Put and call options over shares in private companies: main features and tax considerations
Put and call options over shares in private companies: main features and tax considerations
This blog post explains the main features of put and call options over shares in private companies, details the circumstances in which such options are usually used (and for what reasons) and includes a high-level summary of the tax considerations.
What is a put option?
This is a type of option which grants a right (but not an obligation) for a potential seller to sell an asset (i.e. shares) to a buyer at a pre-agreed price (sometimes referred to as the “strike price”) or at a price to be determined in accordance with a pre-agreed formula, or by a specified time in the future.
The option is generally exercisable by the seller during an agreed period.
A put option therefore provides a safety net for a potential seller by guaranteeing a price for their shares for a limited period.
The put option may be subject to additional conditions as negotiated and agreed between the parties.
A put option will usually be mirrored by a call option (as described below), enabling the company, or other shareholder, to buy the shares back.
What is a call option?
This is a type of option which grants a right (but not an obligation) for a potential buyer to acquire an asset (i.e. shares) from a seller at a specified price or a price to be calculated in accordance with a pre-agreed formula, or by a specified time in the future.
As with a put option, a call option is generally exercisable by the buyer during an agreed timeframe.
The call option therefore gives the buyer a level of security given that it entitles them to purchase the seller’s shares for a pre-agreed price during the agreed limited timeframe.
The call option may be subject to additional conditions as negotiated and agreed between the parties.
Under what circumstances and for what reasons are put and call options generally used?
A put/call option is most appropriate for specific situations (e.g. death) relating to key individuals such as director shareholders, usually to ensure that their shares cannot pass out of the company in such an event but remain held by the existing shareholders. It would be unusual for put/call options to be used generally to provide a wider market for employee shareholders.
By way of example, suppose that Party A is concerned that there may be a steep rise in the price of Company Z’s shares and decides to offset that risk by entering into a call option contract with Party B, which is the majority shareholder of Company Z. Under the option, Party B in consideration of a fee paid by Party A gives Party A the right to buy shares in Company Z at an agreed price on a future date or within an agreed option period. In these circumstances, because Party B is effectively agreeing to cap the price per share at which Party A can purchase shares in Company Z, it is likely that Party B would want Party A to pay a fee in return for the grant of the option (but note that consideration is not always provided for the granting of an option).
The main reasons that individuals may use put and call options are to:
- Achieve or maintain entitlement to entrepreneurs’ relief (“ER”) (to be renamed business asset disposal relief from 2020/21 onwards) from capital gains tax (“CGT”);
- Preserve entitlement to business property relief from inheritance tax (“IHT”); and
- Ensure that interests in the business continue to be held by the remaining members/shareholders.
The main reasons for using put and call options in a corporate context are:
- Putting arrangements in place for the future sale of a subsidiary; and
- Providing for contingencies that may arise in the life of a joint venture company.
Options over shares in a subsidiary
A private limited company can grant put and call options for the sale of all the shares in a subsidiary company to a buyer that is also a private limited company; in other words, it is permissible for a parent company to sell a subsidiary out of a group by entering into a put and call option agreement.
As stated below in the context of capital gains realised by individuals, HMRC accepts that the existence of put and call options does not constitute a binding contract for sale. The disposal of the subsidiary does not, therefore take place until one or other of the options is exercised. It was established in J. Sainsbury v. O’Connor (1991) that where beneficial ownership (for example, the right to vote and receive dividends) remained with the seller, the subsidiary remained part of the group.
Matters to consider when drafting a put and call option agreement
When drafting a put-call option agreement, issues that should be given careful consideration include (but are not limited to):
- When the option should become exercisable – for example during a set option period, or subject to certain conditions;
- Whether the put and call options are exercisable simultaneously or at different times
- When and in what circumstances the option will lapse;
- The number and class of shares subject to the option (including consideration of dilution impacts);
- Whether any consideration should be paid for the grant of the option (or whether the agreement should be executed as a deed – meaning that no consideration is exchanged between the parties upon signing the agreement);
- The effect of a corporate transaction (such as a sale or reorganisation) on the put and call options;
- Tax issues for either party;
- Whether the terms of the put and call options conflict with other documentation such as the articles of association or a shareholders’ agreement;
- Whether the option can be exercised only once or is exercisable in different tranches;
- Whether the option is personal to the parties to the agreement or whether it is assignable; and
- Where the option period does not begin immediately on execution of the agreement, consider whether there are any events that will trigger early exercise of the option. For example, the agreement could provide that if an offer is made by a third party to buy the company (or a majority stake in it) this will enable the option to be exercised, whether or not the option period has begun. This is likely to be the most common scenario in which the option can be exercised early, but there may also be other transactions or circumstances that the parties consider should enable premature exercise of the option. This is a matter for negotiation between the parties.
