Finance Act 2017, passed on Christmas Day, has inserted a new anti-avoidance provision into tax legislation which impacts all management buy-outs (MBOs) involving ‘close companies’. This is an important provision as the vast majority of companies in the SME sector are ‘close companies’ so its impact will be extensive. The legislation, where it applies, imposes a charge to income tax on selling shareholders in certain transactions rather than allowing such shareholders obtain Capital Gains Tax treatment (which would enable the selling shareholder claim entrepreneur relief or retirement relief).
Whilst Revenue guidance appears to allow for a (non-statutory) motive test to be used to avoid the new provision, the guidance is contradictory, unclear and very ambiguous.
The fact that a MBO might be commercially motivated does not matter under the legislation and the Revenue guidance, although making reference to a ‘safe harbour’ in this regard, does not offer any real comfort for the vast bulk of such transactions.
The upshot is that shareholders of such companies, who are thinking of selling to existing management, will need to consider the new provisions carefully prior to agreeing to any such sale.
This measure may act as a practical bar to commercially motivated MBOs. This is unfortunate at best, particularly as it will have most impact on the SME sector, which is, and always has been, the powerhouse of the Irish economy.
Introduction This article will summarise the new provision, the perceived ‘mischief’ it was aimed to address, as well as the effect it will have on MBOs. This article also considers guidance issued by the Revenue in eBrief 3/18.
The Legislation: Section 135(3A) Taxes Consolidation Act 1997
In outline, the new sub-section (3A) provides:
- Where a shareholder in a close company,1 (or a person connected with that shareholder);
- enters into arrangements (a vague concept broadly encompassing any agreement, understanding, scheme, transaction or series of transactions);
- with a second close company;
- either directly or indirectly;
- whereby a shareholder (which it appears may not even have to be the same shareholder as at (1) above);
- disposes of shares or securities in the first company;
- and the payment for those shares is paid or to be paid;
- either directly or indirectly;
- from the assets of the first company [the target];
then any amount received for those shares from the second company [the acquirer] (or such others) shall be treated as a distribution subject to income tax.
The Mischief The mischief which sub-section (3A) seeks to address is set out in example 3.3 of the Revenue guidance.2 That example is now set out below for ease of reference:
“Barry and Bob run a bakery and own 100% of the shares of BB Bakery Limited (‘BBBL’) equally. The company has built up cash reserves over the years and has retained profits of €1,400,000. Bob wishes to exit the business and have BBBL buyout his shares. However, rather than have BBBL purchase his shares directly, where the buy-back would trigger an income tax charge for Bob, Barry arranges to set up a new company (‘NewCo’) to purchase the shares. NewCo purchases Bob’s shares for €700,000. The consideration in respect of the acquisition is left outstanding. BBBL subsequently pays a dividend of €700,000 to NewCo which NewCo uses to pay the deferred consideration to Bob.
The provisions of section 135(3A) TCA apply to treat the payment of €700,000 to Bob as a distribution made by BBBL to Bob on which Bob is subject to income tax. Barry has entered into an arrangement to secure the payment of consideration to Bob from the assets of BBBL and the assets of BBBL have been depleted by €700,000. Previously Bob may also have sought to claim retirement relief in relation to the €700,000 payment received.
It should be noted that had Barry sourced the payment from his own resources then Bob would have been subject to CGT on the disposal of his shares.”
The example can be illustrated with the following diagram.
Commentary: The example acknowledges that Bob may have been able to claim retirement relief on a direct sale to Barry. To claim retirement relief Bob must have owned and worked in the business for at least 10 years (but in practice this is likely to have been for a greater period of time, e.g. 20 plus years).
The ‘mischief’ which the new subsection (3A) is seeking to prevent in this example is to stop Bob from claiming CGT treatment and retirement relief on his exit (from a long held business) where the payment for Bob’s shares has been sourced from BBBL (Barry not having the funds to pay directly himself).
