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Family Investment Companies – Share Capital Pitfalls

Following on from my previous articles on FIC’s, I will now deal with some of the salient issues around share capital.

Shares are just a bundle of rights, namely:

  • voting rights;

  • income rights; and

  • capital rights.

When a new company is established at companies house, it comes with what are called ‘Model’ articles of association. These articles do not mention shares rights, as it assumes that all shares will be treated equally.

Where it is required that shares have different rights, then these must be set out in the articles. I have seen on numerous occasions where clients set out agreed rights in a side agreement, but never think to amend the articles

Voting Having voting rights is a key part of being a shareholder as it encourages interaction amongst shareholders, which is an important factor if the next generation is to to be ready to take over the responsibility for the FIC at some point in the future. This is one of the main points of a FIC, as it is multi-generational planning.

In my previous article, I gave an example where the shares in a FIC were split equally across family members so that no one person has absolute control, or is able to block any company business.

This encourages the family to work together to sort out any issues, but any decision will always be reliant on the parents, as founders shareholders and directors, as they run the FICs on a day to day basis.

However, some founders will want to retain absolute control, and they may achieve this by having a special class of share that have all the voting rights. The problem with this approach is two-fold:

  1. Shares with voting rights have a material value. HMRC have argued in past cases that shares that carry 100% of the voting rights, can have a value of 25% of the whole company.

  2. What happens when the controlling shareholders die? Who exercises control?

Income The rights to participate in the profits of a company is another key part of being a shareholder. However, the directors will want to retain control over the timing and amount of any dividends that are to be paid out. They will also want to pay out different rates of dividends to different shareholders. This is easily achieved by using alphabet shares. This just means shares that are of a different class and for easy of naming each share is given a letter of the alphabet, such as Ordinary A shares, Ordinary B Shares etc.

When using the above classes of shares to payout distributions, care needs to be taken that distributions are not caught by anti-avoidance legislation, designed to prevent individuals re-direct income to individuals with a lower marginal tax rate. One solution around this issue would be to limit the rights attached to each share type so they can only receive dividends up to their proportionate percentage share of any distributable reserves.

It is also important to note that giving shares a different name, does not create a different class of shares if all of the shares have the same rights. Again refer to the articles.

Capital The default position is that all shares will have equal rights to capital, but these rights can be changed by altering the articles. It is common in FICs that some shares types are given a right to future growth ahead of other shares and these are often called ‘growth shares’.

The idea behind growth shares is that it is a share that has very little value when issued, but acquires value over time. Having very little or no initial value means the shares can be gifted to other individuals without triggering a material capital gain tax charge.

Growth shares are useful in FICs, especially when the FIC already has valuable assets.

Share Transfers and Shareholder Agreements The model articles say very little on share transfers, so it will be appropriate to include more bespoke share transfer provisions for FICs.

One simple method to control share transfers is to state that all transfers must have board approval, as this would give the directors discretion. However, it does leave open challenges to how the directors are using their discretion.

It is therefore much safer to set out guidelines of what transfers will be allowed and what will not.

Normally permitted transfers for a FIC would be transfers to:

  • family members; and

  • trusts for family members.

It will be important to define carefully, what is meant by ‘Family’.

Lineal descendants is a good starting point, and it would be normal to exclude spouses or civil partners from being shareholders, to minimise the impact of divorce.

However, care needs to be taken so that any exclusions do not impact on other planning i.e. what happens when a shareholder dies leaving a surviving spouse? In this situation, it may be appropriate to extend the definition of family trusts to include trusts established in a Will on death.

It is therefore very clear that a FICs articles need careful drafting to ensure that the family members have the correct rights attached to their shares and that future transfers are clearly defined.

As I have previously stated, the articles of association of the company are essentially the ‘rule book’ for the company. Any important rules must be included within the articles.

However, there are two important limitations:

  1. Firstly, the Companies Act may sometimes override the rules laid out on the articles.

  2. Secondly, the articles are a public document and some matters may want to be kept private within the family.

Therefore, a shareholders agreement is a very useful tool for incorporating additional rules on the FIC and keeping the details of these rules private. A shareholders agreement is a legally binding contract between the shareholders and the company, but it is usually a private document.

If a shareholders agreement exists, it is normal that the articles will stipulate that the terms in any sharehoders agreement must be agreed to before any shares are issued, or transferred to a new shareholder.

Any shareholders agreement must be read in conjunction with the companies articles. These two documents must work together.

In my next article, I will deal with how FIC’s are normally funded and the relevant anti-avoidance legislation rules surrounding this. Article by Simon Howley ATT CTA ATA AFA MIPA