A tax-efficient exit starts pre-incorporation
For many entrepreneurs the real reward for the risks and efforts taken in developing a business is the opportunity of a profitable exit – generating a material lump-sum profit on selling the business. This article highlights the issues and opportunities to be considered by an entrepreneur who operates the business through a company and who wishes to minimise tax liabilities arising on exit. The article is based on the tax regime in place for the tax year 2016/17.
Tax planning inevitably takes place against a background of an ever-changing set of tax rules. Over the past twenty years or so we have seen a capital gains tax (CGT) regime with rates of tax very much lower than income tax rates, then a move to the same rates applying to capital gains and income, followed by relatively frequent changes over recent years leading back to capital gains now generally being taxed at more favourable rates than income. With effect from 6 April 2016 the normal CGT rate for a higher or additional rate taxpayer is 20% (28% for residential property) and 10% for a basic rate taxpayer (18% for residential property). The lower basic rate tax rates only apply to the extent that the total of the individual’s income and taxable capital gains fall within the basic income tax band (£32,000 for 2016/17). These rates compare favourably with the current top rate of income tax of 45%.
We have gone full cycle, with rates of CGT now usually being materially lower than income tax rates, but against a background of well-developed anti-avoidance rules, such that many of the more sophisticated planning techniques previously used (sometimes involving trusts and offshore structures) are no longer available.
One principle which has applied for a good many of the years, and continues to be the case now, is that care should be taken to ensure that any profit arising on an exit is not subject to income tax and potentially also national insurance liabilities.
Avoiding income tax and national insurance liabilities
Why should this be a concern to an entrepreneur who sets up a company?
There is a rather crude provision in tax legislation relating to shares acquired by employees and/or directors of companies. This provision treats shares acquired by someone who is, or is to be, an employee or director of the company as acquired by reason of the employment or directorship, even where the reality is that the individual is acquiring the shares as the founder of the company and not as a reward of any employment. This deeming provision means that care has to be taken to avoid the application of income tax and national insurance charges.
An example of a situation in which this legislation may apply is when outside investors are involved and the founders are also acquiring additional shares in their company at the same time. If, for example, it is proposed that the founders pay a lower price per share than the investors, this might suggest that the entrepreneur is paying less than market value (in tax terms), with immediate income tax consequences. If the investors will require certain restrictions to be imposed on the shares to be acquired by the founders (e.g. regulating what happens to the shares if the founders cease to be involved with the company), this can also lead to part of any capital gain realised on a future exit being subject to income tax. It may be possible to avoid this by a specific form of election being made when the shares are acquired, but the immediate tax implications of this election being made must first be considered.
These points demonstrate why planning should often start at the time the business is set up, even though a profitable exit is, at that stage, a somewhat distant and even speculative event. In cases where these rules have not been reviewed at that early stage, a “health check” would be in order to establish whether circumstances are such that income tax rules may apply and, if so, whether steps can be taken (e.g. before share values rise) to eliminate the problem.
Other circumstances where income tax liabilities could be an issue include the following:
- If the terms of the exit involve an “earn-out” where part of the proceeds of sale is dependent on future profits and on continued employment of the selling shareholder.
- In cases where the company being sold has accrued profits which could be paid out as a dividend (subject to income tax in the shareholder’s hands) and where, for example, there are arrangements under which those profits will be used to finance the purchase price for the shares. Legislation exists to counter such arrangements and impose income tax liabilities on the proceeds of sale, but these rules are often not applicable where the exit involves a fundamental change in the ownership of the relevant company. In cases where there is any concern about the application of this legislation it is possible to apply for an advance clearance that the legislation will not apply.
With care, income tax and national insurance liabilities are typically avoidable, and the focus is instead on minimisation of CGT liabilities and avoiding any timing problems – avoiding tax charges arising before cash consideration is received.
Avoiding timing problems
It is often the case that at least part of the proceeds of sale is not paid in cash on completion. It may be that the buyer requires at least some of the consideration to be in the form of shares in the purchasing group. It may be that the buyer wishes some of the consideration to be deferred for a period, to help secure potential liabilities under warranties or simply to help with the financing of the acquisition. It may be that part of the consideration is contingent on satisfaction of conditions, e.g. as to future profits.
