The Choice Is Yours

Shares or assets? JONATHAN HAYDEN and MICHAEL RIDSDALE consider the effect of Finance Act 2002 on transactions to buy and sell companies.

MOST READERS WILL be aware of the conflict that can often arise between buyer and seller as to whether the sale and purchase of a business will take the form of a share deal or an asset deal. Each party will have a preferred route in mind even during the early stages of negotiations and much of the debate will centre around the usual commercial arguments. For example the buyer may not wish to assume any risk of being hit with latent liabilities of the target company and will prefer assets, etc. Such arguments are, however, beyond the scope of this article.

This article looks at a transaction from the point of view of both a buyer and a seller and, in particular, considers changes introduced in the Finance Act 2002. The changes arguably impact on the way in which a business should be valued at the outset by each of the parties. We consider how the new tax rules can be used as a negotiating tool from the earliest possible stages by both parties to achieve an acceptable compromise. Readers are, however, asked to note that this article is not intended to provide a comprehensive discussion of the changes introduced by Finance Act 2002.

The Finance Act 2002 implemented two major changes which will have an impact on the decision-making processes of all parties to a transaction at the early stages of negotiation:

• the participation exemption; and
• a new régime for the taxation of intellectual property.

These are significant changes in themselves, but the wider effect is a dramatic change to the driving forces behind the decision as to whether a deal will take the form of a share sale or a business sale.

Pre-Finance Act 2002

Prior to Finance Act 2002, the decision was relatively straightforward. If a parent company was considering a disposal, the sale of its shares in a subsidiary or a sale of the assets of its subsidiary could crystallise a gain or a loss - but apart from that gain or loss arising in a different company, they were broadly neutral. That said, the main advantage for a seller to dispose of shares would be that it could avoid primary liabilities arising in the company as a result of the disposal.

From an individual shareholder's perspective, the situation was slightly different because of the potential availability of taper relief on the sale of the shares. Through the use of taper relief, a reduced proportion of the gain may have been chargeable depending on the length of time the shares have been held and whether or not they qualify for the more advantageous business assets rates. Accordingly, an individual seller would undoubtedly prefer to dispose of shares, otherwise the company would perhaps pay tax on any gain arising on the disposal of assets and the shareholder would pay tax on the dividend he would receive when liberating the company of the cash.

A buyer, on the other hand, would usually prefer to acquire just the assets. This is administratively more complicated (as the relevant assets would need to be identified), but it would be possible to cherry-pick the desirable assets. The other big advantage is that, by acquiring the assets, there is no danger of assuming latent liabilities or other problems of the target company. Whilst the dangers are minimised (from the buyer's point of view) through due diligence, warranties and a tax covenant, it is often more advantageous for a buyer to assume no liabilities than to have recourse against the seller after the event. However, in making the decision, the buyer would need to consider that a share purchase attracts stamp duty at 0.5 per cent whereas an asset purchase attracts stamp duty at up to 4 per cent - depending on the nature of the assets being acquired and the consideration being paid.

In summary, a buyer would, objectively speaking, and in the absence of commercial reasons to the contrary, prefer to acquire the assets. However, shares could be acquired but protection would need to be built in to the acquisition documentation. A seller, on the other hand, would probably seek to dispose of shares; taper relief would be available to an individual and, from a corporate's point of view, it would prefer not to be saddled with a dormant subsidiary. Accordingly, for either party to be persuaded otherwise would be the subject of commercial negotiation.

Post-Finance Act 2002

Although a conflict may have existed prior to the Finance Act 2002, the introduction of the participation exemption for the disposal of certain substantial shareholdings and the new régime for intellectual property has highlighted the disparity between what is sought by the seller and the buyer (i.e. shares or assets). The two changes are summarised below.

The participation exemption

The participation exemption is designed to promote corporate activity by allowing companies to dispose of their subsidiaries without a corporation tax liability arising on any capital gains. Consequently, if various conditions are met, any gains made on the disposal of a subsidiary are exempt from corporation tax and allowable losses will not be recognised.

In order for the shareholding to qualify, it must exceed ten per cent of both the ordinary share capital and the equity holders' rights (although a higher threshold applies for certain disposals by insurance companies). In addition, this shareholding must have been held for a continuous period of twelve months within the two years preceding the disposal.

In addition to the requirements on shareholding levels, the subsidiary being disposed of must be a trading company or the holding company of a trading group. This means it must not be involved to a substantial extent - believed to be around 20 per cent - in activities other than trading activities. The corporate buyer must also be a trading company (or a member of a qualifying group) before and immediately after the acquisition; there are certain conditions that have to be satisfied in this respect. There is also an anti-avoidance provision which, broadly speaking, applies where the sole or main benefit of an arrangement in relation to shares is to achieve the exemption from corporation tax.

