• Whether you are selling your business or passing it on to the next generation, tax will be a key issue in a number of decisions that you take during the disposal process.
• Taking the right decisions can often significantly reduce your tax bill on the disposal and smooth the disposal process for all concerned.
Choice of business vehicle
• Whilst it is likely that tax considerations will play a significant part in this choice, typically these will relate to the ongoing taxation of business profits rather than the ultimate disposal of the business.
• Care is thus needed to ensure that tax liabilities on disposal are minimised in the light of the chosen business structure.
• Tax on disposal of a business by a sole trade or a partnership (or indeed an individual partner in a partnership) will typically be relatively straightforward, as there is only one selling party involved. With a limited company, on the other hand, things can quickly get a lot more complicated. I will concentrate on limited company sales in the rest of this presentation.
• If you trade through a limited company, this does not mean that the company has to own all of the business assets. Apart from the potential tax advantages of direct personal ownership of business assets, there can also be advantages in terms of protecting assets in the event of a company failure.
• Key assets which business owners typically like to retain outside a limited company are land and buildings and intellectual property.
• Apart from safeguarding the asset in the event of business failure, owning property outside the company offers the opportunity to charge rent (carrying no national insurance charge) and avoids a double tax charge if the company ultimately sells its assets, rather than the owner selling shares.
• Owning the rights to key business assets (patents etc.) has become more attractive now that it is possible for a company to claim research and development tax reliefs in respect of projects for which it does not own the intellectual property rights. Again there are both tax and asset security advantages to such a structure.
• Goodwill is another asset that it may be beneficial to own outside a company. Indeed, if the goodwill is personal to the business owner, it may not be possible to transfer it to the company. In such a case a long term licence for a capital lump sum can create tax advantages whilst securing long term personal ownership of the goodwill.
Group structure and pre-sale reconstructions
• Whilst in an ideal world all would be in order within companies or groups when a business disposal occurred, in the real world this is often far from the case. It is often necessary to ‘tidy up’ structures before a sale can take place, in order to ensure that assets being sold and being retained are each in the right places prior to disposal.
• Fortunately there are a number of tax reliefs available to facilitate the internal restructuring of companies and groups without incurring prohibitive charges to corporation tax, capital gains tax, income tax, stamp duty land tax and stamp duty. These can permit, for example, assets to be transferred around a group and shares to be exchanged without tax charges necessarily arising.
• One particularly useful relief is demerger relief, which allows companies to divide trading activities from each other where some are to be retained and some disposed of, or where two or more shareholders are each taking on one trade of a group or company. Another advantage of the reliefs in question is that in general they have an advance clearance procedure to give certainty that they apply in particular circumstances.
Substantial shareholdings exemption (“SSE”)
• The importance of getting group structure right is illustrated by SSE. This is an exemption from corporation tax on capital gains applicable where a trading company or group disposes of a holding of at least 10% of the shares in a trading subsidiary or other company which it has owned for at least a year. The vendor must still be trading after the disposal.
Sale of shares or assets?
• A key issue on disposal of a company trading activity is always whether the sale takes place as a sale of the company’s shares or of its assets.
• There are dramatically different tax implications to the two options, and buyer and seller may well have different views on how they would like the deal structured.
• Typically the vendor would like to sell shares, for the following reasons:
o Only one tax charge rather than two;
o Gives a clean break without the need to wind up the company after sale;
o Gets rid of any ‘skeletons in the company cupboard’ (subject to warranties); and
o Removes any potential issues as to what to do with the company after sale of the business.
• On the other hand the purchaser is likely to want to buy assets rather than shares:
o Avoids buying the company ‘warts and all’;
o Has greater flexibility over what to do with the assets after purchase;
o Likely to be better placed to obtain tax relief on assets acquired; and
o Leaves dealing with the company post-sale to the vendors.
• In practice the question is usually settled by negotiation. The vendor is likely to be prepared to accept a lower price for selling shares than assets, for tax reasons, and thus the purchaser must decide if the ‘discount’ for buying shares is worthwhile. It is usually possible to work out which option is better for the two parties overall.
• It is common for part of the purchase price of a business to be in the form of an ‘earn out’, linked to the company’s profitability after the sale, and usually designed to encourage the vendor to co-operate fully with the hand-over of the business, and often to work effectively for a period in the business after sale to maximise profits.
• Where an earn out is in the form of shares or other securities, it will be treated as giving rise to an exchange of securities unless the vendor elects otherwise.
• In practice this means that, in the absence of an election, the gain on the earn out is not taxed until the shares etc are disposed of by the vendor.
• Cash earn outs are somewhat trickier to deal with. It is necessary to place a value on them at the time of the disposal for capital gains tax purposes, with the actual amount arising in practice giving rise to subsequent capital gain or loss. This can create problems if the initial valuation was significantly inaccurate, and the earn out period is relatively long.
• Often part of the proceeds on a business sale will be in the form of loan notes, which are securities, usually guaranteed by a financial institution, paying a rate of interest and due for redemption for either cash or other shares and securities at some point in the future.
• Loan notes are either qualifying or non-qualifying corporate bonds. A qualifying corporate bond is a normal commercial loan expressed purely in sterling. A non-qualifying corporate bond will either be convertible into securities other than corporate bonds (e.g. shares) or capable of being expressed in a currency other than sterling.
• A gain on shares exchanged for a qualifying corporate bond is ‘frozen’ pending sale of the bond, whereas non-qualifying corporate bonds are capital gains tax assets in their own right. It is thus possible to lose out from owning a non-QCB if it does not qualify for capital gains tax entrepreneurs’ relief.
• Entrepreneurs’ relief is the successor to retirement relief and business assets taper relief as the relief available to mitigate the capital gains tax liability due on the sale of a trade or trading company.
