In this article, I shall focus on share sales of trading companies rather than asset sales since this is usually the preferred method of disposal for vendors exiting a corporate investment.
One of the key tax benefits of selling a company is the potential to obtain Entrepreneurs Relief (“ER”) from Capital Gains Tax which results in a 10% tax rate rather than the normal capital gains rate for higher rate taxpayers of 20%. An individual has a lifetime limit for entrepreneur’s relief gains of £10m.
ER is only available on trading companies. For this purpose, a trading company is “a company carrying on trading activities whose activities do not include to substantial extent activities other than trading activities”. HMRC considers substantial to be more than 20%. This is relevant where a company carries on other activities such as investing in shares.
The selling shareholder must be either a director or employee and own 5% of the company’s shares which they must have held for the required qualifying period – 2 years for disposals taking place from 6 April 2019. The shares must also entitle the holder to at least 5% of the company’s voting rights.
During the 2018 budget, it was announced that there would be an additional 5% ‘economic’ interest test that must also be passed in order to qualify. Now, the shares must also entitle the shareholder to either at least 5% of distributable profits and 5% of the assets available to the equity holders on winding up, or 5% of proceeds on a hypothetical sale for market value at the date of the share disposal.
A good many companies have issued alphabet shares in the past to enable differential dividends to be paid out of their profits to director/shareholders, the holders of which may not pass the 5% entitlement to distributable profits test.
Furthermore, some holders of alphabet shares are entitled to receive, say, the first £1m of proceeds on a hypothetical sale, with the balance allocated to another class of shares. In these circumstances, there is a risk that the 5% hypothetical proceeds test could also be failed.
The position is still not completely clear on certain aspects of these new tests, and the legislation has only very recently been enacted, although it will be applied retrospectively to all transactions after 29 October 2018.
Deferred or contingent consideration must be declared at the time of the disposal, and the Capital Gains Tax will be payable even though the deferred consideration has not yet been received. In very limited circumstances the Capital Gains Tax may be payable in instalments.
Deferred consideration can either be ascertainable or unascertainable. Ascertainable consideration is an amount to be received subject to a warranty or conditions and ER can be claimed. If all the proceeds are subsequently not received then any overpaid Capital Gains Tax can be reclaimed.
Unascertainable consideration will need to be valued at the date of disposal and may be based on whether the company hits certain profit targets in future years. The amount declared will qualify for ER and again, any overpaid capital gains tax may be reclaimed.
However, if the consideration received exceeds the amount declared, then this excess must be declared in the tax year it is received and in most cases, will not qualify for ER. Care should therefore be taken with the initial valuation of the unascertainable consideration, which effectively involves a weighing up exercise involving cash flow, overall tax effectiveness and the likelihood of receiving the money.
In the case of Earn Outs (aka contingent consideration of one form or another), one of the conditions may be that the selling shareholder remains employed with the company for a certain period of time after sale. In certain cases, HMRC can argue that some of the subsequent proceeds received are employment income and should be subject to income tax rates rather than capital gains tax rates, which are generally higher. Indicators that the amounts received are employment income include the earn out being compensation for the employee not being fully remunerated for continuing employment and personal performance targets being incorporated into the earn out. Therefore, the wording of targets and the future remuneration of the vendor should be carefully considered.
A number of the transactions we have worked on have involved companies which have used “tax planning” schemes, in particular what are referred to as disguised remuneration schemes, where loan backs from funds placed in a Trust by the company for key employees have been made. These schemes have generally been found not to be effective following the decision in the “Rangers case”.
Whilst this has not significantly affected the valuation of any of the businesses we have acted for, it has affected the cash receivable by the vendors as they need to set funds aside to reimburse the company for taxes not previously accounted for on the benefits received.
In all our cases the vendors have been upfront with the buyers on the likely liabilities which would arise from the schemes and have allocated relevant amounts of consideration to meet them. These types of scheme are now being settled by HMRC and our experience to date has been that the liabilities, whilst painful, are not always as bad as first contemplated.
The above is a brief high level overview of some of the tax issues which have been relevant to our recent transactions. Whilst the next few months may not be the best time to sell – pending resolution of Brexit position – given the tax complexities involved it may well be worthwhile for potential vendors to have their positions reviewed and we would be pleased to help.