This appears to be the “unfair outcome” 3 which the provision seeks to challenge. The rationale for the approach is not stated in this example but is subsequently expressly stated in the later example 3.4.2, that “in contemplation of the sale … retains profits in
[BBBL] in excess of the company’s commercial needs, rather than taking a dividend.”. This rationale is problematic for a number of reasons, including:
- If Bob was a sole shareholder, he could have simply liquidated the company, obtained CGT treatment on the proceeds returned to him, and claimed retirement relief on these. As it is, Bob is a co-shareholder with Barry. In light of (3A), Bob and Barry may alter their approach and decide to liquidate BBBL, extract the proceeds and qualify for CGT treatment and claim retirement relief. Revenue would not seem to have any qualms with that, but of course that exit would necessitate the closing of the bakery, the redundancy of its employees, and the community losing the benefit of its future productive output.4
- Even if Bob is not the sole shareholder, what incentive now exists for him to allow the business to continue? He will now be fully justified in saying to Barry that he wants to exit and the only exit feasible for him is for the company to be liquidated. He can then claim retirement relief or entrepreneur relief, to which he may be entitled. Whether or not liquidations will increase as a result of the measure, it would seem that unfortunately this is now a conversation which shareholders will have to have with each other.
- The assumption that the ‘excess’ cash5 should be distributed out by dividend (i.e. in the most tax costly manner possible) is also problematic. Why shouldn’t Bob be able to avail of CGT treatment, and claim retirement/entrepreneur relief? After all, he is disposing of his interest in the business and thus incurring the genuine economic consequences of that disposal. In such circumstances CGT treatment is more appropriate. It should also be noted that Barry’s base cost in NewCo’s shares is still negligible so there is still a considerable latent tax charge for Barry on his own ultimate future exit.
- As Revenue note, if Barry had had sufficient personal resources to purchase Bob’s shares then CGT treatment would have applied. It must be asked, why should Barry’s means determine Bob’s tax treatment?
Impact on Management Buy-Outs
Whatever one’s views of the merits or otherwise of Barry and Bob’s situation, when the proposed changes were first published it was immediately apparent that they were too broadly worded and would impact also on management buy-outs (MBO).
The following diagram illustrates a typical MBO structure, and you will note the similarity with the ‘Barry and Bob’ structure outlined above.
The funds used to buy-out the owner are generally initially sourced (either partially or fully) from a bank/equity house, and that that bank loan is then repaid from dividends paid up from the Target company to NewCo. However the purchase price is essentially being funded from the Target’s resources as NewCo does not have any assets (other than its shares in the Target), nor any income stream (other than from the Target) and in most cases a management team will not have the sufficient personal resources to fund the purchase. In this typical scenario the new sub-section (3A) will apply (per the actual wording of the legislation).
Many of Ireland’s indigenous business successes have grown from MBOs. Any measure which challenges domestic MBOs will also inhibit Irish economic growth and employment.
When the measures were published at the committee stage of the Finance Bill, representatives of the main legal, tax, and accounting bodies immediately communicated their concerns regarding the new provision to the Department of Finance and assurances were received that although the wording of draft legislation would not be altered Revenue would issue guidance6 which would clarify that genuine MBOs would not be effected.
Despite the implications for Irish business, the amendment itself was introduced with a bare minimum of discussion at the Dail committee stage on 8 November 2017.
Subsequently on 23 November 2017, at the report stage Dail debate,7 Michael McGrath T.D. (opposition Finance spokesman) tabled an amendment which would require an impact assessment to be carried out on the operation of (3A) and then queried:
“I must ask the question on behalf of those who raised the issue who claim that this will also affect bona fide commercial transactions. Has the Minister examined the impact of this proposal in that respect because a number of people put it to me that the measure will close down most forms of commercially motivated management buy-out transactions and many third party SME company purchases because of the wording adopted? It is important that the Department would deal with it. That is the essential claim that is being made by some representatives and I ask the Minister to give an assurance that it would not be the case and that the anti-avoidance measures that have been introduced by him on Committee Stage are only going to affect the type of contrived arrangements we all agree should not be allowed.”
The Minister of State at the Department of Finance (Michael D'Arcy T.D.): replied that the legislation was targeted at a specific tax avoidance scheme (i.e. akin to Bob and Barry) and then stated:
[The amendment (3A)], has no impact on bona fide management buy-outs, buy-ins or third party SME company purchases. The amendment only has application where shareholders enter into arrangements to dispose of their shares and where the consideration is paid from the assets of the target company.