• It has always been felt necessary to have in the UK tax system a relief to encourage entrepreneurs to develop businesses.
• The effect of entrepreneurs’ relief is to apply an effective 10% tax rate to eligible gains. Each individual has an entrepreneurs’ relief lifetime limit on eligible gains, currently set at £5 million.
• It applies to sales of businesses and certain sales of shares in trading companies or groups.
• In order for company shares to be eligible for relief, the taxpayer must own at least 5% of the total share capital of the company, which clearly has implications for structuring shareholdings.
• In order to qualify as a trading company, a company must be at least 80% a trading entity. This of course begs the question of how one determines this in practice.
• The Courts have determined that one takes an overall view of trading status based on a series of 5 tests, in each case considering whether on the basis of that test the company is 80% trading. In my experience if the company meets 4 of the 5 tests HMRC will more often than not accept trading status, but any less than that is problematic.
• The 5 tests are:
o Management time
o History (has the company traditionally traded or not?)
In view of the increase in the top rate of capital gains tax from 18% to 28% entrepreneurs’ relief is now even more important as a tax mitigation tool.
Management Buy-Outs (“MBO”) and the use of Enterprise Management Incentives (“EMIS”)
• It is often the case that the only realistic purchaser for a private trading company is that company’s management team, through the medium of an MBO. Where it appears likely that this will be the case, some advance planning is likely to be necessary to give an MBO the best chance of success.
• The key element is putting in place the management team before the vendor wishes to dispose of the business. Given that the vendor will wish to appoint entrepreneurial individuals who will be committed to the future success of the company, it will make sense to offer these individuals EMIS share options where possible.
Purchase of a company’s own shares
• Whilst it is now possible in certain circumstances for a company to purchase and hold its own shares, the more traditional approach has been for a company in certain circumstances to purchase and cancel its own shares. This has particularly been the case where a majority shareholder wishes to retire and there is no-one to buy his/her shares, but there are minority shareholders who wish to take over ownership and running of the company.
• The attraction of purchase of own shares from the vendor’s viewpoint is that in certain circumstances capital gains tax treatment will apply, meaning that entrepreneurs’ relief may come into play.
• From the minority shareholders’ viewpoint, the obvious attraction is that they do not have to pay for the vendor’s shares personally to assume control of the company
• The conditions for capital gains tax treatment to apply are as follows:
o The company must be an unquoted trading company or holding company of a trading group;
o The purchase must be to benefit the company’s trade (see examples below);
o Payment must be made in full immediately on purchase (loan back is possible in practice);
o The vendor must be resident and ordinarily resident in the UK for the year of purchase;
o The vendor must have held the shares for 5 years prior to purchase;
o The vendor’s shareholding must be substantially reduced or eliminated by the purchase. This means in practice the holding must be eliminated over a series of transactions or reduced to a small (<5%) holding retained for sentimental reasons.
• The four examples given by HMRC of purchases for the benefit of a trade are:
o Withdrawal of investment by outside equity shareholder;
o Retirement of proprietor to make way for new management;
o Death of shareholder; and
o Disagreement over company management.
• There is an advance clearance procedure whereby a taxpayer can obtain confirmation from HMRC that capital gains tax treatment will (or will not) apply to a particular proposed purchase of own shares.
• A purchase of own shares not eligible for capital gains tax treatment is treated as a dividend (except for the element representing the repayment of the nominal value of the shares).
Inheritance tax business property relief (“BPR”)
• Where a taxpayer gives away, or dies in possession of, an interest in a business, unquoted trading company shares or certain business assets (land, buildings, machinery and plant) used in a trade, he/she may be eligible for 100% or 50% relief from inheritance tax in respect of the value of the relevant business or assets.
• The relevant percentages of relief are as follows:
o Sole trade or partnership interest 100%
o Unquoted shares (including those
traded on the USM, AIM or OFFEX) 100%
o Shares giving control of a quoted
o Land, buildings, machinery or plant in
a partnership or controlled company 50%
• In order to be eligible for relief, a business must be wholly or mainly a trade, that is to say more than 50%. The same tests are used for this purpose as for entrepreneurs’ relief, namely:
o Management time
• Business property relief will not be available to the extent that the value of a business relates to ‘excepted assets’. These are assets neither used mainly in the business in the last 2 years nor required for future use in the business at the time of the transfer. Note that business is a wider term than trade, and thus assets used in a property letting business, for instance, would not be excepted assets.
• The main application of the excepted assets legislation is in dealing with company ‘cash hoards’ where there is no clear business requirement for the retention of large cash balances. It is therefore good policy to regularly minute the business reasons for retaining significant cash sums in a company (for example with a view to buying suitable premises when they become available).
• The minimum period of ownership for business property is 2 years, although there are replacement property provisions where an asset has been acquired within the past 2 years to replace another business asset.
• Because AIM etc shares are eligible for 100% business property relief, some planning for elderly taxpayers centres around moving investments into an AIM portfolio and seeking to survive for 2 years.
• If an asset is subject to a binding contract for sale, it is ineligible for business property relief. This can apply to provisions in a partnership or shareholders’ agreement dealing with automatic succession of surviving partners to a deceased partner’s share of the partnership.
• It is usual to avoid this issue by the use of cross options, whereby the deceased’s executors have an option to sell and the remaining partners an option to purchase the deceased’s partner’s share.
• There are special provisions in respect of lifetime gifts and BPR, relating to gifts where the donor dies within 7 years. In such a case the property must still be eligible for BPR at the date of death in order for relief to be available. There are again replacement property provisions in this respect.
Summary & conclusion
• If you have a business that you are considering selling or giving away, or you are in the process of buying a business, make sure you have all the tax angles covered by speaking to Mark Simpson:
• Telephone 0161 886 8062
• E-mail email@example.com