In a technical feature article which first appeared in Taxation Magazine on 8 February 2007, Colin Kendon considers the tax pitfalls for owner-managers when selling a private company.
Colin Kendon sets out the rules for the tax effective acquisition of a private company.
When one company is seeking to take over another, the bids and counter bids that take place can make a commercial transaction appear more in the nature of a poker game, with the ‘players’ seeking to bluff themselves into a winning position. Once a price has been agreed, getting the tax structure of a company takeover right then becomes equally important if one is not to negate the financial advantages that each side thinks it has gained over the other. This is therefore the first of two articles looking at some of the tax pitfalls with private company acquisitions; this article considers the personal tax position of owner-managers and the second will consider issues relating to enterprise management incentive (EMI) options. References in this article are to paragraphs of TCGA 1992, Sch A1 unless otherwise stated.
To start, let us suppose that Harry owns 100% of Target Limited, which he founded in 1995 by subscribing for 200,000 shares at the par value of £1 each. He intends to sell it to Acquisition Vehicle Limited, a subsidiary of Purchaser plc (which is traded on the alternative investment market, ‘AIM’).
Heads of terms will be signed shortly with Purchaser who intends to buy Harry’s shares through Acquisition Vehicle for initial consideration of £3 million and an earn-out of up to a further £2 million. The earn-out is based on the profits of Target for the years to 31 December 2007 and 31 December 2008. We assume (for the purposes of advising Harry now) that completion will be on 31 May 2007 and we ignore deal costs. Harry intends to take £1 million of his initial consideration in cash and the remaining £2 million in loan notes. (See the Transaction summary below)
Perhaps it is just as well that Purchaser wants to buy the shares in Target (as opposed to the assets); Malcolm Gunn’s article, ‘Double Trouble’ (see Taxation, 16 December 2004, page 279) explains why.
The cash element of the consideration will trigger a disposal for capital gains tax purposes in 2007-08. The base cost of the shares is apportioned between the different elements of the consideration. If we attribute a net present value of £0.5 million to Harry’s earn-out, Harry’s chargeable gain for 2007-08 will be as shown in Table 1.
If Harry is a higher-rate taxpayer, he will pay capital gains tax of £94,285 (i.e. 40% x £235,714, ignoring annual exemptions and indexation up to April 1998).
To calculate Harry’s taper relief, paras 2 and 3 require us to look back over the ten years before the disposal (or over his period of ownership, if shorter) to see if the shares were non-business assets and, if so, to apportion the periods of ownership on a daily basis. Periods of ownership before 5 April 1998 are ignored (para 2(2)(a)).
Paragraph 4(2) requires Target to be a ‘qualifying company’ in relation to Harry for his shares to qualify for business asset taper relief for the period since 5 April 1998. Target must be a ‘trading company’ and Harry must meet the ownership conditions in para 6(1)(b). Harry easily meets the conditions as he has owned 100% of Target since incorporation, but is Target a trading company? We advise Harry of the ‘20% tests’ in HMRC’s Capital Gains Manual at CG17953p (too much cash on the balance sheet, etc.) which set out HMRC’s views on the meaning of trading company. Harry confirms that Target has not breached these tests, so we assume that it is a trading company. Readers are referred to the article, ‘A substantial qualification' (Taxation, 20 January 2005, page 361) for some examples of what happens when the conditions are breached.
Note that it ceased to be possible to obtain COP 10 clearance in advance as to whether Target is a trading company when FA 2006 received Royal Assent.
|Less base cost |
|£1,000,000/3,500,000* x £200,000 (57,143)|
|Business asset taper |
|942,857 x 75% (707,143)|
* Initial consideration of £3 million plus net present value of the deferred consideration of £0.5 million.
Indexation up to 5 April 1998 and dealing costs are ignored.
We might suggest to Harry that he transfers some shares to his wife (Heather) pre-completion to take advantage of her annual exemptions and lower tax rates. The transfer itself is a no gain/no loss transaction (TCGA 1992, s 58). Paragraph 15(2) treats Heather as acquiring the shares when Harry did and para 4(2) means it is her status on completion which determines whether the conditions in para 6(1)(b) are met. Mere ownership of shares in an unlisted trading company is enough to satisfy the conditions for her period of ownership after 5 April 2000, but she has to meet the old conditions (in the footnotes to para 6) for her earlier period of ownership. To satisfy these, Harry needs to transfer at least 25% of his shares to Heather if she was not an employee/officer of Target (or 5% if she was) to avoid her taper relief being tainted.
