Spin-Outs and Start-Ups: Common Pitfalls – Issue the Shares in the Right Order

There are some really quite surprising tax traps for the unwary when a new company is started up.  It is quite possible under certain circumstances for H M Revenue and Customs (HMRC) to argue that an individual subscribing for some shares has a monstrous tax bill, based on income or gains calculated by reference to a number far, far in excess of any cash which has changed hands.  Care and advice must be taken, very early on, to ensure that this does not happen. HMRC’s argument would be based on market values of shares and intellectual property.  Envisage a scenario in which founders and investors agree the following simple but perfectly plausible deal: Investor                      Investment         Shares Founder A                     £ 30,000               30,000 Founder B                     £ 30,000               30,000 Venture Capitalist       £ 1,000,000          40,000 If the founders subscribe for shares first, a “decent interval” is left, and then the VCs take up their shareholdings, all should be well.  However, if the VCs come in first, there will be a problem.  HMRC can justifiably argue that the shares are worth £25 each, as the VCs have just paid hard cash to this value.  So, the logic proceeds, the founders have each received shares worth £750,000 (30,000 x £25) for a mere £30,000.  They have each been “given” £720,000. HMRC will then go on to assert that this “payment” was for whatever – intellectual property, for example – the founders bring to the venture.  Such intellectual property would be the fruits of the founders’ labour and, it is one of the two great certainties in life, that if someone gets paid for doing some work, the taxman will want his cut!  The founders each receive a tax bill for about £324,000, being 45% of £720,000. We recommend getting advice early to avoid any pitfalls.  We are more than happy to give early stage advice, and in many cases this is free of charge.