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Tolley's Practical Tax by Mark McLaughlin CTA (Fellow) ATT TEP

In the first part of a two part article, Mark McLaughlin looks at some key tax planning issues on a company sale.The sale of a company involves numerous tax and commercial considerations. Vendors and purchasers will have their own priorities and agendas. In some cases, the purchaser and/or commercial aspects will dictate the terms of the deal. However, this article concentrates on tax planning opportunities from the viewpoint of owner-managers of single companies (all references are to the Taxation of Chargeable Gains Act 1992, unless otherwise stated).

Sale of shares

A sale of shares will normally be the preferred option for shareholders of unquoted trading companies if full business asset taper relief has accrued for capital gains tax purposes, reducing the effective tax rate to around 10% for a higher rate taxpayer. Care should be taken to ensure that the company satisfies the ‘trading company’ definition for taper relief purposes ( Sch A1 (22A) ), and that its status has not previously been tainted through holding substantial surplus cash and/or investments (see Revenue Interpretations 228 and 247). However, when considering the ‘20% test’ applied by HM Revenue & Customs for these purposes, it should be noted that the trading company definition refers to a company ‘whose activities do not include to a substantial extent activities other than trading activities’ (emphasis added). Annual reviews of the company’s trading status may prove worthwhile, and applications to the company’s tax district for a status ruling should be considered in cases of uncertainty (see Capital Gains Manual, paragraph 17953r).

In husband and wife trading companies, if taper relief has been ‘tainted’ because the company was not one spouse’s ‘qualifying company’ (ie within Sch A1(6) ) throughout their period of ownership (eg if less than 25% of the voting rights were owned before 6 April 2000 by a non-working spouse), consideration could be given to a transfer of shares to the other spouse before sale. However, the donee spouse’s taper relief position should be checked to confirm eligibility at a higher rate of relief and a lower effective capital gains tax rate, for example based on the qualifying company conditions being satisfied throughout the period of ownership.

How will the sale proceeds be paid?

1. Shares

If the disposal consideration for the shares takes the form of shares in an acquiring company, no chargeable gain arises if the ‘share for share exchange’ rules apply in s 135 . The new shares stand in the shoes of the old shares, extending the holding period for taper relief purposes. This may be helpful if maximum business asset taper relief has not accrued on the old shares (eg if owned for less than two years, or because of an earlier period of non-business asset status), and the new company is also a qualifying company for business asset taper relief purposes (eg an unquoted trading company, or a quoted company in which at least 5% of the voting shares are held).

2. Qualifying corporate bonds (QCBs)

The share sale may be structured wholly or partly as loan notes in an acquiring company. If the loan notes are QCBs (ie non-convertible, non-redeemable sterling securities issued on normal commercial terms, within s 117(1) ), the gain computed on that element of the consideration is deferred, interest-free, until redemption or disposal of the bond ( s 116(10) ). Taper relief is calculated on the shares up to the time of disposal, and is effectively ‘locked in’ to the postponed gain until a subsequent disposal of the bond ( Sch A1(16) ).

A QCB loan note may be attractive if maximum business asset taper relief entitlement has already accrued in respect of the shares. The trading status of the acquiring company, and whether it is a qualifying company of the individual, is irrelevant, since it does not affect the availability of taper relief on the shares. Any gain (or loss) on disposal of the bond itself is exempt from capital gains tax ( s 115(1)(a) ).

As any inherent gain on the shares is deferred until a later disposal of the QCBs, it may be possible to stagger the loan note disposals over more than one tax year, to make use of annual exemptions. The same applies to shares in the acquiring company.

3. Non-QCB loan notes

Alternatively, the share transaction may be structured as an exchange for non-QCB loan notes. This has potential advantages. For example, if there is a loss in value of the acquiring company any chargeable gain on a subsequent disposal of the loan notes is correspondingly reduced. For taper relief purposes, the securities stand in the shoes of the shares sold, so the holding period is continuous. Extending the taper relief period in this way will be useful if the original shares are a business asset, which have not been held for two years, and the non-QCB is also a business asset (eg if the security is held in an unquoted trading company or a quoted company of which the vendor is an employee).

However, the possibility that the status of the non-QCB could change from a business asset to a non-business asset should be considered. For example, the acquiring company may cease to satisfy the definition of ‘trading company’ ( Sch A1(22A) ) by holding surplus cash and/or investments. In any event, there should be sound commercial reasons for the loan notes taking the form of a non-QCB, and advance clearance should be obtained from Revenue & Customs under ICTA 1988 s 707 , and also under s 138 , unless the vendor and connected persons do not hold more than 5% of the shares or loan notes in the target company ( s 137(2) ).

Deferred or contingent proceeds

The proceeds from a sale of shares may be fixed and ascertainable in amount, but deferred until a later date or contingent on the occurrence of a future event (eg the company reaching defined profit targets). Nevertheless, the proceeds are taken into account at the time of disposal. However, if the proceeds are payable by instalments over more than 18 months, the vendor can seek to pay the tax by instalments over a maximum eight year period ( s 280 ). Alternatively, a form of effective ‘bad debt’ relief claim for capital gains tax purposes is normally available if any part of the proceeds becomes irrecoverable (eg if instalments remain unpaid). In addition, if contingent consideration subsequently proves not to be receivable, a claim can be made to adjust the tax position retrospectively ( s 48) .

