In order to get the best price for a company and to ensure that taxes arising on sale are minimised, it is important to plan in advance of a sale. This could involve ensuring the company’s compliance is in order, making sure that the company is in a form that would be attractive to potential purchasers, or ensuring that the shareholders can maximise tax reliefs such as entrepreneurs’ relief. VAT issues arising in connection with a sale should not be overlooked.
The shareholders and directors should consider what is being offered for sale. If the aim is to sell only part of the company’s activities, or to retain certain property, the company will need to consider how the activities for sale can be packaged. This could be addressed in a whole range of ways, from simply selling assets to the shareholders to carrying out a group reorganisation to demerge those parts of the trade that the shareholders wished to sell.
The shareholders and directors may also need to decide who is to benefit from a sale of the company; for example, whether there are employees who have been or should have been promised an equity interest in the company. Conversely, are there shareholders who should not benefit from a sale of the shares? This may require a reallocation of the share capital, and perhaps a fresh issue of shares to certain employees.
It is reasonable to assume that if a company is sold to a third party, the purchaser will carry out some due diligence. The company should carry out a review of its PAYE and VAT procedures and ensure that its corporation tax returns have been filed. If there are outstanding issues with HMRC, the company should seek to resolve these before any due diligence takes place.
Whenever looking at these reliefs, the first question is whether the company or group in question is trading. The definitions are contained in TCGA 1992 s 165A for entrepreneurs’ relief (ER) (and gift relief), and in TCGA 1992 Sch 7AC para 21 for the substantial shareholdings exemption (SSE). The basic definition is the same in both, a trading company being ‘a company carrying on trading activities whose activities do not include to a substantial extent activities other than trading activities’.
In establishing what is substantial, the 80:20 test, which was introduced in a Tax Bulletin in the context of taper relief, is fundamental. This looks at three criteria:
These tests are looked at in the round to determine which is of most importance. However, the first of these tests is likely to cause most problems for ‘trading’ companies. If a trading company has a rental property, for example, it is clear that this is not a trading asset. However, if a company holds a large amount of cash, is that a trading asset? In order to answer this question, the company will need to consider its cash requirements – for example, is the cash needed to replace machinery, acquire new premises, provide working capital, fund expansion, or is the cash simply surplus? Holding cash on current account that has been generated from trading activities would be far less problematic than holding that cash on term deposit or in an investment product (which would clearly be a non-trading activity). However, the shareholders should consider extracting surplus cash at least a year before the sale of the company.
The proprietors may want to sell their shares in the company but to keep property that is currently owned by the company. If there are sufficient distributable reserves and the shareholdings are in line with how the property is to be distributed, the company could make a distribution in specie of the property. The advantage of this is that there would be no SDLT (assuming that the shareholders are not agreeing to take over loans on the property), but individual shareholders would suffer an income tax charge at their marginal dividend rate based on their share of the market value of the property. The company would also suffer a corporation tax charge on the gain on the property (remembering that companies are entitled to indexation calculated on the capital gains tax base cost of the property).
Alternatively, some or all of the shareholders could agree to purchase the property from the company, using the proceeds from the sale of their shares. There would be an SDLT charge based on the consideration paid for the property. In the right circumstances the trade could be sold, and the company then liquidated, passing the property out in the course of liquidation. Although this would save SDLT, corporation tax would arise on the disposal of the trade and the property.
Instead of simply taking the property out of the company, the shareholders could consider a corporate reorganisation, in the course of which the property could be passed to a new company which is separated from the trading group, either using an Insolvency Act 1986 s 110 liquidation demerger or a capital reduction scheme.
Proprietors with a number of business interests often build up companies without giving much thought as to how relationships between the companies really work. Growth is often driven by where funds are available, rather than where assets should be held. The purchase of premises is often a case in point. Investments often accumulate in a profitable trading company, simply because that is where the cash is.
When shareholders start thinking about selling, they need to consider whether they can offer a package that is attractive to a purchaser and is easy to buy. If, for example, the trade is held by one company, but the premises are held in another company under common ownership, it may be beneficial from the point of view of marketing the business, as well as maximising the availability of entrepreneurs’ relief, to reorganise those companies so that the trade and the property are in the same company or group. Simply transferring the property from one company to another may not be the answer, if this gives rise to large SDLT and corporation tax liabilities.
A reorganisation of a company or a group of companies can take many forms, and to get from A to B may require a number of steps, each of which needs to be considered in the light of what reliefs are available, and what tax liabilities arise at each step. It is important, however, to plan early, as HMRC could seek to challenge a reconstruction that takes place very close to a sale.
