Weekly tax brief
CGT revenue growth could slow as business owners explore alternative exit routes
28 February 2023
When business owners are planning for a future exit, there are various options to consider. These include the traditional trade sale route, with or without private equity (PE) backing, PE investment, or options involving those currently in the business such as a management buyout (MBO) or a sale to an employee ownership trust (EOT).
As with most things, there are pros and cons of each option, and the chosen route needs to reflect the business owner’s priorities and longer-term objectives. For example, a trade sale can in some circumstances provide the option of a clean break, whereas PE involvement will mean retaining a stake in the business but can also result in higher multiples and a better price on exit. Whilst deal volumes have reduced from their peak during late 2020 and 2021, there is still a significant amount of dry powder to be deployed by PE, which is keeping the market active and pricing strong.
However, we are starting to see many more enquiries from business owners wanting to explore alternative routes to a traditional exit, which in turn could slow the growth of capital gains tax receipts over the coming years. Many business owners, whilst seeking a ‘fair’ value for the business, will be less motivated by pricing and more interested in other considerations such as continuity of the business, or preservation of a culture which reflects their own values, in which case an EOT or MBO could be attractive.
To encourage employee ownership, there are significant tax advantages for owners who sell a controlling stake in a business to an EOT as, providing certain conditions are met, the capital gain arising is tax free. There are continuing tax benefits to an EOT, such as the ability to pay income tax free annual bonuses to employees of up to £3,600. Whilst there are strict requirements which need to be met to access these advantages, it is perhaps not surprising that EOTs as an exit route have been increasing in popularity.
To put this into context, the number of employee-owned companies is still modest but rapidly increasing – in June 2022 there were approximately 1,030 such businesses, but by December 2022 this had increased to 1,300. In January 2021, 1 in 20 business sales was to an EOT. The most widely known employee-owned business is the John Lewis Partnership (which isn’t in fact a partnership, but a trust structure).
Capital gains tax (CGT) receipts have seen huge growth in recent years, in part due to the sale on shares in unlisted companies, and were £13.2bn in January 2023 alone (compared to £10.7bn in January 2022). The increasing trend of EOT disposals carrying a 0% CGT rate has the potential to cause a significant slowdown in the growth of CGT receipts.
An EOT structure is not appropriate for everyone and there are concerns some may be rushing into such structures for the wrong reasons. On a practical level, thought needs to be given to how the purchase will be funded and the timeframe. Generally, the vendor will require an ‘up-front’ payment of consideration, which may be debt funded, with the balance of consideration being deferred and paid out of future profits of the business. This route will only suit highly profitable businesses which can secure and afford the debt or be able to self-fund entirely. Whilst the tax benefits are tempting, it is important to make sure that the business objectives are aligned with long term employee ownership, as unwinding the structure can be costly from a tax perspective.
An EOT will not be the right option for all businesses, particularly those with a further exit on the horizon, and MBOs are an excellent alternative where there is a strong management team in place who want to drive the next phase of growth of the business. This route, as with an EOT, is unlikely to secure the highest price, but provides other benefits to the exiting owner. These benefits include a lighter touch due diligence and non-financial considerations such as the continuity of the business. The transaction may be funded by profits generated by the business or may be debt funded or PE-backed, with the latter more likely to result in far heavier scrutiny and due diligence process. In most cases, as with an EOT, the consideration will be deferred to ensure cash flow affordability for the ongoing business.
Whilst there are no specific tax reliefs for an MBO, the vendor may be able to claim business asset disposal relief (BADR) and pay a reduced 10% tax rate on their first £1m of gains (this can of course apply to multiple family shareholders who are engaged in the business, to maximise the availability of relief). One of the concerns for business owners can be whether HMRC will accept the MBO is being undertaken for commercial reasons, as the sale proceeds can potentially be taxed like a dividend if not. HMRC’s view on this can be sought in advance and if approved, can allow for a business owner to sell a minority interest in their company to management and be subject to a CGT rate of 10% or 20% on any chargeable gain.