Earn-outs

The sale of shares in a company may include a right to receive additional consideration, which is deferred and unascertainable at the time of sale. For example, the amount of further sale proceeds may be calculated by reference to the company’s future profit levels using a formula based approach. The earn-out right is a separate asset for capital gains tax purposes.

(a) Cash earn-outs

If the additional deferred consideration is unascertainable, the value of the right to this future amount is a ‘chose in action’, which is chargeable to capital gains tax at the time of the share sale. This principle was established in Marren v Ingles [1980] STC 500 . The valuation of the right may involve Shares Valuation, ie if subject to an enquiry or if the CG34 procedure is adopted.

The additional cash on disposal of the earn-out right is liable to capital gains tax upon later receipt ( s 22 ). A separate computation is therefore required, comparing the disposal proceeds with the cost of the right, ie the value of the right in the original capital gains tax computation (see Example 1 ).

Example 1

John Rich sells the shares in his trading company, Widgets Ltd, to a competitor, SuperWidgets Ltd, on 1 January 2005. The terms of the sale are that John receives £600,000 cash immediately, plus further cash in April 2007, based on the company’s profits for the first two years following the deal. The market value of the right to the deferred consideration is agreed with Shares Valuation at £300,000. John is charged to capital gains tax in 2004/05 based on consideration of £900,000 (ie £600,000 cash, plus the value of the earn-out right at £300,000). John’s shares in Widgets Ltd originally cost £50,000 in December 1999. However, John benefits from full business asset taper relief, reducing his effective capital gains tax rate to below 10%. On 6 April 2007, John receives a further £350,000 in cash, based on the company’s profits and an earn-out formula. The chose in action (ie the right to the deferred consideration) is treated as a separate asset acquired at the time of the deal, with a base cost of £300,000. The earn-out right is a non-business asset for capital gains tax taper relief purposes. John’s annual exemption is available for 2007/08, but no taper relief is available to reduce the gain.

If the vendor incurs a loss on the disposal of the earn-out right, he may be able to elect for the loss to be carried back ( ss 279A to D ). A claim to offset that loss against taxable gains on the original disposal in an earlier tax year has the potential to generate a repayment of tax paid on the original disposal. ‘A right to unascertainable consideration’ is defined for these purposes in s 279B , generally in terms of the consideration being subject to future events. This includes (as in Example 1 ) an agreement to sell company shares subject to a right to a future cash payment, the amount of which depends on the level of company profits in years following the sale (see Capital Gains Manual, paragraph 15086).

The s 279A election to offset a loss on disposal of an earn-out right against gains of an earlier tax year does not apply to those rights treated as securities by s 138A, ie earn-out rights providing for deferred unascertainable consideration in the form of shares or loan notes ( s 279B(6) ). In those circumstances, if profit targets or other criteria for the earn-out right are not satisfied, such that no deferred consideration is received, an allowable loss potentially arises on the earn-out right, which cannot be carried back except on death.

(b) Share or loan note earn-outs

As mentioned, if an earn-out is in shares or loan notes, the right to receive them is treated as a security at the time of the deal if the value or number of new securities is unascertainable, eg if based on future business profits ( s 138A ). This security is a deemed non-QCB for these purposes ( s 138A(3)(b) ), and is treated as the same asset as the original shares. When the additional shares are subsequently received, there is an effective conversion of the earn-out right into the shares ( s 132 ). No gain or loss crystallises until a subsequent disposal of the shares subject to the earn-out right. (See Example 2 .)

Example 2

The facts are as in Example 1 , except that John receives £600,000 cash immediately plus the right to receive shares in SuperWidgets Ltd, based on a future profits formula. John is charged to capital gains tax in 2004/05 on the cash proceeds of £600,000. In calculating the gain, John can deduct part of his base cost of the shares in Widgets Ltd, apportioned between the cash consideration of £600,000 and the earn-out right (valued at £300,000 in Example 1 ), ie £50,000 x £600,000 / £900,000 = £33,333. On 6 April 2007, John receives shares in SuperWidgets Ltd to the value of £350,000, based on the profit formula. The shares in SuperWidgets Ltd stand in the shoes of the earn-out right, and are treated as having been acquired in December 1999. The base cost of the shares is £16,667 (ie £50,000 – £33,333). No further gain (or loss) arises until John later disposes of the SuperWidgets Ltd shares.

Discussion of the ‘paper for paper’ reorganisation treatment will appear in the next issue, together with coverage of other issues including sale of assets, non-residence and clearances.

May 2005

MARK MCLAUGHLIN CTA (Fellow) ATT TEP

This article was first published in Tolley’s Practical Tax on 20 May 2005, and is reproduced with the kind permission of LexisNexis Butterworths.