Owner-managers who are contemplating a sale of their company, or are actively in the process of selling it, have been 'ruffled' by the proposed abolition of capital gains tax taper relief. The pre-Budget report 2007 announced that this popular relief will disappear from 6 April 2008.
For many years, owner-managers have generally taken business taper relief and the expectation of an effective CGT 'exit' rate of 10% for granted. However, from 6 April 2008, the tax bill for the sale of a typical owner-managed company is going to increase substantially, when a flat CGT rate of 18% will apply to all disposals. Indexation relief, which often provides a further beneficial reduction, is also being removed from 6 April 2008.
The message is clear - if owner-managers wish to enjoy the beneficent 10% effective CGT rate, they must ensure that any sale of their company is concluded before 6 April 2008. For those who have not even started the sale process, this is likely to be unachievable now. Their best option is probably to consider how they might 'bank' business taper relief before it is abolished.Executing sales before 6 April 2008
Many owner-managers will be accelerating the sale of their company before 6 April 2008 to 'lock' into the beneficial 10% CGT rate. However, a pre-6 April 2008 sale would only be effective in fixing the fully (business) tapered CGT rate of 10% to the extent that the sale consideration is taken in the form of cash. If a fixed part of the consideration is deferred, it will be beneficial to leave this outstanding as a simple debt rather than it being evidenced by a formal note. This will bring the deferred consideration within the CGT charge at the date of the contract under the rule in s48 of the Taxation of Chargeable Gains Act (TCGA) 1992. Although this accelerates the CGT charge, it would only be payable at an effective rate of 10% - which is probably a price worth paying. Furthermore, any CGT liability for 2007/08 does not have to be paid until 31 January 2009 and the deferred consideration may be received by then.
A comparison between the sale of a company under the existing and proposed CGT systems is illustrated in Table 1. It will be seen that if a sale is delayed beyond 5 April 2008, vendors will face a significantly increased CGT liability - no wonder owner-managers are livid about Alistair Darling's proposed scrapping of (business) taper relief!
Where the consideration on a pre-6 April 2008 sale is received in the form of shares or loan notes in the acquiring company, the deferred gains are likely to arise under the post-5 April 2008 regime when the 'consideration' shares/loan notes are sold/redeemed (unless specific action is taken to crystallise the tax before then). Under current proposals, such gains are likely to be taxed at a flat CGT rate of 18%.
For some months Jennifer Eccles has been negotiating the sale of 'her' company, The Hollies Ltd. She expects to sell her company for a cash consideration of £2,000,000 (net of legal and professional costs). Jennifer acquired her 100% shareholding in June 1993 for £100,000.
Indicative CGT liabilities for a sale before 6 April 2008 and afterwards are given below:
|Pre-6 April 2008||Post-5 April 2008|
|Net sale proceeds||2,000,000||2,000,000|
|Less:||Acquisition cost (June 1993)||(100,000)||(100,000)|
|£100,000 x 0.153 (RPI increase between June 1993 to April 1998)||(15,300)||-|
|Less:||Business asset taper relief|
|1,884,700 x 75%||(1,413,525)||-|
|Tapered gain/Chargeable gain||471,175||1,900,000|
|Less:||Annual exemption (say)||(9,200)||(9,500)|
|CGT @ 40%||£ 184,790|
|CGT @ 18%||£340,290*|
* It is assumed that no quasi-'retirement relief' is available
Many company takeovers, particularly by listed companies, will entail the purchaser issuing new shares to the vendor shareholders as part of the sale consideration. This enables vendors to defer their capital gain until the shares are sold. The CGT reorganisation rule in s127 TCGA 1992 is applied here (provided the CGT share exchange rules in s135 TCGA 1992 and the 'commercial' purpose test in s137 TCGA 1992 are satisfied). This means that vendors do not make any disposal of their old shares. Instead, they are treated as receiving the new 'consideration' shares at the same time and cost as their old shares.
Vendors will only realise their gain when the consideration shares are sold. Taper relief will therefore only be a relevant factor in the determination of the vendor's CGT liability provided the consideration shares are sold before 6 April 2008. The CGT reorganisation rule permits a vendor's period of ownership for taper purposes to continue after the sale. However, the vendor's 'post-sale' period may not always qualify as a business period. For example, if the acquiring company was listed, the vendor would not accrue business taper if they had no employment/directorship within the acquiring 'group'. This would lead to a dilution in their available taper on sale.
On the other hand, if the acquirer is unlisted (or AIM listed) or the vendor continues to work in the acquiring group after the sale, the vendor's consideration shares will continue to accrue business taper. In such cases, vendors are more likely to consider arranging to sell their 'consideration' shares before 6 April 2008 to pick up a 10% CGT rate. This may not always be a straightforward matter for listed shares, since the vendor may be subject to certain restrictions on the timing of their share sales under the original sale agreement. The vendor would also need to consider whether a sale would be a good investment decision. It is always possible, of course, to re-acquire the shareholding but the CGT planning would only be effective if the purchase was made more than 30 days after the sale. This is to avoid the 'anti-bed and breakfasting rule', which would otherwise match the reacquisition cost (as opposed to the pro-rata cost of the original shares) with the sale proceeds.
