By Mike Hayes, Tax partner, Kingston Smith
The sale of a business will usually take the form of a share sale or a sale of the business’ trade and/or assets. The way in which the proceeds from the sale are structured will directly affect the seller’s claim for entrepreneurs’ relief (ER).
A sale will commonly be structured with one or more of the following:
- upfront cash
- deferred cash payments
- vendor loan
- shares issued in the purchasing company.
Set out below are some of the specific issues to be aware of, depending on how the consideration is structured, along with mitigation strategies.
Provided a seller meets the relevant conditions (as set out in part II of this series of articles) at the time of the sale, the receipt of upfront cash in return for shares in a company or the assets of a business will often qualify the seller for ER on the gain.
It is common practice for sale transactions to be structured with a combination of upfront cash paid and an element of deferred consideration. This deferred consideration may be known at the time of the sale (ascertainable deferred consideration) or dependent on future factors and unknown at the time of the sale (unascertainable deferred consideration). The latter is often referred to as an earn-out.
Ascertainable deferred consideration
If a portion of the sale proceeds is fixed at the time of the sale but deferred over future periods, the total proceeds will be known at this point, enabling a value for the deferred consideration to be entered into the capital gains calculation (CGT) with accuracy. CGT should be paid up front, on which ER will likely apply.
The same applies for deferred-contingent consideration, whereby the amount of the proceeds is known but part depends upon the occurrence or otherwise of a future event; for example, obtaining planning permission for some land. In this case, the total eventual receipts can be accurately estimated at the time of the contracts exchanging and the full amount will be brought into the capital gains tax computation at that point, this enabling a full ER claim. Should the eventual receipts then fall short of the value on which tax has been charged, it would be possible to make a claim for relief against the tax already paid.
Unascertainable deferred consideration
In most cases, an earn-out will be dependent on the success and profitability of the company in the years following the sale. As a result of this, the total amount to be received is unknown at the point of the deal completion. For CGT purposes, the taxpayer must enter a value into their tax return for the earn-out, based on an estimate of what they expect to eventually receive. ER will be available on this to the extent the individual fulfils the conditions at the time of the sale.
The ‘right’ to further consideration is treated as a separate asset for CGT purposes and this is not an asset that is eligible for ER. Any future receipts over and above this initial value will then be taxed at the main rate, meaning that it is important to recognise as much of the deferred consideration as possible upfront for tax purposes.
In order to maximise the availability of ER, one approach that can be taken is to structure the deal with a headline purchase price based on a reasonable estimate of future receipts and attach a profits warranty to this to indemnify the purchaser should these profit targets not be met. The proceeds for inclusion in the CGT computation will be based on this headline purchase price and will be taxable upfront.
Should the earn-out targets not be met, the profits warranty will operate and the purchase price paid will be reduced accordingly. It would be possible to then make a claim to HMRC that part of the original consideration on the transaction was irrecoverable and claim relief against the tax paid. This limits the possibility of further gains being realised that are ineligible for ER, as you are effectively setting the bar as high as possible. This requires careful drafting of the terms to properly reflect the arrangement and protect the interests of both the vendor and the purchaser.
A further solution is to sell a percentage of the shares immediately with the remainder being subject to an option, exercisable at a future date, on a performance-related basis. If this approach is taken, then it may well be possible to ensure that both disposals fully qualify for ER.
The vendor will pay tax upfront on the initial receipt, whilst ideally retaining enough shares and a position in the company such that the conditions for ER will apply at a future date, if the option is then exercised.
As well as deferred cash consideration, a deal may be structured with loan notes issued to the seller in consideration for their shares or business assets. In this instance each ‘cashing in’ of the loan note in the vendor’s hands is treated as a separate taxable event for CGT purposes. The loan notes won’t qualify for ER and the receipt will be taxed at the main rate of 28%.
To avoid paying additional tax at this increased rate, there are tax elections that can be made, enabling the seller to instead pay tax upfront at a rate of 10% based on future receipts. This has the advantage of saving tax overall; however, it will need to be balanced with the cash flow disadvantage of having to pay all the tax upfront.
A similar situation can arise if the purchasing company issues the seller with shares as consideration for the shares being sold. In the event of this happening the capital gain will be realised when these shares are eventually sold on. Again, the conditions for ER at this later point may not be fulfilled, given that the vendor may not own 5% of the shares in the purchasing company..
To avoid paying tax at increased rates on the eventual onward sale of these shares, there are further tax elections that can be made to stop the gain effectively ‘rolling over’ into the base cost of the new shares. This will mean the tax is payable upfront, but at a far lower rate than if it were deferred.
Risk of being taxed as employment income
In addition to the above scenarios, a further risk attached to sale transactions is that an element of deferred consideration is treated as employment income, where the vendor remains in the business.
HMRC may, in certain situations, seek to treat the receipt of deferred consideration as recompense for the duties still being carried out. In this case, the tax rate can be as high as 47%.
It is crucial to minimise the risk of this by ensuring that the Sale and Purchase Agreement is appropriately drafted and that it is clear that the earn-out is not linked to any on-going employment.