I am aware that many management buy-outs involve the provision of financing by the target company out of the assets of the company. However, a bona fide buy-out is not structured on the basis of a shareholder specifically arranging for the proceeds to be funded from assets of the target company. Bona fide financing arrangements entered into by the purchaser to fund the purchase of the shares are outside of the scope of the new provisions. Therefore, on the basis that the proposed amendment to section 135 does apply to bona fide management buy-out transactions, I do not propose to accept this amendment. I am advised that Revenue will be issuing comprehensive guidance once the provision has been enacted and that should meet the Deputy's concerns.” [emphasis added]
Surprisingly the Minister’s response went unchallenged, even though:
- his statement that the amendment would have “no impact on bona fide [MBOs]” has no basis considering the wording of the legislation; and
- he did not answer the question as to whether any impact assessment had actually been undertaken.
There are a number of issues with the guidance:
- The guidance introduces a bona fide motive test. However, there is no basis for such a test in the legislation.
- The guidance operates in a vacuum, and does not take into account either commercial reality or Company Law. For example, paragraph 3.4 of Revenue’s guidance acknowledges that MBO’s require the target to facilitate funding, but then assumes that the exiting shareholder can somehow absent himself from involvement in those arrangements. It states:
“A management buy-out (MBO) involves the management team of a company purchasing the company from the existing shareholders. Typically a new company is created to acquire the shares of the company, the ‘target’. Financing may generally provided to the new company by way of a mixture of equity finance i.e. from venture capitalists and debt finance i.e. bank loans. Many MBOs may also involve the provision of financial assistance by the target company to secure and repay the loans used to acquire the shares of the target.
As stated above, subsection (3A) only has application where a member enters into the relevant arrangements and does not apply to bona-fide financing arrangements entered into by a purchaser. Therefore, whereas a bona fide MBO may involve the provision of financing out of the assets of the target company, the provisions of section 135(3A) TCA will not apply unless the member has engaged in an arrangement to ensure that the consideration is met from the assets of the company. Similarly, any actions of the purchaser subsequent to the disposal, for example a bona fide refinancing using the assets of the company, are outside the scope of the provision. Therefore, in such circumstances, a bona fide MBO may involve the member being aware of the financing arrangements entered into by the purchaser to fund the buy-out and entering into an agreement to sell on the basis of such financing arrangements, however they would not be regarded as arrangements entered into by the member to secure the payment of consideration from the assets of the company. Accordingly section 135(3A) TCA does not apply in such circumstances.” [emphasis added]
Banks and equity houses do not provide funds without security in place, or without knowing how their loan will be repaid. In virtually all cases repayments are made from funds sourced from the target company by way of dividend.
The target company will be required to take some action prior to completion to provide the bank with this security. The Companies Act 2014 prohibits a company from granting financial assistance in connection with the acquisition of its own shares unless a Summary Approval Procedure (SAP) is complied with.
As the SAP requires the members to pass a resolution approving the financial assistance, the exiting shareholder would have to be involved in those arrangements. 8 Accordingly it is difficult to see how MBOs will not fall foul of the new provision, even with the benefit of Revenue guidance.
Sub-section (3A) is broadly worded and does not contain any form of bona fides test. There is little correlation between the wording of the legislation and the description given by the Government Ministers as to how it will operate or its impact on MBOs.
Revenue have been put in the position of legislating their own bona fide test, yet their guidance does not appear to fully factor in that the commercial reality of banks’ security requirements and Company Law will invariably require the exiting member to be an active party to the financing arrangements (thus falling foul of their bona fide test).
The problem is compounded by the fact that Revenue Technical Services will not provide opinions on the bona fides of any particular transaction, so there does not appear to be any mechanism by which a shareholder could seek pre-clearance in advance of a transaction.
The only conclusions to be drawn are:
- All MBOs can now be impacted by the provision;
- It is left to Revenue to decide which transactions they view as ‘bona fide’ and which they do not by applying a non-statutory ‘bona fide’ test of their own design; and
- That bona fide test does not appear to have considered that bank security requirements and company law will often require the exiting member to be involved in the arrangements (to fund the acquisition from the target’s resources) made by the management team.
Given the importance of MBOs to the Irish SME sector, and the significance of that sector to the Irish economy the new sub-section (3A) is of great concern. Uncertainty concerning what arrangements will be viewed as bona fide may lead to arbitrariness and similar cases being treated differently. Exiting business owners are likely to view MBOs as a less attractive exit option and begin considering alternative exit options. The only certainty is that all parties will have to be particularly careful about how they go about structuring MBOs in future.