In simple terms then, it is possible for a company to dispose of a subsidiary with no adverse tax consequences arising in its hands.

The intellectual property régime

The new régime for intellectual property (intangible assets) brings the tax treatment and the accounting treatment for intangible fixed assets closer into line. The assets that will fall within the régime are intangible fixed assets (as defined by Financial Reporting Standard 10) and goodwill (which also assumes its accounting definition).

Broadly speaking, for an asset to fall within the new régime it must be acquired from an unrelated party or have been created after 1 April 2002. It is worth noting that some of the rules which determine the date of creation of certain assets are quite restrictive and it should not be assumed that these assets automatically fall within the new régime. For example, if a business has been carried on before 1 April 2002 any goodwill generated in respect of that business will remain within the capital gains tax régime as opposed to the new intangibles régime.

Income and expenditure on assets falling within the new régime will be treated as revenue in nature and, providing United Kingdom generally accepted accounting practice is adhered to, the tax treatment will normally follow the accounting treatment. The system operates through a system of credits and debits, where credits are receipts and upward revaluations, etc. and debits are expenditure and write-downs, etc. There is also scope for the rollover of credits into acquisitions of other intangibles and controlling shareholdings in companies with underlying intangibles.

It is apparent that these rules mean that a buyer is likely to favour an asset deal in transactions involving a significant amount of intangible assets, particularly as the new régime for intangible assets will not be available on a share sale and tax amortisation may be available under the new intangibles régime (see below). The rules also have an effect on the structuring of a wider variety of deals because goodwill is included with the definition of relevant intangible assets.

Financial Reporting Standard 10 deals with the accounting treatment of goodwill and intangible assets and requires that an estimate be made of the useful life of such assets. The expenditure incurred on the acquisition of appropriate assets will be amortised over the life of the asset which, once amortised, should give rise to a tax deduction equal to the value of that expenditure. Due to the resulting tax deduction, which is in effect a saving, the real cost of the acquisition from the buyer's perspective will effectively be reduced.

Assets or shares?

Accordingly, the factors that determine the ideal disposal route for a buyer and seller are in conflict and may, following Finance Act 2002, go beyond 'commercial arguments'.

A corporate buyer now has an extra incentive to favour an asset purchase by virtue of the new régime for intangibles, particularly if there is a large amount of goodwill, as it may be able to benefit from the corresponding tax deduction. This desire to acquire assets has also been fuelled by the abolition of stamp duty on transfers of goodwill and intellectual property, which is clearly of direct relevance to acquisitions of goodwill/intangible property rich businesses.

A corporate seller, on the other hand, is likely to favour a share disposal for historic reasons and because the availability of the participation exemption may mean that there will be no corporation tax liability on the disposal of the shares (consideration will of course have to be given to the detailed provisions of the legislation). The position for an individual shareholder has not really changed and he is still likely to prefer to dispose of shares because he may be able to reduce the amount of the gain that is chargeable through the use of taper relief. This is also more of an issue for individual sellers following this year's Budget, as the taper relief rules for disposals of business assets have changed, the result being that an effective capital gains tax rate of 10 per cent can be achieved after a holding period of only two years.

Just as the disparity between what the seller desires (i.e. shares) and what the buyer desires (i.e. assets) has been widened by recent tax changes, the effect of those changes can be used to strike a compromise that is acceptable to both a buyer and a seller. This is best illustrated by way of an example - see Example 1.

Example 1

In Example 1 it is ultimately cheaper for A plc to acquire the assets of the consultancy business, simply because of the tax deduction that will be available to it. As the net cost to A plc on an asset deal is far lower than the commercially agreed value of the underlying business, A plc has room to manoeuvre on price when negotiating in favour of an asset deal with B Ltd. This can be used as an incentive for B Ltd to dispose of assets as opposed to shares.

Example 2 illustrates how A plc can increase the price it pays to B Ltd for the underlying business without actually paying, in real terms, more than it considers the business to be worth. Accordingly, as this demonstrates, although the new rules appear to create divergence between the seller and buyer, they also provide a real opportunity. In Example 2 the seller has ended up with almost the full £5,000,000 consideration and the buyer has, in effect, secured the business it wanted - an asset deal - but with a dramatically reduced price from the point of view of its bottom line. Therefore, now more than ever, tax plays a vital part in any negotiations and can offer both parties the deal they want.

Example 2

Jonathan Hayden and Michael Ridsdale are both solicitors in the Tax Strategies Unit of Hammond Suddards Edge. They can be contacted on jonathan. hayden@hammondse.com and michael.ridsdale@hammondse.com respectively.

Issue: 3880 / Categories: