Bear traps on company sale – Capital Gain Tax
Many private company shareholders hope for CGT with Entrepreneur’s relief (ER) on a share sale. Being told otherwise during the disposal would be unwelcome news and could derail a sale process. Being told the unpleasant news after the deal was done, could lead to some awkward conversations with the advisors.
Bear traps could be viewed in two main categories:
- a loss of ER so that the main rate of CGT, currently 28%, applies; or
- sale proceeds taxed under income tax rather than CGT resulting in much higher rates of tax potentially with NIC.
This article covers the first category and briefly looks at some risk areas to review before a deal and some points to consider when structuring the sale consideration.
ER is available for a disposal of shares where, in the 12 months leading up to the sale:
- the shareholder has been an employee or officer of a group company (so don’t resign!);
- the shareholder has held at least 5% of the ordinary share capital and voting rights of the company; and
- the company is a trading company or holding company of a trading group
The 5% test
The ER test refers to holding 5% of ordinary share capital (by nominal value) and voting rights. Where there are different classes of shares with different nominal values, rights and/or preference shares, this test needs careful review.
The definition of “ordinary share capital” is very specific so the rights of each class of share, whether it is called preferred or ordinary, should be checked to see if they count as “ordinary share capital” for the purposes of ER and each shareholder’s percentage holding of these shares by nominal value should then be checked to ensure the magic 5% test has been met.
Most entrepreneurs consider they know whether their company is a trading company, however, HMRC may not agree. A company or group’s trading status is at risk if the company or group has a substantial non-trading activity, meaning more than 20% of the overall activity. HMRC’s manuals refer to various indicators to assess, in the round, if the 20% test is breached.
This could be an issue for a company that holds commercial property that it lets out to third parties, non-trading assets, or an active investment portfolio. In the past there has been concern about excess cash balances, however, this should not itself be a risk to ER status if the cash has arisen from trading activities and is not actively managed to become an investment activity. It is possible to apply to HRMC for a non-statutory advance clearance on whether the company is a trading company for ER purposes.
The 2015 budget attacked a certain planning device, the “Manco structure”, where small shareholders could form a special purpose company to hold their combined shareholding in the trading group, to get them as a group above the 5% level. These structures now need to be reviewed.
Rollover into purchaser shares and loan notes
It is very common for a vendor to receive shares and loan notes in the purchaser as part of their sale proceeds. Tax-free rollover usually applies to this “paper-for-paper” exchange, so this part of the proceeds and gain is not taxed until the loan notes are redeemed or the new shares sold.
The shareholder must pass the ER tests with respect to the purchaser to claim ER on the gain in the new shares and loan notes when realised. If they don’t meet the employee or officer test, or do not pass the 5% shareholding test in the purchaser, there is no ER on these deferred gains. The legislation does allow the shareholder to elect out of the tax free rollover treatment and pay tax on all of the proceeds received up front, so maintaining ER but accelerating the tax due. Some vendors may prefer to take this approach from a risk management perspective.
Cash earn-outs are also very common. A value for this right to an uncertain future cash earn out is included in the capital gain computation at the time of the deal. If more cash is eventually received, the excess is taxed as a further gain when received. This additional gain is taxed at normal CGT rates with no ER. The value included for the earn-out in the initial gains computation, therefore, needs careful consideration.
The tax team at HMT led by Holly Bedford provides specialist advice to shareholders, management and companies on acquisitions, disposals and corporate restructurings. Do not hesitate to contact us on 01491 579740.