Company Share Sales - Plan Ahead!

In the first of a series of four articles from Burges Salmon relating to the sale of shares in private companies, JOHN BARNETT ATII, solicitor suggests some pre-sale tax planning ideas affecting individual vendors.

THIS ARTICLE CONSIDERS points relevant to an individual vendor before the sale of the company completes. Later articles will look at similar issues for corporate vendors, the contractual documentation and the purchaser's position. All references are to Taxation of Chargeable Gains Act 1992 unless otherwise stated.

 

Benchmark of tax planning

 

Since 1998, the starting point in any capital gains tax planning for individual vendors has been the availability of taper relief and, particularly, the enhanced rates of taper relief available for business assets. No vendor wants to pay tax, but faced with a headline ten per cent tax rate after 6 April 2002, many will conclude that this is a better alternative than the more provocative tax planning schemes on the market.

The availability of taper relief should be checked carefully, however. Common reasons as to why a ten per cent tax rate may not apply include:

• A non-business period (often arising prior to 6 April 2000). Where business-asset status starts on 6 April 2000, vendors need to be aware that the ten per cent rate will not apply until 6 April 2010. Trustees should pay particular care.
• Target is an investment company or has substantial non-trading activities (for instance a significant cash surplus).
• Limited exposure to fluctuations in value such as put and call options (paragraph 10 of Schedule A1). Target's Articles and any shareholders' agreement need checking carefully.
• A relevant change of activity by Target (paragraph 11 of Schedule A1).

 

Extending or amending the period

 

If full business asset taper relief is not available, the next step is usually to consider how it might become so. There are two main options.

The taper relief period can be restarted, for instance, by a transfer to a settlor-interested life-interest trust. This may be appropriate if there is a non-business period or if retirement relief is still available. The calculations invariably need to be reworked on each occasion (see Example 1).

Example 1 Jones (a 40 per cent taxpayer) has held four per cent of the shares in Target Ltd since before 17 March 1998. The shares show a gain of £500,000. The shares were not business assets until the change in the law on 6 April 2000. Applying the rules in paragraph 3(2) of Schedule A1 gives an effective tax rate on each quarter date approximately as shown in the top graph immediately below. If Jones had set up a trust for himself on 6 April 2000, this would have restarted his taper relief period. He is worse off until 6 April 2004 but thereafter better off. If he does make a disposal before 6 April 2004, he should wait until just after 6 April in each year due to the stepped nature of the relief. See the lower graph which gives a broad indication of how the steps compare with the top graph.

The alternative is for loan notes (or less commonly shares) to be taken from the purchaser. If loan notes are used to extend a taper relief period, they will generally need to be structured as non-qualifying corporate bonds rather than as qualifying corporate bonds (see Figure 1).

Figure 1: How to make a loan-note a non-qualifying corporate bond Structuring a loan-note as a non-qualifying corporate bond requires some careful drafting. Generally, the desired treatment is achieved in one of the following ways:   Express the note in a non-sterling currency ( section 117(1)(b)), but consider the currency risk and the possible impact of Britain joining the euro. Allow for redemption in a non-sterling currency. Typical clauses will allow this, but provide for a cap-and-collar to limit the exposure to currency fluctuations and to avoid the note being treated as a relevant discounted security (section 117(2AA)). We understand that the Revenue may query the efficacy of such clauses. Include a right to convert into shares ( paragraph 1(5)(a) of Schedule 18 to the Taxes Act 1988) – purchasers may often object, however. Include a right to take further loan-notes (paragraph 1(5)(a)). This may be the preferred route but consider carefully: section 209(2)(e)(ii), Taxes Act 1988 – interest paid will be treated as a distribution and therefore non-deductible; if notes are issued by a subsidiary, this may degroup that subsidiary. Andrew Gotch's article, 'Loan Note Litmus' in Taxation, 26 April 2001 at page 86, makes a number of other points concerning the drafting of loan notes which are relevant in this situation. The Revenue's views on the meaning of 'security' (see the Tax Bulletin issued June 2001 at page 858) must also be carefully considered.

