Structuring a business sale from a tax perspective

This is relevant across a wide range of sectors that we advise on from a shareholder transaction perspective, but it often crops up in the financial services sector specifically.

The structure of the deal can significantly impact the financial outcome for the vendors. 

Background 

Recent transactions in the financial services sector, whereby we have advised the vendors on the sale of a majority stake in their business to third parties, have changed quite considerably in structure throughout the process.

The initial offers from the purchasers frequently comprised multiple elements of consideration for the vendors, for example cash on completion, earn-outs, deferred cash consideration and equity in the purchaser.

The equity in the purchaser can often be structured as cash payments at completion, with the vendors then being required to reinvest in ordinary shares, preference shares and/or loan notes in the purchaser.

The various forms of consideration provide several tax issues for the vendors that need to be managed carefully.

This is to ensure that any tax liabilities that arise on the disposals are aligned with the timing of the cash being received by the vendors.

Equity roll up rather than reinvestment 

The purchaser equity element, when structured as a reinvestment using their cash completion payment, has specific capital gains tax implications.

It results in the entire consideration being taxable for the vendors in the year of disposal, leading to a tax charge in excess of cash received and a cash flow issue for them.

For a transaction which completed in the 2023/24 tax year, the associated capital gains tax would be payable by January 31 2025.

If a share exchange structure is implemented the vendor would be subject to CGT only on the cash element of the proceeds received

However, with a complex consideration structure, in many cases the vendors would only have received a small amount of cash on completion relative to the value of the transaction, which was subject to tax on completion.

A better approach is therefore to structure the transaction so that vendors exchange their current shares for shares or securities in the purchasing business.

To take a simple example, imagine a vendor receives total consideration on a transaction of £5m; split £1m in cash on completion and £4m worth of equity in the buyer structured as a reinvestment.

The vendor would pay CGT on the total proceeds of £5m, resulting in tax of £1m payable by January 31 in the year following the tax year of completion.

After taking into account various transaction deal fees, the vendor is actually at a cash flow disadvantage as the entirety of the proceeds which they received in cash are required to pay the CGT bill.

Conversely, if a share exchange structure is implemented the vendor would be subject to CGT only on the cash element of the proceeds received.

Continuing the example above of £1m in cash proceeds, CGT payable would therefore only be £200,000 in the year of disposal.

The effect of the exchange provisions is that the shares received by the vendors on the transaction inherit the relevant proportion of the original base cost and acquisition date of the vendors’ original shares.

This means the new shares acquired would stand in the shoes of the vendors’ existing shares and the inherent gain of £4m would be rolled over into the Newco’s shares.

Conditions

In order for the share exchange provisions to apply, there are a number of conditions that need to be met.

The most common condition we see from a shareholder transaction perspective for vendors, is that as a consequence of the exchange, the acquiring company holds more than 25 per cent of the vendor company’s share capital.

Different share rights amongst various share classes, sweet equity allocation and the level of management rollover can make this condition complicated to review.  

Another area of complexity in relation to the share exchange provisions is the classification of the buyer.

For example, these provisions only apply where the ‘company’ issues ‘shares or debentures’. If the buyer is a UK limited company, then this condition should be fairly straight forward to analyse, but if for example there is a US LLC involved in the acquisition, the treatment may require further review. 

A further note on the exchange provisions is that the deferral of CGT is automatic, it is not an election which is made by the vendors, and therefore careful consideration needs to be given to the structure of the transaction.

In circumstances whereby an individual qualifies for Business Asset Disposal Relief, there is a specific election which can be made to opt out of this automatic rollover treatment.

This provides qualifying shareholders with an element of flexibility as they have the opportunity to decide whether they would rather pay CGT on the rollover element at the time of disposal as well.

There is usually a timing advantage as this decision doesn’t need to be made until the tax return submission due date, which could be up to 20 months later.

By this time, a vendor may have further information on potential timing of a secondary transaction or other investment decisions which may influence their choice of making this election or not. 

Other tax risks

Examples of other tax risks which regularly crop up in transactions and would be worth discussing with clients is key relationship holders operating through personal service companies and the treatment of earn-outs.

This can open up a wide range of tax complications in the run up to a transaction and, if approached early enough in the process, can be resolved well in advance of causing any real headaches on the deal itself. 

From a tax perspective an earn-out right can be ascertainable (where the amount can be determined at the time of a transaction) or unascertainable (where the calculation of the amounts depends on events which have not taken place) and whichever category the earn-out falls into can have a big impact on the tax treatment.

If an earn-out is ascertainable, therefore the amount which a vendor would receive is fixed at completion, then the full cash amount is brought into the tax computation in the year of disposal.

This again, can cause cash flow complications for vendors if the earn-out does not pay out until after the CGT is due. 

If an earn-out is unascertainable for tax purposes at the point of the disposal, a valuation will need to be made to estimate the value for the earn-out under the Marren V Ingles principle.

Under this principle, the right to receive future unascertainable consideration is a chargeable asset in itself and the value of the right is to be included as part of the original consideration.

This is applicable to both a cash and a securities element. This value is taxable in the year of disposal and forms the base cost for the disposal of the earn-out right in the future.

Complexity arises surrounding the value of the potential earn-out and the tax treatment if there is a loss on disposal of the right to receive future income.  

Ross Stupart is a tax partner at RSM UK