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

Mark McLaughlin continues his look at tax planning issues on a company sale.The first part of this article (which appeared in TPT 2005 page 81) ended with Example 2, which illustrated a sale for share or loan note earn-out. As in the previous article, references are to TCGA 1992 unless otherwise stated.

‘Paper for paper’ reorganisation treatment is automatic for rights conferred after 9 April 2003 if the relevant conditions are satisfied, but can be disapplied by making an irrevocable election no later than one year from 31 January following the end of the tax year. For rights conferred before 10 April 2003 the opposite applied, ie an election had to be made for the right to be treated as a security.

For s 138A treatment to apply, the original shares must have been such that the share-for-share exchange conditions (see s 135 ) would have applied if shares or debentures had been received instead of the earn-out right. In addition, the deferred unascertainable consideration can only be discharged through the issue of new shares or debentures. S 138A therefore does not apply if the deferred unascertainable consideration could potentially be paid in cash, or to the extent that the earn-out is actually paid in cash (eg where the earn-out right is to be satisfied by a combination of securities and cash ( s 138A(1)(d) ).

If the earn-out right provides for the later issue of QCBs, the right itself is not a QCB and therefore the share exchange rules apply when the original shares are sold. When the earn-out right crystallises, the right is exchanged for the QCBs. Any gain is calculated on a disposal of the earn-out right at market value when the QCBs are issued, and is deferred until a later disposal of the QCBs (see Capital Gains Manual, paragraph 58070).

The vendor may be required to continue working for the company after it has been sold. The employment-related securities provisions in ITEPA 2003 Part 7 may require careful consideration. HMRC takes the view that if the earn-out relates to further sale proceeds for the shares sold, no income tax or National Insurance contributions should be payable. However, if the earn-out contains an element of reward for services, liabilities may arise. HMRC has specified a number of ‘key indicators’ in determining whether an earn-out right is further sale consideration or remuneration. Indicators of further sale proceeds include if the value received from the earn-out reflects the value of the shares sold, or if the vendor is retained as an employee but personal performance targets do not form part of the earn-out. Conversely, if there is evidence to suggest that the earn-out right represents disguised remuneration for future services or a profit-related bonus rather than disposal proceeds, the employment-related securities provisions may wholly or partly apply to the earn-out right (See Question 5(l) of ‘Frequently asked questions’ in the Share Schemes section of the Revenue & Customs website:
http://www.hmrc.gov.uk/shareschemes/faq_emprelatedsecurity-ch5.htm ).

The sale of shares in exchange for loan notes is subject to a clearance procedure with HMRC to ensure that the deal satisfies a ‘bona fide commercial’ test ( s 137(1) ). In practice, HMRC does not normally give clearance in respect of ‘short-dated’ loan notes, ie stock with a life of less than six months (ICAEW Memorandum TR 657, April 1987).

Sale of assets

A business and asset sale is potentially more attractive for owner managers of investment companies. However, there is a potential ‘double charge’ to tax to consider, ie firstly on a sale of the company’s assets, and second on distribution of the proceeds to the shareholders as a dividend or in liquidation.

If the owner-managers intend the company to carry on another trade after a sale of trade and assets, rollover relief may be available on the disposal of trading premises by reinvesting the proceeds in new trading premises within three years ( s 152(3) ). A similar rollover relief claim is potentially available on the reinvestment of proceeds from the sale of intangible fixed assets (eg goodwill) into new intangible fixed assets ( FA 2002 Sch 29(40) ).

On a sale of trading premises including fixtures, balancing charges for capital allowances purposes may be avoided if the purchaser is willing to elect with the vendor to fix the disposal value of the fixtures. The value must not exceed the vendor’s capital expenditure on the fixtures or the actual sale price ( CAA 2001 s 198(2),(3) ). The election may result in balancing allowances. The original cost of the fixtures can normally be deducted in the computation of gain on the premises, unless it produces a loss ( s 41(1) (2) ).

Non-residence

A change was announced in Budget 2005 to block a popular planning arrangement involving the business vendor realising the gain whilst not resident and not ordinarily in the UK by becoming ‘treaty non-resident’, ie temporarily resident in a country with which the UK has a Double Taxation Agreement with a suitable tie- breaker clause making the vendor resident in the other country (eg Belgium). The effect of this intended change would be to ignore the terms of the treaty in determining whether a tax charge arises under the temporary non-residents rule (in s 10A ) in the tax year of return to the UK.

The temporary non-residents rule in s 10A can be overcome if the vendor disposes of the shares when not resident and not ordinarily resident in the UK, and remains so for at least five complete tax years. However, concessionary ‘split-year’ treatment in the year of departure from the UK (see Concession D2) does not apply if the taxpayer was resident and ordinarily resident in the UK during four out of the seven tax years immediately preceding the tax year of departure (Concession D2, paragraph 2). In any event, from a practical viewpoint it can be difficult to manage the sale of a business whilst abroad for a sufficient length of time to attain non-resident status.

Clearances

As mentioned, clearance applications to HMRC should not be overlooked. Business sales involving an exchange for shares in the acquiring company will be subject to a clearance application under s 138 , apart from the above possible exception for small minority shareholders in s 137(2) . If HMRC gives clearance, it is on the basis that the transactions are effected for bona fide commercial purposes. It does not confirm that the share exchange conditions in s 135 (or 136 ) are satisfied for ‘stand in shoes’ tax treatment to apply.

Similarly, a clearance application under ICTA 1988, s 707 is subject to a ‘bona fide commercial purpose’ test.

All material facts must be included in the clearance application for it to be relied upon. The scope of the transactions in securities rules is very broad, and includes transactions of whatever description relating to securities, including the purchase, sale or exchange of shares or securities. For example, the provisions can apply to a cash sale of shares in a company with accumulated profits to a connected person, resulting in cash being extracted from the company in capital form, where the company could have distributed it as dividends (see Cleary v IRC (1967) 44 TC 399, HL).

Other planning points

(a) Pre-sale dividends could be considered if the effective income tax rate on dividends is lower than the capital gains tax rate on a sale of shares. The dividend payment reduces the value of the company for capital gains tax purposes. Due to the reduction in the taper relief ownership period for business assets to two years from April 2002, pre-sale dividends are only likely to be advantageous in limited circumstances. For example, pre-liquidation dividends by an investment company may be appropriate where non-business asset taper relief results in a higher tax liability compared with the 25% effective income tax rate on a net dividend payment for a higher rate taxpayer.

(b) Payments as compensation for loss of office (ie to take advantage of the £30,000 exemption) or pension contributions are sometimes considered to improve the vendor’s tax position and to obtain a tax deduction. However, compensation for loss of office to retiring director shareholders may be treated by HMRC as representing disguised proceeds on a share sale. In addition, an expense deduction may be disallowed on ‘wholly and exclusively’ grounds if the sale and retirement are considered to be connected ( James Snook & Co Ltd v Blasdale (1952) 33 TC 244, CA). Company contributions to an approved pension scheme may also be subject to challenge depending on the circumstances (see Inspector’s Manual, paragraph 8212).

(c) The timing of the disposal may be significant if an immediate tax liability arises on the sale of a company (eg the sale is for cash as opposed to shares). Consideration should be given to deferring the disposal to the start of a new tax year to delay the payment of tax by twelve months.

May 2005

MARK MCLAUGHLIN CTA (Fellow) ATT TEP

This article was first published in Tolley's Practical Tax on 03/06/2005.