This is because non-qualifying bonds are treated as the same asset as the shares sold (see section 135) and the taper relief period is aggregated. A qualifying corporate bond, by contrast, results in the tapered gain being frozen – such gain crystallising on the bond's disposal. A further disadvantage of qualifying corporate bonds is that, if they ultimately prove worthless, the gain may still crystallise, but the loss on the bond itself will not be allowable.

 

Getting help from the company

 

One element of company sales which vendors may often raise is the possibility of funding some of the purchase price from Target itself. This might take the form of:

• contributions to personal or company pension schemes;
• golden handshakes using the £30,000 exemption;
• pre-sale dividends.

Such strategies can play an important part in any tax planning scheme. The first two, in particular, might result in both a tax-free sum for the vendor and a corporation tax deduction for Target. However, vendors should be aware of the limitations of this approach:

• Under section 151(ff), Companies Act 1985, any direct or indirect financial assistance which Target gives in relation to the acquisition of its shares is a criminal offence for the directors of Target and voidable by Target's creditors. The 'whitewash' procedure under section 155 may be available but adds at least six to eight weeks to the timetable.
• Pay-in-lieu-of-notice clauses in the vendors' employment contract will vitiate the £30,000 limit. The payment must genuinely be to compensate for loss of employment (see Statement of Practice 1/94).
• Overfunding of company pension schemes and limits on contributions to personal pensions or retirement annuity policies.
• Lack of distributable reserves (section 263, Companies Act 1985) – contributions to personal pension plans and golden handshakes may be treated as distributions for these purposes.
• Lack of cash with which to pay dividends. Since 6 April 2001, the effective rate of capital gains tax after taper relief is usually more attractive than a pre-sale dividend, in any event.

 

Stock dividends

 

Stock dividends (the declaration of a cash dividend with an alternative to take further shares) have been less attractive since 6 April 2001 due to business taper relief. However, stock dividends may still prove useful where:

• business asset taper relief is not available (for example, for investment companies); and
• a pre-sale dividend is not possible (for instance, because of lack of cash or distributable reserves).

Inevitably careful calculations need to be undertaken to maximise the benefits for all shareholders. The aim is to set the stock dividend at an appropriate level such that it leaves sufficient gain to be eliminated by annual exemptions, carry forward losses, etc. This may not be easy, particularly where different shareholders have different capital gains tax profiles. Careful use of different classes of shares may help, but the more contrived the share rights, the more likely the Revenue is to attack the scheme.

The principal difficulty with stock dividends is their timing. Ideally the dividend should be declared well (perhaps a month or more) in advance of sale. If the stock alternative is taken up too far in advance of the actual sale, there is a danger of the sale falling through and vendor finding himself with a tax charge and no cash with which to pay it. Take up the stock alternative too close to the date of sale, however, and the more likely the Revenue is to treat the transaction as pre-ordained. Particular care should be taken if applications are being made for clearance under section 138 or section 707, Taxes Act 1988.

A more aggressive scheme involves the payment of a stock dividend to a non-interest in possession trust. Some commentators argue that this is not caught by section 249(6), Taxes Act 1988 provided the share-alternative is capital as a matter of trust law. The Revenue, apparently, does not agree.

 

Non-residence

 

Since the introduction of the re-entry charge (see section 10A), and the beneficial rates of business taper relief, non-United Kingdom residence has been less popular. However, for those with larger capital gains, the difference between ten per cent and zero per cent capital gains tax may still be worthwhile. Again, non-residence may be more attractive where business asset taper relief is not available.

Many advisers will be familiar with the possibility of avoiding the five-year rule by establishing non-residence in an appropriate jurisdiction such as Portugal or Belgium. However, the advice in this area is complex and relies on a combination of factors including:

• the definition of residence in the United Kingdom and in the foreign jurisdiction;
• the tax law of both countries;
• the application of the double tax treaty.

