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John Barnett CTA outlines the potential implications of the Capital Gains Tax changes announced in the Pre-Budget Report 2007 in terms of company sales and 'earn-out' deals.

Background

Within a day of Alastair Darling's pre-budget announcement of the 18% CGT rate, four separate colleagues asked me how the announcement would affect earn-outs.  While the mainstream press has concentrated on the disparity between entrepreneurs (+8%) and investors (-6%), the true impact of the proposals will be on those who have already sold assets but who are locked into a structure where part of the price is not payable until after 6 April 2008.  The lack of transitional provisions makes their position particularly difficult. Earn-outs are a classic example of this.

This article therefore looks at how the tax treatment of earn-outs will be affected by the Pre-Budget Report 2007 and how earn-outs may come to be restructured over the next few months.

What is an earn-out?

When a company is sold, it is common for the purchaser to defer payment of some of the purchase price until the results of the current, and sometimes the next few, trading periods are known.  In many such cases, the amount finally payable may vary according to the results of the business on an ongoing basis.  This is known as an "earn-out".

The conventional structure of an earn-out

Until now, such earn-outs have invariably been structured for tax purposes so that, once the targets are achieved, rather than paying cash, the purchaser would issue loan-notes (or occasionally shares) to the sellers.  The loan-notes would typically be held for at least 6 months and would then be cashed-in.  This structure is designed to fall within Taxation of Chargeable Gains Act 1992, s 138A (which itself enacts a previous Revenue concession).

Since April 2003, this conventional structure has occasionally been abandoned due to concerns that it might be taxed as an unapproved share option under the Employment-Related Securities provisions  introduced by FA 2003 ("Schedule 22").  However, in most cases HMRC's frequently asked questions – see www.inlandrevenue.gov.uk/shareschemes/faq_emprelatedsecurity-ch5.htm. -  give comfort that the Schedule 22 provisions will not apply.  As a result the conventional structure is still frequently adopted.

However, since the PBR conventional earn-outs which pay out after 6 April 2008 will now typically face 18% CGT rather than the 10% which currently applies.

Possible Solutions

For anyone currently negotiating the sale of a company, there are two main solutions to the CGT changes.   Interestingly these two solutions also go a considerable way to answering the Schedule 22 difficulties introduced in 2003.  As such conventional wisdom as to how to structure an earn-out may shift radically over the next 6 months until 6 April 2008.

The two possible solutions are:

• Cash earn-outs
• Artificially capped cash earn-outs

Cash earn-outs

The first solution may be to revert to a cash-based earn-out.  Because the earn-out is now a "right to acquire cash", it cannot be taxed in the same way as a share option and therefore largely answers many of the Schedule 22 concerns introduced in 2003.

It should be noted that the Revenue do still have other powers to re-characterise such an earn-out as a disguised bonus if blatant tax avoidance is taking place.  However, their powers are much more limited.  It is therefore likely that a cash earn-out will be taxed as a capital gain rather than as income.

Traditionally, cash earn-outs have not been favoured for reasons which are highlighted by the case of Marren v Ingles [1980] 3 All ER 95.

Marren v Ingles decided that where shares are sold for a price which includes an earn-out, one needs to calculate - at the date of completion - the present value (PV) of the earn-out.  This is not an easy exercise and will invariably require a professional valuation.  However, the broad principle can be illustrated by an example.

Example

Assume that a company is sold for £10m upfront, plus earn-out.  The valuer calculates that there is a 60% chance that the earn-out may pay out £4 million.  In broad terms, therefore, the PV of the earn-out is 60% x £4 million = £2.4 million (this is obviously a hugely simplified calculation and is used merely to illustrate the principle).

On completion, the taxpayer pays tax on £10 million plus £2.4 million = £12.4 million.

The earn-out is then treated as a separate asset in its own right.  If it ultimately pays out, say, £4 million then there is a further disposal at that stage.  The earn-out's base-cost is its PV.  So if it pays out £4 million, there is  a further gain at that point of £4 million less £2.4 million = £1.6 million.

So, conventionally, cash-earn outs have had two main problems:

• Tax is payable on completion on £12.4 million even though only £10 million of cash is received;
• Until now the earn-out right will not have been a business-asset for taper relief purposes and therefore the additional gain of £1.6 million would typically have been taxed at 40% rather than 10%.