Paper for paper
Paper for paper treatment will be available for the exchange of the rest of Harry’s shares in Target for loan notes if the conditions in TCGA 1992, s 135 are met (which allow the loan notes to qualify for the re-organisation treatment afforded by TCGA 1992, s 127). Acquisition Vehicle Limited must issue the loan notes to satisfy s 135; if Harry wants security, Purchaser (or a bank) can always give a guarantee.
TCGA 1992, s 137 disapplies s 135 (for 5% plus shareholders) if the transaction is not for bona fide commercial reasons or the main purpose (or one of the main purposes) is the avoidance of capital gains tax.
The loan notes should not be redeemable within six months of issue so that HMRC are satisfied they are not a mere proxy for cash (see ICAEW Technical Release 657).
We advise Harry that the decision of the High Court in the recent case of Snell v HMRC  EWHC 3350 (Ch) (which upheld the Special Commissioners’ decision reported at length in Taxation, 8 June 2006, page 263) has made this area a bit more tricky. Mr Snell took loan notes intending to shed his UK residence and later redeem them. The court held that his main purpose in taking the loan notes was to avoid capital gains tax. Harry might want to do something similar on a smaller scale by utilising annual exemptions or he may tell us he wants to move abroad before redeeming the bulk of his loan notes – like Mr Snell. What do we suggest?
We tell Harry that s 138 allows us to apply to HMRC for clearance that s 137 does not disapply s 135; it binds HMRC if we make full disclosure. We could suggest that the purchaser adds a line to the heads of terms saying the initial consideration of £3 million assumes the bulk is taken in loan notes. We can then say in the clearance application that Harry is taking the loan notes to maximise the purchase price, not to avoid tax (we may be able to point to other issues in the negotiations which support this too).
The references to ‘paper for paper’ treatment above are a shorthand and, for a fuller explanation of how these sections operate, readers are referred to the article ‘Have I the right (to taper)?’ (Taxation, 20 July 2000, page 413.)
QCBs or non-QCBs?
The loan notes issued in settlement of the initial consideration could be structured as qualifying corporate bonds (QCBs) or non-QCBs.
If Harry takes non-QCBs, business asset taper relief would continue to run (providing the conditions are met). Harry takes a real risk, however, that Purchaser will cease to be a trading company causing his non-QCB loan notes to cease to qualify for business asset taper relief. You might think that para 6(1A) assists Harry (it allows employees/officers of investment companies who do not have a material interest to qualify). Unfortunately, para 6A(1)(a) will treat Harry as having a material interest as the loan notes are a separate class of securities of which he will hold more than 10%.
We advise Harry to take QCBs to preserve his business asset taper relief after completion. The gain is crystallised on the issue of the QCBs by TCGA 1992, s 116, but held over interest free until redemption.
The loan notes must satisfy the QCB conditions in TCGA, s 117(1). The loan notes must be securities for the purposes of TCGA 1992, s 132(3)(b), but this includes any loan stock whether secured or not, so the condition will be satisfied. The other conditions in s 117 will be met if the loan notes pay interest at a normal commercial rate (say 2% above the Bank of England base rate), are not convertible, interest is not dependent upon business performance, and they are expressed in sterling with no provision for conversion or redemption into another currency.
As mentioned above, if Harry takes QCBs, the gain is calculated on completion, but is held over until the loan notes are sold or redeemed. The held over gain on Harry’s QCBs will be £471,428; i.e. twice the amount shown in Table 1, being calculated by reference to the loan note consideration of £2 million instead of the cash consideration of £1 million.
It is essential for the earn-out to be unascertainable on completion. HMRC’s Capital Gains Manual at CG14875 to CG14890 deals with the border between ascertainable and unascertainable consideration.
If the earn-out terms say Harry is to receive £2 million if profits for the year to 31 December 2008 exceed £10 million, that would be ascertainable (i.e. £2 million), but contingent and would be taxed under TCGA 1992, s 48 on the full £2 million in the year of completion.
If the earn-out terms say that Harry receives anything up to £1 million for the year to 31 December 2007 calculated by applying a profit/earnings ratio to profits and up to £2 million calculated in the same way for the next year (after deducting anything paid in year 1), that should do nicely.
Marren v Ingles
If the earn-out is unascertainable on completion, the tax treatment depends on how it is settled. If Purchaser has a right to settle in cash, Marren v Ingles treatment applies.