Alternatively, the shares could be transferred into a (settlor-interested) trust to trigger a gain by reference to their market value. The inheritance tax consequences would also need to be considered, although many AIM listed shares are likely to qualify for 100% IHT business property relief. As the acquirer's shares would have been acquired under the CGT reorganisation rule, the two year ownership requirement for business property relief would be counted from when the original shareholding was acquired (s107(4) Inheritance Tax Act (IHTA) 1984).Dealing with 'loan note' consideration
In many deals, the vendor may agree to accept deferred payment for part of the sale consideration by taking loan notes in the acquiring company. In such cases, an appropriate part of the vendor's gain is deferred until the loan note is redeemed for payment. This rule is subject to Revenue & Customs being satisfied that the loan note has been issued for genuine commercial reasons and not mainly to avoid tax (s137 TCGA 1992). The vendor would normally apply for a s138 TCGA 1992 clearance to seek advance confirmation of this point from the Revenue. The mechanics of the CGT deferral and hence any available taper relief depends on whether the loan note is a qualifying corporate bond (QCB) or a non-QCB.
Broadly, most 'non-convertible' loan notes will represent QCBs. The capital gains deferral mechanism for a QCB is governed by the rules in s116 (10) TCGA 1992. These provide that the chargeable gain on the loan note consideration is computed at the date of sale. This gain is then postponed and becomes taxed only when the loan note is encashed (or otherwise disposed of outside the cases specified in s116 (11) TCGA 1992). Taper relief will only be applied to the postponed gain if it crystallises before 6 April 2008 and para 16, Sch A1, TCGA 1992 provides that the taper relief is only calculated up to the original sale date (rather than the date of redemption).
After 5 April 2008, no taper would be given, and the gain on encashment would be taxed at 18%.Loan notes received on earlier sales
Where a company has been sold in the past few years, it is likely that most shareholders would have been on 'maximum' business asset taper of 75% (having amassed at least two complete years of qualifying ownership before the sale). In such cases, taking a loan note in the form of a QCB was often considered beneficial. Vendors were advised that QCBs enabled them to 'bank' the maximum (business) taper relief entitlement (since they would not be exposed to any post-sale dilution in taper). However, the proposed abolition of taper relief will have altered these expectations unless the loan note can be encashed before 6 April 2008!
However, some vendors who have received loan notes as part of their sale consideration may find that no redemption can be made before 6 April 2008. (The Revenue insists that they must have a minimum redemption period of six months). In such cases, the vendors/loan note holders may seek to negotiate an early pre-6 April 2008 redemption with the acquiring company. Such negotiations may require acquirers to review such aspects as banking covenants etc, and they may therefore seek a 'slice' of the holder's CGT saving as part of the deal. Where the purchaser still requires the funding, it may be possible to redeem the loan note (which will crystallise the CGT) with all or part of the proceeds being lent back to the purchasing company as a separate loan/debt.
Where a loan note is redeemed early, this will not normally have been covered by the original s701 Income Tax Act (ITA) 2007 tax clearance obtained on the sale. The redemption of a loan note would constitute a 'transaction in securities' within s698 ITA 2007. However, while it is possible to construct a robust argument for not seeking a further s701 ITA 2007 clearance for the early redemption (because the tax advantage is purely a CGT one), some feel that it would be prudent to seek a fresh s701 clearance.
The CGT implications of redeeming a QCB loan note (under the pre-6 April 2008 regime and afterwards) are shown in Table 2.
In some cases, vendors will have taken loan notes which were structured as non-QCBs. These would be subject to a different CGT deferral mechanism. Non-QCB loan notes represent a security for CGT purposes and are treated as being exchanged under s135 TCGA 1992 (and therefore follow the 'share exchange' rules discussed above). The appropriate part of the vendor's original base cost in the target company's shares is therefore treated as given for the non-QCB security at the original acquisition date(s).
With a non-QCB, the vendor's taper accrual would continue up to the redemption of the loan note. However, this means that the loan note holder would be exposed to a dilution in their taper relief where part of their post-sale period was a non-business one for taper relief. Clearly, such taper relief issues are only relevant where the non-QCB is encashed or otherwise disposed of before 6 April 2008. After 5 April 2008, the gain arising on the redemption of a non-QCB (which would normally be computed by reference to an appropriate part of the vendor's original base cost), is likely to be taxed at the flat CGT rate of 18%.
In June 2006, Bobby Joe sold his 100% shareholding in Equals Ltd to Viva plc. He had formed Equals Ltd in April 1999, subscribing for 1,000 £1 ordinary shares at par. Equals Ltd has always been a trading company for taper relief purposes.
On the sale in 2006, Bobby received sale consideration of £3m, £2m of which was paid in cash on completion and £1m was satisfied by a Viva plc loan note. All relevant tax clearances were applied for and given on the sale.
The Viva plc loan note carried an interest coupon of 8% and was redeemable at any time after 31 December 2007. It was agreed that the £1m loan note would be structured as a qualifying corporate bond (QCB).