Certain components are common to most reorganisations. First, there is likely to be a share for share exchange which, as long as the requirements in TCGA 1992 s 135 or s 136 are met, and the anti-avoidance provisions in s 137 do not prevent those sections from applying, shareholders are able to treat the new shares as standing in the shoes of the old shares. This means that the CGT base cost of the old shares flows into the new shares. If the percentage shareholdings and the classes of shares in the target company are, after the share exchange, the same as the acquiring company, relief from stamp duty is likely to be available under FA 1986 s 77. If this relief is not available, stamp duty will be payable by the acquiring company at 0.5%.
There are a number of options when dealing with the separation of activities of a company or a group, referred to generally as demergers.
The statutory demerger provisions in CTA 2010 ss 1073–1099 impose a number of conditions which, if they apply, prevent a distribution from arising on the shareholders of the demerged company or group. These provisions allow a trade to be transferred to a new company, or a subsidiary to be transferred either directly or indirectly to the shareholders without triggering an income tax charge on the distribution. However, this relief cannot be used where the demerger is in preparation for the sale of one of the demerged companies.
The most common demerger route in preparation for a sale is a liquidation reconstruction under Insolvency Act 1986 s 110 (see figure 1). In essence, this involves the liquidation of a single company or the holding company of a group, in the course of which the liquidator transfers the assets of the liquidated company to new companies, the consideration being the issue of new shares in those new companies to the shareholders of the old company. This can be done across the board (where all the shareholders become shareholders of all the new companies, retaining their percentage shareholdings), or as a partition (where different shareholders take different parts of the business, usually with some form of equalisation).
Alternatively, the demerger can be effected by means of a capital reduction, which is attractive to some shareholders as it does not involve a liquidation. This would typically involve: the creation of a new holding company; passing some assets or shares to the new holding company; the redesignation of the shares in the holding company so that rights are attributable to different assets held by the group; followed by a capital reduction of one of the classes of shares, which is satisfied by the transfer of designated assets to a new company which issues shares to some or all of the shareholders of the group. There are, however, many variants to this basic model, depending on the required end result.
Both the s 110 liquidation reconstruction and the capital reduction demerger rely on a combination of reliefs, principally, TCGA 1992 ss 135, 136, and 139 to ensure that there are no CGT liabilities on the shareholders. Relief from stamp duty under FA 1986, s 75 may be available, as long as the demerger is across the board and the various requirements of that section are met. It should be borne in mind that stamp taxes do not share the statutory definition of a reconstruction set out in TCGA 1992 Sch 5AA, but instead relies on case law, and in particular Baytrust Holdings Ltd v IRC [1971] 3 All ER 76. For all but the most straightforward reconstructions, it is advisable to ensure that the proposed steps fall within the definition of a reconstruction for the purposes of CGT and stamp taxes.
Finally, will the proposed reconstruction fall within the transactions in securities anti avoidance provisions in ITA 2007 ss 682–713 for individuals, or CTA 2010 ss 731–751 for companies? These provisions must be considered, especially whenever cash, or an entitlement to cash, passes to some or all of the shareholders as a result of the reconstruction. The purpose of these provisions is to counter any avoidance of tax that results from the way in which the share transactions operate. For individuals, this would usually mean imposing an income tax charge on the basis that the amount received was a dividend.
Clearance should always be obtained from HMRC in advance of any reconstruction to ensure that they are satisfied that there is no tax avoidance motive, and that the transactions are being effected for bona fide commercial reasons. It should be emphasised that clearance from HMRC does not mean that the reorganisation is covered by the various relieving provisions in ss 135, 136 or 139. Clearance only confirms that HMRC will not prevent them from applying on the basis of tax avoidance.
As part of a reorganisation it is common to transfer chargeable assets, principally land, buildings and pre-April 2002 goodwill, between group companies. Such transfers take place on a no gain/no loss basis under TCGA 1992 s 171. SDLT is not charged on transfers of property between group companies under FA 2003 Sch 7 para 1.
However, transfers will often be one of a number of steps leading up to a demerger of the group’s activities, so the clawback provisions for CGT and SDLT must be considered.
For capital gains purposes, where a company leaves a group while holding an asset which was acquired from the group within the previous six years, the gain that would have arisen at the time of the intra-group transfer falls into charge. However, following changes to TCGA 1992 s 179, which were introduced by FA 2011 Sch 10, that gain no longer falls on the company leaving the group, but instead forms part of the computation on the disposal of the shares in the demerged company. If the disposal of shares is covered by the substantial shareholding exemption, this relief will extend to the gain coming into charge under s 179. It is possible, therefore, given the right circumstances, to transfer property out of the group without triggering a corporation tax charge on the gain. See figure 2.