Practical issues include:

• Time of year – non-residence must generally span at least one full tax year so departure should be no later than February or March.
• Timing – completing a company sale while out of the United Kingdom is not easy. Often a vendor may remain tied to Target for a period after the sale, in any event.
• Clearances – the possibility of taking loan notes may help solve the timing issue, but if the intention to become non-resident precedes the sale, clearance is unlikely to be granted under section 138.
• Establishing a full-time contract of employment in the new country – this will generally be necessary if only one tax-year's non-residence is envisaged. The Revenue's recently published views on mobile workers should be considered carefully.
• Whether to move the family and sell the family home.

Subject to these points, non-residence may be a realistic option and the number of countries which are appropriate, may be more than at first thought. The flowchart in Figure 2 summarises the position.

Figure 2

Capital gains tax deferral

 

For vendors who appreciate that a tax deferred is a tax saved, a number of possibilities still exist to defer capital gains tax. Such possibilities are more limited than prior to 1991 (when a vendor would simply set up an offshore trust). However, the determined vendor might consider a Guernsey protected cell company, which is essentially a collective investment scheme established as a single company. The protected cell company is divided into separate cells. The assets of each cell are free from the claims of creditors and shareholders of all other cells. Provided the protected cell company is not close and/or that the individual holds no more than five per cent of the protected cell company, section 13 cannot apply. Gains made by a cell of the protected cell company on the disposal of shares in Target therefore achieve a capital gains tax deferral.

Alternatively, the vendor could consider an offshore trust in a jurisdiction which has a suitable tax treaty with the United Kingdom. Mauritius may be one possibility.

These possibilities both rely on getting the shares in Target into the structure before they stand at a gain. Such planning is most usefully undertaken well in advance of any possible sale. If, as is more common, the shares in Target already stand at a significant gain, these schemes may be more difficult. Further planning may be required to get the shares into the structure without a tax charge. This might include creating a class of deferred shares within Target or taking advantage of the 30 day bed and breakfast rules (section 106A(5)). However, the Revenue's recently published views on the latter indicate that such a scheme will inevitably face challenge.

An alternative, if the shares already stand at a gain, would be a capital redemption bond. The terms of such a bond give it a very low present value. Therefore, when the shares in Target are transferred to an insurance company in return for the bond, there should be no gain. The bond, on the other hand, takes the shares in Target with a high base cost. The vendor faces an income tax charge (section 547, Taxes Act 1988) on redemption of the bond, but other planning (such as subsequent non-residence) may be possible.

 

Post-transaction tax planning

 

If no tax planning has been put in place before the sale of Target, the number of options open to vendors becomes more limited:

• Tax-efficient investments. These would include investing as a business angel in an enterprise investment scheme company. Such investments could be spread via a venture capital trust or through a packaged-scheme designed to take advantage of enterprise investment scheme relief. Great care should be taken over the qualifying conditions (for instance, has the enterprise investment scheme company previously returned value to any shareholder).
• If the receipt is in an income form (for instance, because a stock dividend has been paid), investments in an enterprise zone trust or film partnership can eliminate the income tax charge altogether.
• An enterprise investment scheme may also be appropriate for vendors who undertake further business ventures on their own. Although income tax relief and capital gains tax exemption will not be available if the individual owns more than 30 per cent of the enterprise investment scheme company, the same is not true of capital gains tax deferral under Schedule 5B.

More aggressive tax planning

Artificial stock dividend

An artificial stock dividend can be created in a company specifically set up for the purpose. The vendor, having realised a gain, would subscribe cash for shares in the new company. In the same tax year as the original disposal, the new company would issue a significant stock dividend, swamping the existing shares. The aim is to create a capital loss equivalent to the original gain. In its place, the individual faces an effective 25 per cent tax charge.