The put and call option agreement should be drafted within the context of the company’s articles of association and/or any shareholders’ agreement – for example, care should be taken to ensure that the terms of the put/call options do not conflict with any pre-emption rights contained within the articles.
Careful consideration must be given to the tax effects of a put and call option agreement and therefore specialist tax advice should always be taken. This section of the blog post is not intended to be a comprehensive analysis of the tax considerations, but merely a high-level of summary of tax issues that should be borne in mind when contemplating granting put/call options over shares in a private limited company.
The granting of a call option by one party and a put option by the other(s) is often used to achieve certainty as to the terms on which a transaction may take place at some point in the future without causing the potential seller to suffer the adverse tax consequences of entering into a binding contract for sale.
The date of sale, or the entering into arrangements to sell, is relevant for the purposes of CGT, IHT, income tax (“IT”) and corporation tax.
HMRC accepts in Capital Gains Manual 14275 that an option in itself is not a conditional contract but operates as an offer which is irrevocable during the option period.
If consideration is paid for the granting of an option and the option is exercised, the total of the consideration paid for the option and the consideration on sale are brought into the seller’s capital gains tax computation. If the option is not exercised, the amount paid on the grant of the option is a windfall gain for the person who received it (with no base cost) and a capital loss for the person who paid it.
Disposal for the purposes of CGT
The date of disposal for CGT purposes is the date on which a contract becomes unconditional. As per section 28(2) of the Taxation of Chargeable Gains Act 1992, this may be the date of exchange, the date on which an option is exercised or the date on which any condition on which the sale depends.
In the context of a sale of shares, where a shareholder who is also an employee or officer of the target company has not yet completed the period necessary for the gain on disposal to qualify for ER or business asset disposal relief (“BADR”), the granting of put and call options, exercisable once the qualifying period has been met, gives certainty to buyer and seller that the transfer will take place at the agreed price. The period those shares are held, for ER/BADR purposes, will continue to run until they are treated as disposed of on exercise of the option.
Business property relief from IHT
Business property relief (“BPR”) is a relief from IHT set out in sections 103 – 114 of the Inheritance Tax Act 1984 (“IHTA 1984”).
The main aim of BPR, in policy terms, is to reduce the risk of IHT charges resulting in the break-up of a viable business in a succession situation (for example, when an owner of a family business passes control of the business on to his children or grandchildren, either during the owner’s lifetime or by way of a gift in his will). To qualify for the relief, the relevant business property (“RBP”) must have been owned by the transferor/deceased for a period of at least two years ending on the date of transfer or constitute replacement RBP.
The principal qualifying property for BPR purposes includes shares held in an unquoted (i.e. private) company (including companies listed on AIM).
Broadly, where the conditions for the relief are met, BPR reduces the value of gifts (known as transfers of value for IHT purposes) of RBP made by a transferor during his lifetime or on his death, for the purposes of calculating any IHT due on those gifts. The reduction in value will be either 100% or 50%, depending on the type of asset and who owns it. BPR is, therefore, a very valuable relief and much IHT planning involves strategies to enhance or preserve it.
Property subject to a binding contract for sale
Property (i.e. shares) will not qualify as RBP if it is subject to a binding contract for sale at the time of the transfer (section 113 of the IHTA 1984). The purpose of this exclusion is to ensure that BPR is only available where a transfer involves a business interest rather than the cash proceeds of a business.
HMRC accepts that an option to sell or buy does not in itself constitute a binding contract. A binding contract may of course arise once an option has been exercised. It is necessary to look at the terms of any particular arrangement to establish at what point a binding contract does arise.
HMRC’s view is confirmed in the Inheritance Tax Manual at IHTM25292 (‘Contracts for sale: Shareholdings and partnership interests’). This addresses an issue that commonly arises in partnerships. BPR is available on the death of a partner if the surviving partners and personal representatives (“PRs”) respectively have an option to buy the deceased partner’s interest in the business and the PRs have an option to sell that interest. BPR will not be available if the PRs are obliged to sell the interest to the surviving partners, an arrangement that HMRC refers to as a “buy and sell agreement”.
HMRC accepts that, where partners or shareholders grant options to buy out each others’ interest in the business in the event of death or retirement, this will not constitute a binding contract for sale so long as the PRs of the deceased partner or shareholder are not obliged to sell to the surviving owners of the business and those owners are not obliged to buy. Therefore, a cross-option agreement will not generally lead to the denial of BPR (note: a cross-option is an agreement under which two or more parties each grant a put and call option to the other parties. They are often used by partners and by shareholders in small companies to retain control of all shares in issue after the death of a partner or shareholder).
Term of the options
There is sometimes debate over whether the put and call options should run concurrently or whether one should start on expiry of the other. Toby Harris and Chris Erwood, ‘Business and Agricultural Property Relief’ (Bloomsbury Professional, 6th edition, 2014) states at paragraph 6.15:
“Whilst cross-options do not constitute a binding contract for sale, care should be taken to ensure that the options do not exist over precisely the same period. This is because HMRC consider that such arrangements do, in effect, between them amount to a contract. The call option should therefore expire before the put option can be exercised”.
