Alistair Darling's proposed capital gains tax reforms (announced in October 2007) were met with a hard 'push-back' from business leaders. Having been used to a 'tapered' CGT rate of 10% for almost a decade, owner-managers and entrepreneurs were very upset that their CGT rate would almost double to 18% when they sold their companies/businesses after 5 April 2008.
In January 2008, Darling attempted to deal with these concerns by announcing a new-style entrepreneurs' relief (ER) from 6 April 2008. I dealt with the main aspects of ER in last month's edition of Accountancy (p92). However, 'Murphy's law' prevailed and that article was passed for publication shortly before the draft legislation was (finally!) issued on 28 February 2008. My March 2008 article did not therefore cover the new 'transitional' ER rules which apply to gains held over on pre-6 April 2008 loan notes which crystallise under the new CGT regime.
This article builds on my previous one and deals with the ER treatment of corporate share sales that contain consideration satisfied in the form of shares and/or loan notes.Key conditions for ER
For share sales executed after 5 April 2008, the key qualifying conditions for ER (contained in s169I Taxation of Chargeable Gains Act (TCGA) 1992 (draft)) which must be satisfied throughout the 12 months before the sale are as follows:
• the shares must be held in a trading company or holding company of a trading group (defined in a similar way to the 'old' business taper rules); and
• the shareholder must be a director or employee of that company/fellow group company and it must be their 'personal company' - ie, they must own at least 5% of the ordinary share capital (carrying at least 5% of the voting rights).
These conditions are relatively restrictive when compared to the (pre-6 April 2008) business taper regime. Although most owner-managers should have little difficulty in satisfying the relevant tests, the minimum 5% voting rights requirement will disqualify many minority shareholders (including employee shareholders).
ER is limited to the first £1m of qualifying gains, which are taxed at 10%. ER achieves this by reducing the relievable element of the gain by 4/9ths. Table 1 shows the computation of ER for different levels of qualifying share sale gains. The relief is capable of applying to multiple disposals up to a cumulative lifetime limit of £1m.
|Less: ER (4/9ths reduction)*||(222)||(444)||(444)||(444)|
|CGT @ 18%||50||100||280||820|
|Effective tax rate||10%||10%||14%||16.4%|
* Restricted to a maximum of £1m x 4/9ths
Many company takeovers, particularly by listed companies, will entail the purchaser issuing new shares to the vendor shareholders as part of their sale consideration. This enables the vendor to defer their capital gain until the shares are sold. Such share exchanges normally fall within s135 TCGA 1992 (provided the 'bona fide commercial purpose' test in s137 TCGA 1992 is satisfied). This brings the CGT reorganisation rule in s127 TCGA 1992 into play, which means the vendor does not make any disposal of their old shares and is treated as receiving the new 'consideration' shares at the same time and cost as their old shares.
Because the 'reorganisation' rule provides there is no CGT disposal, the vendor would not normally be able to claim ER on the sale consideration satisfied by the acquirer's shares (post-5 April 2008). This would be unfortunate if the vendor was unable to claim ER on a later sale of their 'consideration' shares - for example, because they did not possess the requisite 5% shareholding in the acquiring company.
The draft ER legislation recognises this problem and provides that the vendor can make a special election (under s169Q TCGA 1992 (draft)) to opt out of the normal share-for-share exchange treatment. By making a s169Q election the vendor is treated as having made a normal CGT disposal with the value of the acquirer's shares being reflected in the overall sale consideration. In such cases, the benefit of the ER would be reflected in the (higher) market value base cost of the shares in the acquiring company. The CGT mechanics of making the election are illustrated in the worked example in Table 2.
Peggy Sue has been a ‘management’ shareholder since June 2000 and holds 10% of the equity share capital of Holly Ltd (a successful music publishing and recording company). She acquired her 10,000 £1 shares at their full market value of £40,000.
In May 2008, Holly Ltd was taken over by Buddy plc. As part of this transaction, Peggy Sue received sale consideration of £600,000, which was satisfied as follows:
|Shares in Buddy plc, valued at||400,000|
Peggy Sue’s shares in Buddy plc represented a 3% shareholding (with commensurate voting rights). She was therefore unlikely to qualify for ER on their subsequent sale.However, by making a s169Q TCGA 1992 (draft) election, she could benefit from ER on the total consideration received on the May 2008 sale, as shown below:
|Buddy plc shares||400,000|
|Less: Base cost||(40,000)|
|Less: ER - £560,000 x 4/9||(248,889)|
|Gain after ER||311,111|
|Less: Annual exemption||(9,600)|
|CGT @ 18%||£54,272|
Peggy Sue's base cost of her Buddy plc shares would be their full market value of £400,000 (as opposed to £26,667 (4/6 x £40,000), being the pro rata original cost of her Holly Ltd shares if the reorganisation rules had applied).
The s169Q election is made on an 'all or nothing' basis. It is not therefore possible to restrict its application to gains of £1m. Such elections must broadly be made within 22 months after the end of the tax year in which the sale occurs.
