Succession Planning

There comes a point in the life of every business when the owner decides to step down and sell the company.

As we saw in last month’s blog, you will want to make sure that you only pay capital gains tax at the 10% rate (the ‘entrepreneur’s relief’), when you sell a trade or trading company. But there may be further complications.

First of all, who are you selling to? You may structure a transaction differently if it is to a third party, to a management team, or to your children, or even to a mixture of any two or three of these. If a third party is willing to pay cash on day one, then you can simply walk away, worry free. But often your buyers won’t have the money to pay up-front, particularly in the case of a management buy-out or a sale to your children or other family members, so you may need some kind of structured disposal.

Typically, in these cases, the people wishing to buy the business will form a company (the ‘BidCo’). Let’s imagine the buyers are your management team:

BidCo buys your trading company for a mixture of cash, loan notes, and sometimes shares issued by BidCo. The cash element may come from the amounts subscribed for shares in BidCo by the management team, or from dividends paid by the acquired company to BidCo immediately after the acquisition. Either way, assuming you have a trading company and you otherwise qualify for entrepreneur’s relief, you will generate a 10% tax bill on the cash element, that capital gains tax being payable on January 31 after the next April 5 (so 31 January 2016 for transactions completed on or before 5 April 2015).

Generally, the CGT liability on the loan note element, or shares, only arises when the loan notes are redeemed or the shares are sold. However, it is important to ensure that redemption of the loan notes or sale of the shares in BidCo will also qualify for the 10% CGT rate. If, for example, you are only issued with loan notes and cash, the loan notes will not qualify for entrepreneur’s relief, as this relief requires you to hold at least 5% of the shares in the company. So if you are not receiving shares, you will need to make an election that says your CGT charge crystallises on the sale, not on the later redemption of the loan notes.

You must also make sure that you have the cash available to pay the January 31 tax bill. To do that the loan notes must be at least partly redeemable before that date.

This special treatment of shares and loan notes can be confirmed by a clearance from HMRC. This important process affords some degree of certainty over the tax treatment of your disposal and is best done for you by an experienced advisor.

We can also add other features to a buy-out. For example, in a case where parents were selling to their children in return for loan notes, the parents remained on the company’s board, partly to guide the children through the transition into full ownership, and partly to protect their investment until the loan notes were redeemed.

We are currently working on a phased management buy-out, with BidCo acquiring just over 25% of the company in the first instance, 25% later on, and then buying out the remainder with bank financing within about five years.

This gives just a brief overview of some of the issues that arise on structured disposals of your business, and highlights the need to speak to an experienced advisor on these matters.

Entrepreneurs’ Relief – The 10% Tax Rate!

It is a ‘well known fact’ that when you sell your business you will only pay Capital Gains Tax at 10%.

This is the so called Entrepreneurs’ Relief. Unfortunately, like all well known facts, there is more to this story. The tax rules are complex, and not entirely logical, so let’s take a look at the areas where you might be at risk of paying tax at the full rate of 28%.

Probably the most important feature of the Entrepreneurs’ Relief is that it only applies to trading companies. Unfortunately, there is no definition of what constitutes a trade and the decisions of the courts over the past 160 years have not always been helpful.

In most cases it is clear that you have a trade if, for example, yours is a retail operation or a manufacturing business, so it’s perhaps easier to discuss what does not qualify for the relief.

In general terms, concerns such as property investment businesses or, indeed, any other business which relies solely on passive investment income, would be exempt. Cases on the margins would include enterprises such as caravan parks, which HMRC generally considers to be investment businesses, even where the owners carry out related activities, such as providing utilities or other facilities.

If you’re a sole trader or carry out your trade through a partnership, then when you sell your trade or the partnership rights you should qualify for Entrepreneurs’ Relief.

The situation gets more complicated, however, if you trade through a company.

To be eligible for the relief, firstly you must own at least 5% of the company’s ordinary shares and hold at least 5% of the voting power in the company. Secondly you must be an employee or officer (director) of the company, or of a company within the group, if you have more than one company. As long as these conditions have been satisfied for a full year immediately before the sale, selling the shares, or any proportion of them, you should qualify for the 10 per cent tax rate.

However, problems can arise in instances where employees receive shares that were not voting shares, or where the company is co-owned by both husband and wife but where the wife has never been a director or employee of the company.

Another pitfall can emerge when accepting a loan document rather than an immediate cash payment from the purchaser of your business. This type of “share exchange”, can lead to difficulties, as any cash you receive when you sell the shares may qualify for the Entrepreneurs’ Relief, but the later redemption of the loan notes will not – so you might end up paying tax at 28% every time you redeem a loan note.