SDLT relief on an intra-group transfer is withdrawn if, within three years of the transfer, the purchaser ceases to be a member of the same group as the seller. However, a clawback may not arise if any of the cases set out in FA 2003 Sch 7 para 4 apply, or if reconstruction relief under Sch 7 para 7 applies to the subsequent transaction.
It should be borne in mind, however, that goodwill created on or after 1 April 2002 is transferred intra-group under CTA 2009 s 774 on a ‘tax-neutral’ basis. However, if the transferee company leaves the group within six years of the transfer, the gain on transfer will fall into charge under s 780. This charge will fall on the transferee company, as the FA 2011 changes to TCGA 1992 s 179 do not apply to goodwill dealt with under the intangible fixed assets rules.
Where a company reorganisation is contemplated prior to sale, there may be implications for those employees holding options over shares. A review of the share schemes rules should be undertaken to ascertain whether options could be exercised early or whether replacement options could be granted in a new company. In some instances, it may be necessary for such options to lapse and for new options to be granted.
Situations can arise where promises made to key employees to provide them with an equity stake in the company have not been fulfilled at the time of a sale, which can arise unexpectedly. In such situations, it may be impracticable to issue new shares and there may be clear drawbacks for the employee faced with having to pay a significant amount for the shares upfront or be exposed to income tax and NIC, under the employment related securities provisions where shares are acquired at undervalue. Tax will be payable under PAYE, as trading arrangements exist via the impending sale which is likely to make the shares readily convertible assets. Where an equity stake is provided before a sale is even contemplated, it may be possible to shelter employees from this potential exposure.
The use of an approved scheme such as a company share option plan (CSOP) (ITEPA 2003 Part 7 Chapter 8 & Sch 4) or enterprise management incentive (EMI) (ITEPA 2003 Part 7 Chapter 9 & Sch 5) can avoid upfront income tax charges. Such schemes are designed to help attract and retain key employees, where employees have the opportunity to share in the growth of the business. The rewards can be taxed as a capital gain and where shares are held in a trading company, the eligibility of ER would mean that such gains are taxed at 10%.
It is not unusual for approved share options to be drafted so that exercise is only possible if an exit occurs. Although the favourable tax treatment is lost if the option is not exercised within 10 years, such schemes are implemented in the knowledge that a sale or flotation of the business will take place within this timeframe.
CSOP options generally escape tax and NIC where three years have elapsed between grant and exercise, making the pre-sale planning more difficult. An EMI is more flexible and can be exercised at any point without losing favourable treatment. Options can also be granted over shares with a maximum value of £250,000, compared to £30,000 for a CSOP. Recent changes relating to EMI shares and ER make them more attractive for both employees and employers looking to implement a share incentive plan in the lead up to a sale of the company.
The key changes which apply to EMI shares disposed of after 5 April 2013 are, first, that the personal company tests for ER have been removed. There is no need to hold at least 5% of the nominal share capital; any holding will qualify and the shares do not have to carry votes. Second, the 12-month qualifying period for ER will start from the date the options were granted. As a result, employees who were granted exit only EMI options at least 12 months before a sale will now qualify for ER and where most of the growth in value of the shares occurs in the final year or so before sale, this could be quite valuable.
As with all approved schemes, there are a number of qualifying conditions which have to be met to allow for options to be granted under EMI. Details of these can be found in Schedule 5 but in essence the options must be granted over shares in an independent company with gross assets of less than £30m, where the activity conducted by the company does not fall within any of the excluded activities listed at para 16.
Where an approved scheme cannot be used, alternatives such as the use of partly or nil paid shares, where all or part of the share capital is left uncalled, or the use of growth shares which only participate in value above a specific hurdle can, if set up correctly, mitigate upfront income tax charges.
Where employees hold shares or options which may have been acquired before a sale was anticipated, consideration should be given to any adverse implications which may arise on the employees and what should be done to maximise any favourable tax treatment for the employees and the company. It may be necessary, for instance, to consider elections under ITEPA 2003 s 431 in respect of restricted shares acquired. In relation to partly paid shares, employees could still be saddled with a charge where shares are sold for their partly paid value. To avoid this, shares should be sold ‘fully paid’, with an agreement for purchasers to deduct amounts from the sale proceeds to make the shares fully paid. In relation to the exercise of EMI options, it is important that the timing of the exercise does not prevent the company from claiming what could be a valuable deduction based on the difference between the market value at exercise and the amount paid by the employee. Finally, a review of the company’s articles should be undertaken to ensure the appropriate rights exist to facilitate the sale of all the shares, including those owned by the key employees.
We have looked at some of the main issues that should be addressed when a company sale is being contemplated.
Closer to the sale, the company will need to address issues such as the PAYE treatment of redundancy and termination payments, and the application of partial exemption rules on professional fees in connection with the sale or the TOGC rules in connection with the sale of a business carried on by the company.