The artificial stock dividend route might theoretically be coupled with non-residence in the following tax year. This takes advantage of the timing difference between the capital gains tax loss and the income tax charge. The former occurs at the time of contract (section 28), the latter at the time of issue of the stock dividend shares (section 249(4), Taxes Act 1988). If the transaction can be timed so that the capital gains tax loss occurs while the vendor is resident but the issue of the shares is delayed until the following (non-resident) tax year, this offers the possibility of an entirely tax-free realisation.

Offshore option scheme

Under an offshore option scheme, the shares in Target are held by an offshore structure which is connected with the vendor under section 286, Taxation of Chargeable Gains Act 1992 but from which the vendor is excluded from benefit. The vendor retains an option to buy the shares back from the offshore structure for a nominal amount. Shortly before the sale of Target, the vendor exercises the option. This is deemed to take place at market value (sections 17 and 18). The vendor can sell Target with an updated base cost. The offshore structure realises a gain but this cannot be apportioned to the vendor.

Offshore employee benefit trust

The employee benefit trust is essentially an offshore discretionary trust set up for the benefit of employees of Target. As such, gains realised by the trust do not face an immediate capital gains tax charge and cannot be apportioned back to Target under section 86. Furthermore, section 87 should not apply to such gains as there is no element of bounty when Target sets up the trust. Benefits paid to employees face an income tax charge, but there are a number of ways to avoid this. The employee could become non-resident or loans could be made to a family trust after the employee has ceased employment. While superficially attractive, such schemes can rarely, in practice, be used to benefit existing majority shareholders in private companies.

The last two schemes generally rely on such arrangements being put in place at an early stage. In any event, such schemes are highly provocative to the Revenue and need to be carefully planned and implemented. Only vendors who relish a long fight with the Revenue need apply.

 

Other tax issues

 

Tax issues can potentially occur at any stage during the sale process. The following points may commonly arise.

Earn-outs

The right to receive further consideration dependent upon the future results of Target is very common. However, unless the earn-out right is structured within the terms of section 138A, the present value of such a right will be assessed under Marren v Ingles [1980] STC 500. The terms of section 138A require the earn-out only to be capable of payment in further shares or loan-notes. The points made earlier in Figure 1 on structuring such loan-notes should again be considered and clearance under section 138 applied for. There is also a technical concern as to whether an earn-out right constitutes a relevant discounted security (paragraph 3 of Schedule 13 to the Finance Act 1996) although, in practice, the Revenue is unlikely to take this point. For more on this topic, see Taxation, 16 November 2000 at page 180.

Payment by instalments

Where payment by instalments is contemplated, the later payments should be structured as loan-notes to avoid an upfront tax charge (section 48).

Money to others

A relatively common situation is for a vendor to wish to make an ex gratia payment to, for instance, a key employee. This might arise where the sale is reliant upon that employee remaining with Target or where the company has no formal employee share incentives in place. Such payments may cause difficulties. If made by the company, they may well constitute unlawful financial assistance. If made by the vendor, no deduction will be available in the vendor's capital gains tax calculation (section 38) and the payment is likely to be taxable on the employee as an emolument. Vendors might consider a pre-completion gift (or declaration of trust) over a small number of shares claiming holdover relief under section 165 as an alternative.

Anti-embarrassment

The situation sometimes arises where a vendor is concerned that he does not lose out should the purchaser re-sell the shares in Target for a short-term profit. An anti-embarrassment clause may be used in these circumstances allowing the vendor to take a share of any such profit should the purchaser sell on within a specified time. To protect the purchaser's position, it is wise for the purchaser to declare himself to be a bare trustee of any such payments under section 60.

Clearances

Almost invariably the consideration for a company sale will involve one or more non-cash elements, such as deferred consideration, an earn-out or loan-notes or shares in the purchaser. Whenever this happens, clearance applications under section 138 and also under section 707, Taxes Act 1988 will be needed. Vendors need to be made aware of this early in the 30-day time scale, and of the possibility that the Revenue might extend this by asking for further information.

 

John Barnett ATII, solicitor is an associate at Burges Salmon and a former winner of The Chartered Institute of Taxation's Institute Medal. He can be contacted on 0117 902 2753.