In any such case the selling shareholder will wish to avoid any tax charge until cash is received (so that funds arising from the transaction are available to pay the tax). Where deferred cash consideration is involved (whether or not contingent) the usual approach adopted is for the consideration in question to be satisfied in loan-note form (i.e. a loan recorded in an appropriate legal form). Provided that any paper consideration (whether shares or loan notes) is provided for commercial reasons and not for tax avoidance reasons (a point on which prior clearance can be obtained from HM Revenue & Customs (HMRC)) and the paper consideration is properly structured, the timing problems should be avoided. However, additional issues may arise if entrepreneur’s relief is being sought (see below).
Minimising CGT liabilities
Having circumnavigated the above issues the next question will be whether it is possible to improve on a 20% CGT rate. Some opportunities in this regard are referred to below.
Entrepreneurs’ relief: When this relief is available the CGT rate is reduced to 10%. A lifetime limit of £10m applies to the amount of gains eligible for the relief. The main conditions to be satisfied in order to be able to claim the relief are:
- the shares in question must be shares in a trading company or a holding company of a trading group;
- the shares must represent at least 5% of the company’s ordinary share capital and must have at least 5% of the votes;
- the selling shareholder must be an employee or director; and
- the selling shareholder must have owned the shares for at least one year.
Where a sale involves deferred consideration (e.g. an “earn-out” where part of the consideration is contingent on future profits) problems can arise in securing entrepreneur’s relief in relation to any additional consideration which may become payable at a later date under the earn-out terms. This is because the conditions for claiming entrepreneur’s relief may no longer be satisfied in the period of 12 months leading up to payment of the deferred consideration (e.g. because the seller was not a 5% shareholder throughout that period). Various alternative strategies can be considered to overcome problems of this nature.
Investors’ relief: This new form of relief also provides for a 10% tax rate with a lifetime limit of £10m of gains. It applies to issues of ordinary shares which take place after 17 March 2016 and requires the shares to be held for three years after 6 April 2016. However, it is not available to “relevant employees”, and this condition means that it will not typically be available to entrepreneurs involved with the running of the business; such persons should typically instead focus on use of entrepreneur’s relief.
Seed enterprise and enterprise investment scheme (SEIS and EIS): One or the benefits of qualifing for SEIS or EIS is an exemption from CGT on a sale of shares which are eligible for relief (where the shares have been held for at least three years from the relevant date). However, one of the many conditions to be satisfied (both for SEIS and EIS) is that the shareholder must not be “connected” with the company. This excludes a shareholder who has a stake of more than 30% in the company. In the case of EIS, the rules also exclude directors and employees (save in limited circumstances designed to allow business angels who might also sit on the board). In the case of SEIS, directors can participate. So EIS is usually not of help to an entrepreneur establishing his own business, but SEIS may be worth considering in a case where a number of founders are involved such that the relevant individual has an interest in the company of no more than 30%. SEIS relief is aimed at very small new businesses and has an overall limit of £150,000 of investment attracting the relief and a limit of £100,000 for each participating individual.
Non-residence: A more radical approach is to be non-resident when the gain is made, since non-residents are not subject to UK CGT. There used to be ways of achieving this by being non-resident for a period as short as one year. However, the rules now provide that someone who has been UK-resident for more than a very short period and who becomes non-resident before the gain is made must remain non-resident for five years in order to escape the clutches of the UK tax system. An entrepreneur who needs to have hands-on involvement with the business up to the point of sale and possibly also afterwards (e.g. if part of the consideration is dependent on future profits, responsibility for the delivery of which will fall on the entrepreneur) will need to review whether the rules can in practice be satisfied, even if the individual is in principle willing to undertake a substantial change of living arrangements.
Other: Finally there remains the possibility of a more aggressive (and expensive) form of planning arrangement. Products are developed from time to time which aim to reduce or eliminate tax liabilities. Usually the marketing of these products must be notified to HMRC. As a result they tend to have a short shelf life before counteracting legislation is introduced. The nature of products of this type is also such that they are highly likely to be challenged by HMRC, with a real likelihood of litigation. They are invariably far from being risk-free. Where such products are developed they can be fairly aggressively marketed by their promoters (who may look to be paid by reference to a percentage of the savings achieved). There is often value to be obtained from obtaining a second opinion on any such scheme from an adviser who is not involved in its promotion (even where the scheme has the benefit of specialist tax counsel’s opinion). For many sellers, achieving a 10% rate under entrepreneur’s relief will be a more than satisfactory basis on which to proceed.