The House of Lords case of Marren v Ingles  STC 500 decided that unascertainable consideration is valued and taxed on completion. If we value Harry’s earn-out at £0.5 million, Harry’s additional gain for the year of completion would be as shown in Table 2.
|Value of earn-out on completion|
|Less base cost 0.5/3.5 x £200,000 (28,571)|
|Business asset taper|
|471,429 x 75% (353,572)|
|Capital gains tax @ 40%|
Indexation up to 5 April 1998 and deal costs are ignored.
The earn-out is a separate asset (a chose in action) which is not a security so it does not qualify for business asset taper relief, the base cost is its value on completion. When the earn-out is settled, the payment is a capital sum derived from an asset (TCGA 1992, s 22). If Harry’s earn-out is settled in cash in full in (say) March 2009, Harry’s gain for 2008/09 would be as shown in Table 3.
|Capital sum derived from an asset |
|Less base cost|
|Taper relief |
If Harry is still a higher-rate taxpayer, his capital gains tax for 2008-09 would be £600,000 (i.e. 40% x £1.5 million). Note that Harry does not qualify for any taper relief; the earn-out is not a security, so it does not qualify for business asset taper relief and the £2 million was paid within three years of completion (when the earn-out right was acquired) so he does not qualify for non-business asset taper relief.
If the earn-out were to be settled in part in March 2008, the base cost of £500,000 is apportioned using the A/A+B formula in TCGA 1992, s 42 (this requires the earn-out (i.e. ‘B’) to be re-valued in March 2008).
TCGA 1992, s 138A treatment
Fortunately TCGA 1992, s 138A allows Harry to avoid Marren v Ingles treatment by affording paper for paper treatment to the earn-out. The main conditions are that:
- the earn-out is unascertainable
- is settled in shares or loan notes (not cash); and
- s 135 is not disapplied by s 137.
Note that if the conditions are met, s 138A applies automatically unless Harry elects to disapply it (s 138A(2A)).
If s 138A applies to Harry’s earn-out, it is treated as a security to which the re-organisation treatment afforded by s 127 applies. The security is treated as a non-QCB (even if it is settled in QCBs), so business asset taper relief can continue to run.
If the earn-out is settled in QCBs, s 138A(3) allows the gain to be calculated in accordance with TCGA 1992, s 116(10) when the loan notes are issued, but it is held over until redemption or sale of the loan notes. If the earn-out is settled in non-QCBs, s 138A(3) allows a further ‘internal re-organisation’ to occur thereby avoiding capital gains tax until the non-QCBs are sold or redeemed.
If the first part of the earn-out is settled in (say) March 2008, Harry should still be ‘fully tapered’ if business asset taper relief continues to run on the earn-out after completion. We advise Harry that his earn-out should be settled in QCBs so the gain is crystallised on the issue of the loan notes. Harry need not worry about Purchaser ceasing to be a trading company thereafter.
Harry still takes a risk that Purchaser will cease to be a trading company after completion, but before the loan notes are issued, so we need to do some due diligence on the Purchaser to ensure it is a trading company. Again, as mentioned above, para 6(1A) will not allow Harry to qualify for business asset taper relief on his earn-out if Purchaser is an investment company (as the earn-out will then be treated as a separate class of securities for the purposes of para 6A(1)(a) of which he owns more than 10%).
If the loan notes are issued in settlement of the earn-out as QCBs, they must satisfy the conditions in TCGA 1992, s 117(1) (see earlier) and should not be redeemable within six months of issue otherwise HMRC may refuse s 138 clearance (on the basis that the loan notes are a mere proxy for cash).
If s 138A were to apply, Harry would have no capital gains tax to pay on his earn-out in the year of completion. If the earn-out were settled in full in QCBs in (say) March 2009, the gain is calculated in 2008-09 (i.e. the year in which the QCBs are issued) as shown in Table 4.
|Less base cost 0.5/3.5 x 200, 000 (28,571)|
|Untapered gain |
|Less business asset taper |
|1,971,429 x 75% (1,478,571)|
|Held over gain |
If the loan notes are redeemed at the earliest opportunity in August 2009, his capital gains tax liability for 2009-10 would be £197,143 (i.e. 40% x £492,858).