The potential consequences of making a s169Q election should always be considered when structuring any deal. Because the reorganisation rule is disapplied, the vendor would generally incur a CGT liability on the 'ER-relieved' gain. The vendor would therefore need to ensure they had sufficient cash consideration to fund the tax liability. Clearly, such an election would not be appropriate where the 'cash' element of a company share sale produced chargeable gains exceeding the ER limit of £1m.ER interaction with QCB loan notes
Most types of 'non-convertible' loan note constitute qualifying corporate bonds (QCBs). Where QCBs are received as consideration for a share sale, the CGT deferral mechanism works in a different way from share exchanges (since QCBs are not chargeable assets for CGT purposes). The relevant tax treatment is governed by s116(10) TCGA 1992, which provides that the chargeable gain on the loan note consideration is computed at the date of the share sale. This gain is then postponed and becomes taxed only when the loan note is encashed or sold.
Where QCBs are received on a post-6 April 2008 share sale, any available ER would be deducted in arriving at the held-over gain. This means that the 'carried-forward' gain reflects any ER that was available and claimed at the original sale date.
Special rules apply to QCB loan notes that were acquired as consideration for a pre-5 April 2008 share sale. Taper relief ceases to be relevant where QCB gains are crystallised under the new CGT regime. However, Revenue & Customs has considered that it would be inequitable to grant no form of transitional relief and has introduced special rules to enable ER to be claimed in such cases (para 6 of the draft ER schedule). ER (not business taper relief) can be claimed on the QCB gain becoming chargeable on a post-5 April 2008 redemption provided the vendor would have been entitled to ER on the original pre-6 April 2008 share sale. (For this purpose, it is assumed that the ER legislation had been in force then.) However, the relief will not always be available (for example, the vendor may have sold a very small (less than 5%) holding on the original sale. Table 3 shows how ER can be claimed on a (pre-6 April 2008) QCB that is redeemed under the new regime. For these purposes, the transitional ER claim must be made within (approximately) 22 months following the tax year in which the held-over gain crystallises.
In June 2006, Jennifer Eccles sold her 100% shareholding in The Hollies Ltd to Bus Stop plc. Jennifer had formed The Hollies Ltd in April 1999, subscribing for 1,000 £1 ordinary shares at par.The Hollies Ltd had always qualified as a trading company under the taper regime. On the sale in 2006, Jennifer received sale consideration of £6m, £4m of which was paid in cash on completion and £2m was satisfied by a Bus Stop plc loan note. All relevant tax clearances were applied for and given on the sale.
The Bus Stop plc loan note (which was structured as a QCB) was redeemable at any time after 30 June 2008. On the assumption that Jennifer redeems her £2m loan note in (say) July 2008, her CGT position would be as follows:
1. Her postponed gain (calculated before taper relief ) would crystallise under s116(10) TCGA 1992. No taper relief would be applied since this ceases to be available on chargeable gains arising after 5 April 2008.The gain would therefore be computed as follows
|Less: Part disposal cost:*|
|£1,000 x £2m||(333)|
|(£4m + £2m)|
* The CGT base cost is apportioned between the cash proceeds (£4m) and the loan note (£2m)
2. Since the loan note is being redeemed after 5 April 2008, Jennifer would be entitled to claim ER under the special transitional rules (since she would have qualified for the relief if it had been in force before 6 April 2008).
Therefore, provided she makes a claim for ER, her taxable gain would be £278,212, as shown below
|Chargeable gain (as above)||1,999,667|
|Less: ER (restricted to maximum):|
|£1,000,000 x 4/9||(444,444)|
|Gain after ER||1,555,223|
|Less: Annual exemption||(9,600)|
|CGT @ 18%||£278,212|
These transitional rules only became known when the relevant draft legislation was issued on 28 February 2008. However, many loan note holders have still opted to redeem their loan notes (or sell them) before 6 April 2008 to obtain a business 'tapered' rate of 10% on the entire gain. This was attractive for those loan note holders who would have faced a significantly larger tax liability on a post-5 April 2008 encashment (since the effective ER rate of 10% is restricted to the first £1m of gain). Furthermore, many holders preferred their gains to be banked under the business taper regime as they did not wish to 'waste' their £1m lifetime allowance under these transitional rules.Non-QCBs and ER
The tax treatment of non-QCBs (which are chargeable assets) follows the same rules as share exchanges (see above). Thus, where a non-QCB is received as consideration for a share sale, the vendor is normally treated as acquiring it at the same time and for the same (pro rata) amount as their original shares.
However, vendors can make a s169Q (draft) election to 'bank' ER under the new regime (as explained above). For non-QCBs redeemed after 5 April 2008, ER may be claimed against the chargeable gain on the redemption/disposal provided some fairly restrictive rules are satisfied. ER can be claimed on the gain provided that throughout the period of one year before the redemption/disposal:
• the issuing company (ie, the purchaser) is a trading company or the holding company of a trading group;
• the loan note holder owns at least 5% of the ordinary share capital (which carry at least 5% of the voting rights); and
• the loan note holder works as a director or employee of the issuing company or any fellow group company.
It will be appreciated that such conditions are unlikely to be satisfied in the majority of cases because the vendor/holder will not generally have the requisite 5% equity stake in the acquiring company.Back to a 10% CGT rate!
The scope of ER is certainly not as wide as the former business taper relief. However, ER enables most owner-managers to retain a beneficial 10% CGT rate, so after the intense business backlash and representations, there is no change for gains up to £1m (and we hope that the chancellor will look to increase this limit in future!). ER must therefore always be considered on owner-managed company sales or where 'consideration' shares/loan notes are sold/redeemed under the new CGT regime.
Peter Rayney FCA, FTII, TEP is the national tax technical partner of BDO Stoy Hayward LLP. He is author of 2007/08, recently published by Tottel.