The first of these problems still exists.  However, if the earn-out pays out after 6 April 2008, the rate will now be 18% rather than 40%.  And, in addition, the higher the PV, the greater the percentage which will continue to benefit from the existing 10% rate.

If the above transaction were conventionally structured the tax would be 10% x £10 million plus (after April 2008) 18% x £4 million.  The total is therefore £1.72 million.

By using the cash earn-out route, the tax is reduced to 10% x £12.4 million plus 18% x £1.6 million = £1.53 million -  a saving of nearly £200,000 – albeit at the cost of an accelerated tax charge.

Prior to 2003 there were additional problems if the earn-out actually paid less than its PV.  In that case a loss arose on the earn-out which could only be carried forward.  Fortunately, Finance Act 2003 introduced new provisions allowing the loss to be carried back in these circumstances.

Artificially capped cash earn-outs

Many earn-outs are open-ended.  For instance, they will be structured so that the payment is - say - £2 for every £1 by which Earnings before interest, taxes, depreciation and amortisation (EBITDA) exceeds a certain figure.  As seen above, where they are paid in cash, this brings in the problems associated with Marren v Ingles.

One possible solution is to apply an artificial cap to the earn-out.  For instance take an earn-out which pays £2 for every £1 by which EBITDA exceeds £X.

Suppose that EBITDA will never conceivably exceed £4 million.  Given this, the earn-out could be restructured so that it pays out from the top down rather than the bottom up.  Rather than paying £2 for every £1 by which £X is exceeded, the earn-out could pay a flat £4 million but reduced by £2 for every £1 by which EBITDA is less than £4 million.

By paying a flat sum which is reduced, different taxation treatment applies.  Tax is now payable upfront on the full amount of the possible payment (£4 million in the above example).  The legislation then states (TCGA 1992, s 48) that a tax reclaim can be made if less is actually received.

The advantage of this approach is that the whole of the earn-out will be taxed as part of the consideration for the main sale.  This means that a 10% rate of CGT should apply prior to 6 April 2008.

Compared to a conventional earn-out this reduces the tax bill to £14 million @ 10% = £1.4 million saving £320,000 compared to the earlier example.  This structure also alleviates possible Schedule 22 problems.

The disadvantage is that tax is paid immediately on completion and that an artificial cap must be applied to the earn-out.  Set the artificial cap too high and too much tax will be paid upfront.  Set it too low and the commercial deal may be prejudiced.

Despite these disadvantages, the artificially capped cash earn-out may prove to be increasingly popular where deals complete before 6 April 2008.  This will particularly be the case for shorter earn-outs which may be close to paying-out anyway by the date the additional tax is payable (31 January 2009).

What about existing earn-outs?

Existing earn-outs will require more careful thought.  One obviously possibility is to look to accelerate the payment of the earn-out (i.e. the encashment of the shares or loan-notes) ahead of 6 April 2008.  Alternatively, the earn-out rights might be artificially disposed of before that date – perhaps by being swapped for a cash-based earn-out instead.  However, each case will need to be considered on its own facts and the Schedule 22 provisions, in particular, will need to be carefully considered.

Conclusion

It is to be hoped that the draft CGT legislation promised in December is not hedged about with measures designed to tackle what might be perceived as avoidance of this nature.  In reality, restructuring earn-outs in this way is not avoidance.  It merely seeks to take advantage of the fact that the existing CGT rules are stated to continue to apply until 6 April 2008.  And, in the process, it accepts the economic (cashflow) consequences of doing so.

An early statement from HMRC would be welcome on this subject given that deals are happening now.  Those doing them need commercial certainty as to how they will be taxed.

Burges Salmon LLP is a top 50 law firm based in Bristol offering a full service to commercial and private clients.  Despite being based in the South West, over 75% of the firm's clients are based outside the region.  The Tax & Trusts department is one of the largest at any law firm in the country with 8 partners and 38 total lawyers - six of whom are dually qualified as Solicitors and Chartered Tax Advisers.  John Barnett jointly heads the corporate tax team specialising in the intersection of corporate and personal tax for owner-managers, entrepreneurs and senior executives.  He can be contacted on 0117 902 2753 or at john.barnett@burges-salmon.com