21 January 2022
In 2020, the Chancellor of the Exchequer asked the Office of Tax Simplification (OTS) to undertake a review of capital gains tax (CGT) to ensure that the system is fit for purpose and runs as smoothly as possible. On 30 November 2021, the Government responded to the recommendations made by the OTS.
We were particularly interested in one of the most complex areas of CGT - the sale of a business. In its report, the OTS relayed the view that, ‘understanding the tax rules in this area is beyond even the most sophisticated non-professional taxpayers.’ Clearly it is prudent to take professional tax advice when contemplating such transactions, particularly as the way the payment of the sale proceeds is structured may affect how much capital gains tax is payable, and when it is due for payment.
Tax structuring is a term often bandied about in the context of significant business transactions, and for a person selling a business it is generally used to refer to such things as the timing and type of payments that the seller receives for the business, and the method for quantifying those payments.
Share sales are often structured with an element of deferred payment rather than all proceeds being paid up front in cash, and whilst there may be good commercial reasons why this can be the case it does add complexity from a tax perspective.
For example, imagine Lucy sells her company for £5m on 31 March 2022 and is presented with four potential disposal structures. The disposal qualifies for business asset disposal relief (BADR) and Lucy has not made any previous qualifying disposals, meaning that the first £1m of gain is taxed at 10 per cent and the balance at 20 per cent.
Scenario 1 – Consideration is £5m cash on completion. Tax of £900,000 is due on 31 January 2023.
Scenario 2 – Consideration is £500,000 cash on completion and £4.5m deferred cash consideration which she will receive in 2025. Tax of £900,000 is still due on 31 January 2023, but in this case Lucy only has £500,000 cash from which to pay the tax. She can apply to pay in instalments (which is rarely used as it requires a bespoke agreement with HMRC) or fund the shortfall in cash to pay the tax from other sources.
Scenario 3 – Consideration is £500,000 cash and £4.5m in loan notes. Lucy pays tax at 10 per cent of £50,000 on the £500,000 cash, which is due on 31 January 2023. When she redeems the loan notes, this disposal does not qualify for BADR and so she pays 20 per cent tax and is unable to access her remaining BADR entitlement. Her total tax bill is therefore £50,000 higher than in Scenario 1 and 2.
In this scenario, Lucy could elect to pay tax on the loan notes up front, so that she qualifies for BADR to the maximum possible extent on her gain. Without further structuring, this would leave her short of cash to fund the tax bill as in scenario 2.
Scenario 4 – Consideration is £500,000 cash and an ‘earn-out’, which will be calculated based on future profits. The earn out ‘right’ has to be valued and taxed up front, it is valued at £3m. Tax of £600,000 is due on 31 January 2023. The balance of tax is due when the earn-out ultimately pays out. Again, Lucy does not have sufficient initial cash proceeds to fund the tax payment.
Each of each of these scenarios for the same underlying disposal is taxed differently, and the way that deferred payment arrangements are worded in the transaction documents is critical to the analysis and ultimately the amount and timing of the net cash proceeds the seller walks away with. If expected deferred proceeds are not received in full, there are claims and/or elections that need to be made to reclaim any overpaid tax.
In the context of the challenging economic conditions stemming from the coronavirus pandemic, it is possible that the use of deferred proceeds on the sale of a business could become more common in future as purchasers try to hedge their bets.
The OTS recommended simplifying the tax treatment of deferred consideration so that proceeds are taxed when received, thereby removing the cash flow challenges for a seller, making reporting simpler and removing the need for later claims and elections to adjust the position. To make such a sweeping change fair on sellers there are various issues the OTS has identified that would need to be tackled in the detailed policy design. For example, some individuals will qualify for tax relief at the time they sell their business but will no longer meet the qualifying conditions at the time the proceeds are received. Provision would need to be made to ensure that tax relief in such situations is not lost. There are also a host of other administrative points that would need to be dealt with and it is not hard to imagine that this intended simplification could end up becoming quite complex.
The downside to the Exchequer with this approach would be a delayed tax take, and potentially a lower tax take if individuals have multiple annual allowances to use for each future receipt.
Perhaps not surprisingly, the Government’s decision was to reject the recommendation – it is satisfied with the existing rules and we are in broad agreement. Greater simplification should generally be welcomed, as it often brings greater certainty for the taxpayer. However, whilst the report identified a way to (perhaps) eliminate some of the administrative burden of the proposed alternative approach, the current system, whilst necessarily complex, allows flexibility and therefore the opportunity to finely structure a sale to achieve the right commercial and tax outcome for both purchaser and seller.
Given the importance and value at stake in an event such as a business sale, it is always advisable to talk through your options with an experienced tax specialist ahead of a transaction.