Bear traps on a company sale – Income Tax

Our Tax Director Holly Bedford-Bell is back with a  second article in  The Business Magazine, to explain what are the main tax traps when selling a business, especially income tax.

Many private company shareholders expect to pay capital gains tax (“CGT”) at 10% with Entrepreneur’s relief on a sale of the company shares.  It can be a very unpleasant surprise if they find that they don’t qualify for Entrepreneur’s relief or, potentially worse, have to pay income tax and NIC.

An article published in the July/August edition of The Business Magazine covered events that can lead to a loss of Entrepreneur’s relief.  This article looks at three common risk areas that could give an unexpected income tax charge on a sale.

Earn-outs

If the selling shareholders remain employed post-sale, there is a risk that HMRC will consider the earn-out to be disguised employment income assessable under PAYE with NIC, rather than taxable under CGT, with implications for the individual and the employing company.

Red-flags in earn-out clauses include:

  • earn-outs only being paid to the employed shareholders;
  • below-market rate salaries;
  • targets based on personal performance targets; and
  • the earn-out being dependant on continued employment, “beyond a reasonable requirement to stay to protect the value of the business being sold“.

Preferential share pricing

Disposal proceeds above market value

If an employee/director shareholder receives a higher price per share on a disposal than the other shareholders, which is not justified by the share class having more valuable transferable rights, HMRC may assess the excess payment as an employment reward with income tax and NIC due under PAYE.

Shares acquired at an undervalue

If an employee/director receives shares and pays less than market value, there is an income tax exposure for that individual.  Sweet equity deals or ratchets in favour of management need careful review.

HMRC will not give advance share valuations, but a post-transaction valuation can be agreed to give certainty over the employee’s income tax position.

Transactions in Securities rules

These wide-ranging anti-avoidance rules apply to closely held companies (generally controlled by five or fewer shareholders or controlled by the directors).

These rules often present a problem on Newco acquisition structures where there is a partial exit of the major shareholders for cash or loan notes, such that they are retaining a material shareholding going forward.

These rules will tax share sale proceeds as if they were a dividend, subject to income tax, rather than capital proceeds under CGT. As the reports on www.pan-card.org.in explain, the higher rate tax payers, this could mean significantly higher tax rates, particularly if the client expected to pay 10% under Entrepreneur’s relief.

There is a safe-harbour where a shareholder retains less than 25% going forward, but the details of this provision need very careful review.

This can be a deal-breaker and it is crucial that vendor’s expectations are managed and that advance HMRC clearance is considered early in the sale process.

The tax team at HMT led by Holly Bedford-Bell provides specialist advice to shareholders, management and companies on acquisitions, disposals and corporate restructurings. Do not hesitate to contact us on 01491 579740.

Read the first article about bear traps on a company sale – Capital Gain Tax