value of €5 per share in 2019. If the employee did not expect the value to rise much over €5 and the company was sold at that price their future gain would only be €1 per share on which they would pay income tax or CGT, and therefore they might perceive the benefit of being granted the shares as relatively low.

Now imagine the value of the business was currently supressed due to factors outlined above, leading to a 2020 valuation of €3 per share and the options came with the same €1 discount on the exercise price (€2 per share). If the employee could see potential growth in the company so that it could rebound to a valuation closer to €5 per share, the perceived benefit to the employee has tripled from €1 per share to €3 per share. This could therefore provide the employee with a much more incentivised path to value and benefit the business overall. 

Other share awards
If a business grants shares to an employee for no or minimal cost, a notional taxable benefit arises for the individual which is liable to income taxes through payroll deductions. 

A business with a €200k valuation that wanted to grant shares of 5% to an employee would have been obliged to calculate the nominal BIK at €10k (ignoring minority discounts for now) which would have given rise to a liability for the employee of c. €5k (assuming marginal rates of 50%). 

If that valuation was reduced to €100k it would reduce the liability to c. €2.5k which would cost the business a total of €5k if it wanted to cover the employee cost and provide them with the shares. 

2. Transferring a family businesses or shares in a family company
The second area to consider is the transfer of shares in family or closely held businesses. 
A number of tax reliefs and exemptions are linked to the value of shares or assets being transferred to family members. 

By way of examples (all figures for valuation below are illustrative only):

• Retirement relief for CGT purposes is available to the disponer of shares in a family business if conditions are fulfilled. The exemption on a transfer to a family member is limited to €3m where the disponer is over 66 years old. If a family business had a “pre-Covid” valuation of €4m and the shareholder was aged 67 or older and wanted to transfer the shares to a family member they would have faced a CGT liability of c. €333k (i.e. €4m - €3m = €1m at 33% CGT). If that business is now valued at €3m or less the transfer could be made at no tax cost to the disponer. A similar situation would arise for business assets, such as a farm, being transferred to the next generation. 
• Business or agricultural relief is available to the recipient of certain gifts of assets or shares in qualifying businesses. This relief reduces the value of the gift by 90% where conditions are fulfilled. If an individual was due to be gifted shares in a family business in which they work, or agricultural assets, and they met the relevant conditions for relief then the value of the assets would be reduced by 90%. If such assets had a pre-Covid valuation of €4m the reduced taxable value would have been €400,000. If the recipient was a child and had their full CAT threshold available, the taxable amount would have been reduced to €65,000 (i.e. €400,000 – the €335,000 threshold) with tax arising of c. €21,000 and the CAT threshold fully used. If the value of those assets or shares has reduced to €2m post Covid the reduced value would be €200,000 which would result in no tax arising and only €200,000 of the CAT threshold being utilised. 

What should you do?

If you have agricultural or business assets and / or shares in a family business, now would be a great time to consider plans for transferring these assets or shares to the next generation as the reduced values of property and businesses may provide opportunity to avoid tax liabilities on certain transfers. 

Also if you are running a business and are facing challenges of retaining key staff, either due to business uncertainty or cash flow difficulties for paying benefits or bonuses, now would be an excellent time to consider providing share participation for those key employees in a very tax efficient manner. 

At Crowe we provide tailored solutions to best meet our clients’ objectives as efficiently as possible. If you are considering how best to structure share plans for your key staff or planning for a succession with your business contact a member of our tax team.