We advise Harry that s 138A treatment is preferable to Marren v Ingles as he saves capital gains tax on the earn-out (£197,143 in Table 4 as compared to a total of £647,143 from Table 2 and Table 3). The saving occurs because the earn-out exceeds its estimated value on completion by £1.5 million, none of this gain benefits from business asset taper relief if Marren v Ingles applies, but it is fully tapered if s 138A applies.
Earn-out expires worthless
Harry then asks what happens if the earn-out expires worthless (e.g. because he falls out with Purchaser or his team agree to work for a different area of Purchaser’s business).
If Marren v Ingles treatment applies and the earn-out expires worthless on 31 December 2008, Harry would have a loss for 2008-09 of £500,000 (i.e. the value attributed to the earn-out on completion). TCGA 1992, s 279A to 279D allow him to carry this back to the year of completion and reclaim the capital gains tax of £47,143 he paid on it.
If s 138A treatment applies, Harry has a loss for 2008-09 of £28,571 (i.e. the proportion of the base cost of his Target shares apportioned to the earn-out), which has to be set-off against any gains for that year and thereafter is available to be carried forward. TCGA 1992, s 279B(6) prevents Harry from carrying his loss back and setting it off against his gains for the year of completion if s 138A applied to the earn-out.
Securities options treatment
The earn-out has to be settled in shares or loan notes to secure paper for paper treatment, but this also makes it an ‘employment-related securities option’ for the purposes of ITEPA 2003, Pt 7 Ch 5. Income tax and Class 1 National Insurance contributions apply when the loan notes are issued in settlement of the earn-out displacing s 138A treatment.
We tell Harry this should not be a problem as it is likely the earn-out will satisfy the conditions in Q&A 5(l) of HMRC’s ‘Frequently Asked Questions on the Taxation of Employment Related Securities’ (available by clicking ), in which case HMRC will treat the earn-out as further consideration for the sale of the shares and not as a securities option. For an analysis of the conditions, readers are referred to the article ‘Earn-Out Reprise’ (see Taxation, 9 October 2003, page 37).
Harry says that Purchaser wants to make his earn-out forfeitable until the earn-out period expires on 31 December 2008 (the conditions allow this providing it is for no more than a ‘reasonable period’). HMRC should accept that just under two years is a reasonable period, but we will obtain COP 10 clearance just to make sure.
The biggest problem in practice with Q&A 5(l) is where the target has a mixture of employee and non-employee shareholders. Purchasers often only want employee-shareholders to benefit from the earn-out (for understandable commercial reasons), but if the earn-out is so restricted it looks like remuneration rather than further consideration. If COP 10 clearance is refused, a solution may be to alter the terms of the earn-out so the purchaser has a choice of settlement in cash or securities. Q&A 5(l) says securities option treatment does not apply in these circumstances, but it means shareholders are then subject to Marren v Ingles treatment.
The gain on completion can be reduced by business asset taper relief whereas subsequent gains cannot if Marren v Ingles treatment applies, so it makes sense to agree a high up-front value for the earn-out (if possible).
Other ITEPA 2003, Part 7 charges
We need to check that no charges to income tax arise on completion pursuant to ITEPA 2003, Pt 7 Chs 2 to 3D (the disposal of shares gives rise to several ‘chargeable events’ under these chapters). The ‘restricted securities’ rules in Ch 2 do not apply to shares acquired before 16 April 2003 so cannot apply to Harry. Chapters 3 to 3D can apply, but it is unlikely that any charges will arise as the share capital has been unaltered since incorporation and the shares are sold on arm’s length terms.
The loan notes acquired in settlement of the initial consideration are treated as being received by reason of employment by ITEPA 2003, s 421B(3) and s 421D. It is difficult to see how the loan notes could be restricted securities if they are transferable freely and not forfeitable. It is arguable that the consideration Harry gives for the loan notes (i.e. his shares in Target) is equal to the unrestricted market value of the loan notes so no election is necessary under ITEPA 2003, s 431 (although Purchaser might insist on it to protect its position). Note that redeemable securities are no longer exempt from the restricted securities regime by ITEPA 2003, s 424.
Hopefully this article has given an overview of the potential problems, pitfalls and liabilities that can arise in a private company takeover involving cash, loan note and earn-out elements. The next article (available by clicking here) looks at what happens if Harry grants some EMI options just before completion.
Colin Kendon is a senior associate in the Employee Incentives & Benefits Group of international law firm Bird & Bird; he can be contacted on 020 7905 6312 or by e-mail at firstname.lastname@example.org