If Bobby redeems his loan note before 6 April 2008, he would qualify for full business taper relief up to June 2006 sale. His postponed chargeable gain would be computed as follows:
|Less: Part disposal base cost*|
|£1,000 x (£1m/(£2m + £1m)||(333)|
* The CGT base cost is apportioned between the cash proceeds (£2m) and the loan note (£1m)
When the redemption takes place (before 6 April 2008), business taper relief would be applied to Bobby 's chargeable gain and therefore his CGT liability (for 2007/08) would be £96,287, calculated as follows:
|Less: Business taper relief @75%||(749,750)|
|Less: Annual exemption||(9,200)|
|CGT at 40% (Bobby's marginal tax rate)||96,287|
However, if Bobby encashed his loan note after 5 April 2008, his postponed chargeable gain would be dealt with under the new CGT regime. This would mean that the postponed gain is taxed at a flat rate of 18% (irrespective of the period of share ownership etc).
Thus, assuming the loan note was redeemed in (say) March 2009, Bobby's CGT liability would be £178,230, calculated as follows:
|Less: Annual exemption (say)||(9,500)|
|CGT at 18%||178,230|
Clearly, it would be very beneficial for Bobby to redeem his loan note before 6 April 2008 to secure the benefit of the business taper deduction. Although he would pay his CGT a year earlier (31 January 2009 for 2007/08), the interest cost of paying the tax early would only be around (say) £8,000. Taking everything into account, this would mean that the overall saving is around £74,000 (£178,230 less (£96,287 + £8,000)).
Under the taper regime, most earn-outs on share sales were structured so that they would be satisfied by loan notes (which would be issued when each earn-out tranche was determined). This enables the 'deferral' mechanism in s138A TCGA 1992 to apply (automatically) and avoids the vendor suffering an 'up-front' CGT charge on the value of the earn-out right under the principles established in Marren v Ingles (1980) STC 500. (The same rules apply to shares issued as earn-out consideration.)
By falling within s138A TCGA 1992, the vendor is treated as exchanging his original shares (normally partly) in exchange for a deemed non-QCB security (representing the earn-out right) under s135 TCGA 1992. For pre-6 April 2008 deals, s138A has the effect of extending the vendor's taper period in the same way as an actual non-QCB. Provided the acquiring company or group has the requisite 'trading' status and one of the relevant qualifying conditions is satisfied (for example, the vendor is continuing to work for the target company, as will often be the case under an earn-out arrangement), this will qualify as a business period. When the actual 'earn-out' consideration loan notes are issued, there will be a further CGT deferral into those loan notes for CGT purposes. However, business taper relief will only be applied to earn-out loan notes redeemed before 6 April 2008 (under the rules explained above).
From 6 April 2008, taper will cease to apply to the deemed s138A debenture and the earn-out consideration loan notes, since it will no longer be relevant. Consequently, for earn-out deals concluded over the past few years, vendors should consider whether it is still beneficial for their earn-out consideration to be taxed under s138A. In some cases, vendors may find it advantageous to make a s138A(2A) election to disapply the s138A deferral relief. The efficacy of this strategy would depend on a number of factors, including:
• the ability to agree a substantial value for the earn-out right - which should bring most of the CGT charge into the pre-6 April 2008 taper relief regime and hence mean that it is taxed at an effective rate of 10%;
• the timing of the 'earn-out' tax charges - maximum savings would occur when all or substantially all of these arise after 5 April 2008 and would otherwise be exposed to the 18% CGT charge. (Broadly, any excess of the actual earn-out payments over the initial value of the right would then be subsequently taxed under the flat rate of 18%.)
It is still possible to make s138(2A) elections to disapply the CGT deferral treatment for earn-out deals made in 2006/07 and 2007/08 by 31 January 2009 and 31 January 2010 respectively.
Those that are currently entering into earn-out transactions before 6 April 2008 might wish to enter into a 'cash-based' earn-out deal and seek to obtain the maximum possible value (appropriately discounted for contingency and delay in receipt) for the earn-out right (in anticipation of the CGT changes). Alternatively, a loan note-based earn-out deal may offer more flexibility, since this would give more time to prepare the appropriate valuations to determine whether to opt out of the s138A deferral regime.Lack of certainty
This article assumes that the 2007 pre-Budget report's CGT proposals will be enacted as announced but the existing CGT legislation will continue to apply. However, given the overwhelming criticism of the proposed abolition of taper relief (and the 10% effective CGT rate for business assets in particular), it is possible that these measures may be amended or even ditched before they reach the statute book.
The indications are that Mr Darling will not wish to make such a drastic U-turn on his first pre-Budget report, although he has opened up a dialogue with business leaders to discuss his proposed CGT regime. At the time of writing, it is quite possible that some concession may be given to those owner-managers selling on 'retirement' (it has been rumoured that the first £100,000 of 'retirement' gains may be completely exempt).
One thing is clear though - vendors can only be certain of their tax treatment by taking action before 6 April 2008.
Peter Rayney FCA, FTII, TEP is the national tax technical partner of BDO Stoy Hayward LLP. He is author of , recently published by Tottel
See also ICAEW section, p120