The disposal of a business should always be driven by the commercial objectives of the buyer and the seller and tax planning should not distract from this. However, ensuring an exit is implemented in the most tax efficient manner can help bridge any commercial disparities between the two parties. Often tax planning structures require to be put in place prior to a disposal but, without a crystal ball, it is difficult to predict when an exit opportunity will arise. However, reviewing the existing company structure and shareholding profile should be considered to increase tax efficiencies prior to selling an entrepreneurial company.
The main tax relief that a seller will want to secure on a disposal of their shares is Entrepreneurs’ Relief (“ER”) which allows the first £10m of gains to be taxed at a 10% Capital Gains Tax (“CGT”) rate. There are some traps that the unwary can fall into which would result in their shareholding not meeting the sometimes complex conditions attached to ER. In summary, the conditions attributable to the disposal of a company are;
- the relevant company must be a “trading company”,
- the individual must be an officer or employee of the company,
- the company must be the individual’s “personal company”
and each of these conditions must be met throughout the 12 month period ending with the date of disposal.
Firstly it is important to ensure the company is trading. HMRC’s definition of a trading company is “a company carrying on trading activities whose activities do not include, to a substantial extent, activities other than trading activities”. In this context HMRC consider substantial to mean a combination or more than 20% of turnover, company assets, expenses incurred, or time spent by officers or employees on non-trading activities. This can be an issue for many companies over time as the business grows, there may be acquisitions of investment properties, expansion into different non-core activities and non-trading investments made with the company’s excess cash. One way of ensuring the trading part of the business is not tainted by any non-trading activity is to restructure or demerge the activities. There are various methods in which a demerger or restructure can be effected, however it is important that this is planned and considered carefully to ensure that there is little or no tax leakage arising from the restructure. The most common methods of splitting or partitioning a company or group of companies is to utilise Insolvency Act rules or utilise Companies Act via a reduction of capital. Both methods allow businesses to demerge and access tax reconstruction reliefs to achieve the restructure in a tax neutral manner. Care needs to be taken over Stamp Duty and Land and Buildings Transaction Tax reliefs when undertaking a demerger. This is especially relevant if the business is being split between different shareholding groups as there is likely to be some unavoidable stamp taxes incurred. However, this may be a price worth paying if ER can be secured on the trading part of the business. Similarly, VAT Transfer of a Going Concern conditions should be considered to ensure no VAT will arise on the restructure.
The other ER qualifying condition which can cause complications is the definition of “personal company”. An individual’s personal company is one in which they hold at least 5% of the voting rights and 5% of the Ordinary Share Capital (“OSC”). This can cause confusion where there are multiple classes of shares, each with different rights, nominal values and shareholder groups. The vesting of rights held by certain shareholders or the exercise of share options prior to an exit event can also cause existing shareholders to be diluted below the requisite 5%. An understanding of whether shares are deemed to be OSC is also required. HMRC define OSC as all of the company’s issued share capital, other than capital the holders of which have a right to a dividend at a fixed rate but no other right to share in the company’s profits. Therefore, assumptions may be made that Preference Shares, for example, will into this category and are not OSC. However the rights attaching to the company’s share capital require to be reviewed in detail as there can be situations where Preference Shares have more than just a fixed dividend right, they may have entitlement to share in the profits of a company on an exit or winding up and if this is the case they will be deemed to be OSC for ER purposes. This can cause dilution to other share classes.
HMRC are currently consulting on a proposal to secure ER in situations where shareholders will be diluted below 5% through new investment or the exercise of share options. This is welcome news however may only help if sellers realise there is a potential dilution issue in the first place.
In summary it is recommended that focus is given to the trading requirements and personal company conditions well in advance of a sale so there is time to ensure any issues can be rectified and improved.
As well as the ER points noted above, there are various other tax considerations which the owner managed business should review prior to a sale. This includes utilising other family members CGT allowances, exemptions and reliefs; an appraisal of the IHT and wealth planning impact of the disposal as well as ensuing there are no surprises which could be discovered during pre-sale diligence process. Consequently undertaking an internal diligence process prior to marketing the company for sale is recommended.
For more information contact Kevin Meaney, Partner (email@example.com) or your usual AAB Advisor.