Elephant traps on company sale – Capital Gain Tax

Elephant traps on company sale – Capital Gain Tax

Shareholders expect to pay tax CGT on a share sale, hopefully with 10% tax under Business Asset Disposal Relief (BADR) (previously known as Entrepreneurs’ Relief).  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 very awkward conversations.

Elephant traps fall in two main categories:

  1. a loss of the 10% BADR rate so all gains are taxed at the full CGT rate; or
  2. sale proceeds are taxed under income tax rather than CGT giving much higher rates of tax potentially with NIC on top.

This article covers the first category, looks at risk areas on a deal and planning points when structuring the sale proceeds.

BADR tests

BADR is available where in the 2 years leading up to the sale:

  • the shareholder has been an employee or officer of a group company;
  • the shareholder has held at least 5% of the ordinary share capital, voting rights and economic rights of the company; and
  • the company is (or was within 3 years) a trading company or holding company of a trading group

The 5% test

The 5% of ordinary share capital test looks at nominal value. 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 what are called ordinary and preference shares are not actually so for the purposes of this test.

This can lead to shareholders believing they qualify for BADR but failing the tests when the strict tax definitions are applied.  This is something to check well in advance of a sale if possible.

Trading?

This could be an issue where the company has material non-trading assets or activities such as commercial property that it lets out to third parties, an active investment portfolio or non-group loans.  High cash balances can cause concern depending on how they have built up and how they are managed.

Rollover into purchaser shares and loan notes

It is very common for a vendor to receive shares and loan notes in the purchasing company as part of their sale proceeds.  A 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.

To claim BADR on the gain realised in the new shares and loan notes when they’re sold, the shareholder must pass the BADR tests in force at that time, if BADR even exists at that time, with respect to the purchasing company.  If they will not be employees of the purchasing company, or will hold less than a 5% shareholding, there is no BADR on these deferred gains.

The legislation does allow the shareholder to elect out of the tax-free rollover treatment and pay tax on all the proceeds received up front, so allowing them to claim BADR but accelerating the tax due.  Some vendors may also prefer to take this approach from a risk management perspective, if they expect tax rates to increase in future.

Earn-outs

Cash earn-outs are also very common.  An estimated value for this uncertain future cash is included as proceeds in the CGT computation at the time of the deal. If more cash is eventually received than was estimated, the excess is taxed as a further gain when received.  This additional gain is taxed at normal CGT rates with no BADR.  The value included for the earn-out in the initial gains computation, therefore, needs careful consideration as there is a balance between cash-flow and higher tax rates.

 

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