‘McCutcheon on Inheritance Tax’ (Sweet and Maxwell, 6th edition, 2013) does not discuss the question of concurrent or consecutive options, stating only in paragraphs 26-73:
“HMRC have always accepted that, although put and call options leave the respective parties in essentially the same commercial position as a buy and sell agreement, they do not of themselves constitute binding contracts for sale, with the result that s.113 (of the IHTA 1984) does not apply”.
There is nothing in the publicly accessible parts of the HMRC manuals to suggest that HMRC views the existence of put and call options that are exercisable during the same period as constituting a bar to BPR. Nevertheless, if there is no disadvantage to the parties in staggering the options, adopting this approach may make it less likely that an HMRC officer will refer the case to the Technical Division.
Using put and call options for the transfer of unquoted company shares
A cross-option agreement in respect of unquoted company shares seeks to ensure that the ownership of a business remains with the surviving owners following the death of any of the shareholders in a company. In such event the agreement gives the surviving shareholders the right (but not an obligation) to buy the deceased shareholder’s shares (call option) and gives his PRs the right (but not an obligation) to require the surviving shareholders to buy those shares (put option).
Articles and shareholders’ agreement
A company’s articles may provide that a person will cease to be a director if he is absent from board meetings for an extended period of time and the directors resolve that his office be vacated (see, for example, Regulation 81(e) of the Table A articles, although note that this provision does not appear in the model articles for private companies limited by shares).
Also, the company’s articles or shareholders’ agreement may deem a shareholder, who ceases to be a director and/or employee, to have served a transfer notice on the other shareholders which triggers a pre-emption process. If there is such a provision, it is important to ensure that the triggering of a pre-emption notice on the death of a shareholder does not result in a binding contract for sale (for the reasons mentioned above).
The above scenario could be avoided if the shareholders agreement or articles provide that the recipient of a pre-emption notice (or his PRs) is required to offer the shares for sale at fair value to the continuing shareholders, who will be entitled (but not obliged) to purchase the shares.
If continuing shareholders are obliged to purchase the shares which are subject to a transfer notice, this would have the effect that IHT BPR would be lost.
Purchase by remaining shareholders
From a CGT perspective this approach may be of greater benefit to the continuing shareholders than if the company took an option over those shares. Assuming the shares in the company have increased in value since the surviving shareholders acquired their original shares, this approach will result in a higher base cost for their shareholdings. This is because the price they pay for the deceased’s shares will be cumulated with the cost of their existing shareholdings.
The use of put and call options between the shareholders, particularly within the context of a family company, will offer flexibility for exercise of the options by the younger shareholders, and a change in the ratio of shareholdings, should that suit the purposes of the older members.
Share buyback by the company
In principle, there seems to be no reason why a shareholder could not enter into a put and call option with the issuing company. However, there will be issues to consider that are not applicable to an agreement between shareholders, which might include (without limitation):
- The issue of the availability of distributable profits at the time of exercise of a put option by the shareholders’ PRs. Inevitably, the company will require its right to purchase to be conditional on there being sufficient reserves available. Such conditionality will of course limit the certainty the shareholder (and his PRs) will have as regards the ability to sell the relevant shares for the agreed price at the date of exercise. It may be necessary in these circumstances to consider whether there is scope for a partial buyback with the balance of the shares being purchased if and when reserves become available. From the company’s perspective (and that of the surviving shareholders), it may wish to restrict the PRs ability to transfer legal or beneficial title to those shares during any period when the company does not have sufficient distributable reserves to complete the buyback of the relevant shares.
- The question of whether the option agreement would constitute an off-market purchase contract for the purposes of section 694 of the Companies Act 2006 (“CA 2006”), given that such a contract requires shareholder approval.
- The need for there to be other equity shares in issue following completion of a buyback (as per section 690(2) of the CA 2006).
- Whether the remaining shareholders might wish the company to hold the repurchased shares in treasury rather than cancelling them (see sections 724, 727 and 729 of the CA 2006).
What might be best is to give the company only the right to call for the shares with cross-options between the shareholders exercisable only if the company does not exercise that right within a certain period. The directors, acting in accordance with their duties, can then decide whether to buy back the shares according to the company’s then financial position.
As for the cross-options between shareholders, there would, of course, need to be wording in the option agreement that suspends the right to exercise in the event that the company exercises its call option. This should be a suspension rather than a cancellation to allow for the situation that the company fails to complete the buyback.
Put and call option agreement template
You can buy a template put and call option agreement from our shop here. Our put and call option agreement template is for use by a private limited company where the seller grants the buyer a call option over shares and the buyer grants the seller a put option over the same shares. For the avoidance of doubt, this template is not suitable for use as a cross-option agreement.