Sale of a business – tax considerations
Building a successful business is time consuming and it is often challenging to understand the options and devise a clear exit strategy that works and maximises the value created. With some proper consideration and the right advice, exit planning can help achieve a tax efficient outcome. Whether this involves ensuring statutory reliefs are realised or appropriate succession planning is implemented, it is also important to fully understand the tax consequences of any proposals being assessed.
Entrepreneurs’ Relief (“ER”)
ER is a very generous statutory relief which, subject to meeting various conditions, allows the rate of Capital Gains Tax (“CGT”) applicable to a sale of shares in a trading company to be reduced from the headline rate of 20% to 10% (subject to the individual’s lifetime allowance of £10m of gains).
We often hear business owners confidently stating that they will qualify for ER. However, there have unfortunately been some instances where that has not been the case. Changes in the Finance Act 2019 which affects disposals from 6 April 2019 further increase this risk. We therefore always recommend the position is reviewed well ahead of time.
One change introduced from 6 April 2019 is that the required ownership period of the shares has been extended from 12 months to 24 months. Given this extended lead time, we recommend checking the position sooner rather than later. This extension also applies to shares acquired under an Enterprise Management Incentive scheme but disposed of on or after 6 April 2019.
A key condition of ER was that an individual must hold at least 5% of the issued ordinary capital and have an entitlement to at least 5% of the company’s voting rights. However, from 29 October 2018, the Finance Act 2019 now requires that in addition to these conditions, the shareholder must also either:
- be beneficially entitled to at least 5% of the profits available for distribution to equity holders and, on a winding up, be beneficially entitled to at least 5% of net assets so available; or
- in the event of a company sale, be beneficially entitled to at least 5% of the proceeds.
It is very common for growing businesses to issue special classes of shares, such as flowering or growth shares. Such share classes may not become entitled to certain economic benefits until specific hurdles are met. What this can mean is that the holder of those shares may not begin to satisfy the conditions until such point the hurdle is met. Furthermore, the above conditions of ER must be satisfied throughout the 24 months ending with the date of disposal.
It is not uncommon to come across businesses which have built up significant cash reserves ahead of a potential sale or have over time made various investments. One of the requirements of ER is that the company being disposed of is a trading company (or a holding company of a trading group). The legislation defines a trading company as one which does not to a substantial extent carry on non-trading activities. For these purposes HMRC consider ‘substantial’ to be 20%.
One of the tests that HMRC may consider concerns the balance sheet of the company – if a company builds up cash in excess of working capital requirements and/or investments which exceed 20% of its gross assets, this could indicate that the company is non-trading.
Advance clearance can be sought from HMRC to give the shareholders certainty. We have had a lot of experience in this area and understand the circumstances, which have generally been accepted by HMRC.
Where the investments and/or cash is very significant, we can advise on other planning which can allows those assets to be extracted tax efficiently, making the ER position more robust.
Trusts and Succession Planning
On a value realisation event, it is normal for people to think about the future and potentially how their loved ones may be provided for going forward. Trusts can facilitate effective succession planning, allowing funds to be put aside for future generations, albeit at the discretion of appointed trustees. However, where an individual transfers value to a discretionary trust in excess of their available nil rate band (currently £325,000 per person), a lifetime Inheritance Tax (“IHT”) charge of 20% can arise. This can therefore limit the ability of transferring substantial value into a trust.
However, no such IHT liability should arise where shares, such as those in an unquoted trading company, which qualify for Business Property Relief (“BPR”) are transferred to the trust (subject to various conditions being met). Therefore, prior to a sale an individual may wish to consider transferring some of their BPR qualifying shares into a trust.
Employee Ownership Trust (“EOT”)
Where various conditions are satisfied, a sale of a controlling stake in a business to an EOT can allow the vendor to qualify for a statutory exemption from CGT.
A transaction will often involve different types of consideration, such as cash, deferred cash/loan notes or rolled equity. Each of these differing types of consideration can result in different tax implications, including potential upfront tax liabilities ahead of the receipt of physical cash. In addition, there will be various claims and elections which the shareholder should consider.
Deferred consideration will generally be assessed on the vendor in the tax year when the contract becomes unconditional, regardless of the fact that the consideration may not be paid until a future date. This can result in a dry tax charge which needs to be funded.
Deferred consideration can be considered ascertainable or unascertainable. Unascertainable consideration is generally where the value of the consideration is not known at the time of the transaction for example where it is calculated as a percentage of future EBITDA above a hurdle. There are certain nuances with the tax treatment between these types of deferred consideration at the time the cash is later received which a shareholder should be aware of.
Loan notes are also a common form of consideration. Where certain conditions are met, a proportion of the gain arising on the share disposal may automatically be deferred until such point the loan notes are later redeemed. The exact mechanics of how this is achieved will depend on whether the loan notes represent qualifying corporate bonds (“QCBs”) or non-QCBs. This will impact on the availability of automatic tax relief where the loan notes are sold at a loss. Therefore, careful thought is required and any loan note documentation should be reviewed in detail.
It is possible for the vendor to elect for the reorganisation rules not to apply to the loan notes. This might be beneficial if they wish to secure their ER upfront or are concerned about the rate of CGT increasing in the future. However, this needs to be considered carefully, especially where there is also rolled over equity involved. Again, the use of QCBs may need to be considered if the vendor wishes to perhaps disapply the reorganisation provisions in relation to the loan notes but not the rolled over equity element of the consideration.
Rolled Over Equity
Where certain conditions are met, gains arising on the sale of the shares in the business may be rolled over into the newly issued shares in the acquisition vehicle. The gain would be deferred until the eventual sale of the new shares. As above, it is possible to elect for these reorganisation provisions to not apply, but careful consideration is required.
It is worth noting that the rollover provisions will only apply where the new shares are issued in the direct acquisition vehicle and not where the shares are issued by a company higher up in the acquisition structure, for example.
As is evident from the above, there are a host of tax implications and decisions ahead of a sale which need proper consideration and require professional advice.
Furthermore, post transaction, significant thought may also be needed with regards to tax efficient succession planning as the vendor will likely have a significant IHT which they didn’t have previously.
If you would like to discuss selling your business or any wider planning, please contact Richard Perry on firstname.lastname@example.org.
This paper is intended to be a brief note for clients and other interested parties. The information is believed to be correct at the date of publication but should not be relied upon as a substitute for professional advice. Please speak to a member of our team.