With the deal market cooling and wider uncertainty around what will happen to CGT rates following a general election, it is important that business owners understand the implications of each route and take steps ahead of the event to make sure that they and their business are well prepared.
As with most things, there are pros and cons of each option, and the chosen route needs to reflect the business owner’s priorities and longer-term objectives. For example, a trade sale can in some circumstances provide the option of a clean break, whereas PE involvement will mean retaining a stake in the business but can also result in higher multiples and a better price on exit. Whilst deal volumes have reduced from their peak during late 2020 and 2021, there is still a significant amount of dry powder to be deployed by PE, which is keeping the market active and pricing strong.
However, we are starting to see many more enquiries from business owners wanting to explore alternative routes to a traditional exit, which in turn could slow the growth of capital gains tax receipts over the coming years. Many business owners, whilst seeking a ‘fair’ value for the business, will be less motivated by pricing and more interested in other considerations such as continuity of the business, or preservation of a culture which reflects their own values, in which case an EOT or MBO could be attractive.
To encourage employee ownership, there are significant tax advantages for owners who sell a controlling stake in a business to an EOT as, providing certain conditions are met, the capital gain arising is tax free. There are continuing tax benefits to an EOT, such as the ability to pay income tax free annual bonuses to employees of up to £3,600. Whilst there are strict requirements which need to be met to access these advantages, it is perhaps not surprising that EOTs as an exit route have been increasing in popularity.
To put this into context, the number of employee-owned companies is still modest but rapidly increasing – in June 2022 there were approximately 1,030 such businesses, but by December 2022 this had increased to 1,300. In January 2021, 1 in 20 business sales was to an EOT. The most widely known employee-owned business is the John Lewis Partnership (which isn’t in fact a partnership, but a trust structure).
Capital gains tax (CGT) receipts have seen huge growth in recent years, in part due to the sale on shares in unlisted companies, and were £13.2bn in January 2023 alone (compared to £10.7bn in January 2022). The increasing trend of EOT disposals carrying a 0% CGT rate has the potential to cause a significant slowdown in the growth of CGT receipts.
An EOT structure is not appropriate for everyone and there are concerns some may be rushing into such structures for the wrong reasons. On a practical level, thought needs to be given to how the purchase will be funded and the timeframe. Generally, the vendor will require an ‘up-front’ payment of consideration, which may be debt funded, with the balance of consideration being deferred and paid out of future profits of the business. This route will only suit highly profitable businesses which can secure and afford the debt or be able to self-fund entirely. Whilst the tax benefits are tempting, it is important to make sure that the business objectives are aligned with long term employee ownership, as unwinding the structure can be costly from a tax perspective.
An EOT will not be the right option for all businesses, particularly those with a further exit on the horizon, and MBOs are an excellent alternative where there is a strong management team in place who want to drive the next phase of growth of the business. This route, as with an EOT, is unlikely to secure the highest price, but provides other benefits to the exiting owner. These benefits include a lighter touch due diligence and non-financial considerations such as the continuity of the business. The transaction may be funded by profits generated by the business or may be debt funded or PE-backed, with the latter more likely to result in far heavier scrutiny and due diligence process. In most cases, as with an EOT, the consideration will be deferred to ensure cash flow affordability for the ongoing business.
Whilst there are no specific tax reliefs for an MBO, the vendor may be able to claim business asset disposal relief (BADR) and pay a reduced 10% tax rate on their first £1m of gains (this can of course apply to multiple family shareholders who are engaged in the business, to maximise the availability of relief). One of the concerns for business owners can be whether HMRC will accept the MBO is being undertaken for commercial reasons, as the sale proceeds can potentially be taxed like a dividend if not. HMRC’s view on this can be sought in advance and if approved, can allow for a business owner to sell a minority interest in their company to management and be subject to a CGT rate of 10% or 20% on any chargeable gain.
With the deal market cooling and wider uncertainty around what will happen to CGT rates following a general election, it is important that business owners understand the implications of each route and take steps ahead of the event to make sure that they and their business are well prepared.
