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Worthy thoughts

I concluded my last article – the third in a short series in which I am discussing key issues in a director share purchase strategy – by highlighting the importance of the valuation of the shares. This week, I will make recommendations as to how financial advisers should ascertain those values.

To recap, I have already identified circumstances in which DSP arrangements might be appropriate, particularly to small to medium-sized companies, and discussed the relevance of different percentage shareholdings in the company. So, on to the valuation.

During my own fairly basic training in financial services many years ago, when I worked for a major high-street bank, I was encouraged to become involved in the promotion of DSP arrangements to client companies but to leave the valuation of the business – which, of course, affects the level of life insurance required within the DSP arrangement – to the client.

In other words, I should simply ask the director/ shareholders how much they thought the company was worth and base the DSP strategy on the consensus figure. If the directors undervalued the company, they would either be providing too little life insurance to buy out a deceased’s share if the company was properly revalued at that time or, if their consensus figure was to be used to determine the company’s value at the date of death, then the deceased’s dependants would be lowly compensated for the sale of their shares.

I later discovered that this very simplistic approach was at the time quite widely used within other firms of financial advisers but, as I only found out some months later during my further studies, it is simply not acceptable. The tax authorities were, and still are, lurking in the background, waiting with potentially severe penalties for transfers of shares at a value arrived at by other than one of the ways acceptable to them.

This means that the life insurance policy should usually be written for a sum assured equal to the amount of money needed by the surviving directors or, if the arrangement is written in such a way, the company to buy out a deceased shareholder’s shares at the pre-determined price. The sum assured may be lower than the buyout price if alternative part funding can be anticipated, say, from the client’s own resources or from borrowing capacity.

I will therefore include the tax authorities’ interest in the overall theme of this week’s article, it being a variation of the long-established financial services theme for protection policies of “the right money paid to the right hands at the right time”.

As regards the “right money,” if the share purchase arrangement determines a fixed price for the shares, the sum assured should be equal to the value agreed within the arrangement and no allowance needs to be made for the sum assured under the life insurance policy ever having to change. Such types of arrangement in this purest form are rare although variations on the theme are quite common.

Where, as is more often the case, an initial valuation of the shares is agreed but stated to be subject to later amendment by agreement between the participants, then the initial sums assured under life insurance policies can be determined easily although it could be advantageous to anticipate changing valuations and ideally provide for fluctuating sums assured within the type of life insurance policy selected and the way the policy is written, as I will discuss in my next article.

The adviser must be aware of the need for regular reviews of the sum assured based on the fluctuating value of the company.

The shareholders should agree, at the outset of agreeing a strategy for the passing of shares on their death, a value to be put on the company’s shares or a basis for the valuation of those shares at the time of death. The latter option is generally more desirable and convenient as it avoids the need for the company’s shares to be valued regularly for this purpose, without which the initially agreed value will probably soon become highly inappropriate due to the changing value of the business.

The valuation basis may be agreed as a multiple of annual profits, asset value of the company (with or without allowance for goodwill), a combination of these bases or, indeed, any other method agreed to be fair for this purpose. The involvement of the company’s accountant, initially to give an indication of the current valuation that each of these methods would generate, is highly desirable.

Another possibility is that the sum assured under the life insurance policy is agreed to be the purchase price of the deceased shareholder’s shares. If the latter basis is adopted, then it is important to ensure that the sum assured in place at any time is a reasonable reflection of the true value of the company as agreed by all the shareholders.

A number of financial advisers have found, perhaps not least prompted by their own method of approach, that shareholders in some companies are happy to determine between themselves the value to be placed on the business without recourse to formulae or the input of their accountant. In these circumstances, the participants must be made aware of the possible tax consequences of such a course of action.

HM Revenue & Customs takes an interest in the consideration on the transfer of shares, most particularly to determine liability to capital gains tax and inheritance tax. CGT will be levied on the gain in the value of shares from the date of acquisition (the date the company was established, for founding shareholders) to the date of disposal (date of death, in this regard).

It is keen to prevent CGT avoidance by, say, a low valuation of shares, even if such a low valuation occurred with no intent by shareholders to avoid CGT. Thus, if the company’s value for the purposes of the DSP arrangement has been agreed at, say, £200,000 but HMRC determines it to be worth 10 times this figure, a CGT liability will usually be computed at the higher amount, notwithstanding the possibility that the deceased’s shares have already been transferred on the lower valuation.

Similarly, HMRC seeks to prevent IHT avoidance where the shares are valued too low (to reduce the value of the deceased’s estate) or too high (if this higher valuation still leaves the deceased’s estate below the IHT threshold).

Taking into account the potential liability to these two forms of taxation, HMRC has produced acceptable valuation methods. The early and continuous involvement of the company’s accountant (or, less likely, some other person or organisation competent to value shares for this purpose) is essential if the undesirable attentions of HMRC are to be avoided on the death of a shareholder.

Of course, this means that the competent financial adviser must liaise closely with that nominated valuer, both at the outset of the DSP arrangement and at the time of subsequent reviews in order to ensure the appropriateness of the level of death benefits under life insurance policies.

In passing, I would like to suggest from my own experience that co-operation between these professional advisers might well lead to referrals for similar types of business from the accountant to the financial adviser.

That deals with the “right money” part of the “right money, right hands, right time” principle. I will cover the other issues in my next article as I start to conclude my discussions about key issues in DSP arrangements.

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