Considerations When Selling Your Business
Why it’s always important to “think carefully about your consideration” when selling your business
Introduction
As a chartered tax advisor, one case that stands out from my years of study is Marren v. Ingles and the curious reference to a “choice in action.”
For those interested (?), the dictionary (or legal) definition of a “choice in action” is
An intangible property right or property. which is not legally in the possession of a person. but is only enforceable through legal proceedings.
It makes perfect sense, right?
Before you stop reading, let me explain why this is important in the context of deferred review.
The rise of deferred consideration
Deferred consideration is increasingly common in business sales because it allows sellers to achieve their desired price while reducing the risk of the buyer paying too much up front, especially in a volatile market .
How does deferred consideration work?
Often, the deferred consideration is contingent on the occurrence of certain future events and payment of that amount will be deferred until that event occurs.
Deferred consideration can also be used to incentivize key people to stay with the company after the sale.
Usually, the deferred amount is calculated later, often based on the company’s profits over the next two to three years.
So why is this important from a tax perspective?
This is important because the structure of the consideration determines when capital gains tax (“CGT”) arises.
What are the different types of deferred consideration?
verifiable (can be calculated)
As mentioned above, deferred consideration is often paid once certain conditions are met or events occur. This could be, for example, listing the company on the AIM, achieving certain profit targets or securing a new contract.
Although the seller does not know when the consideration will be paid, he knows what amount will be paid, i.e. the deferred element is fixed (or can be easily calculated) on the date of sale.
The deferred verifiable consideration must be taken into account for its full value on the date of transfer and will be taxed in full during that tax year.
No discount is granted due to payment spread over several years. Therefore, even if the consideration that will be received in three years is worth significantly less than the consideration received immediately, no reduction is applied.
The only concession is that if the deferred consideration is paid more than 18 months after the date of sale, the seller may be able to ask to pay the capital gains tax due in installments.
Additionally, if the full deferred consideration is not paid, an application can be filed to adjust the sale proceeds and the seller can recoup a portion of the capital gains tax it has paid.
Indeterminable (cannot be calculated)
Sometimes the deferred consideration element cannot be calculated at the date of sale – it is indeterminable. This is your classic “additional price”. This is generally because the amount of this consideration is directly linked to the outcome of future events.
I now take you back to the beginning of this article, because when this happens, the right to future consideration (the “chosen in action”) is treated as an asset in its own right.
Undeterminable contingent considerations are not taken into account in the initial calculation of capital gains tax.
Instead, on the date of sale, the seller must pay capital gains tax on the cash received plus the value of the right to the future contingent consideration. This essentially means the seller is paying taxes on something they don’t know the value of.
Assessing this right can be tricky and require the help of a specialist. (This is something ETC Tax can help you with if necessary).
When future contingent consideration is received, this is treated as an assignment of the right and therefore an additional capital gains tax calculation will be necessary!
And it becomes even more complex… because if the contingent consideration is received in stages, more capital gains tax calculations will be required, with the entitlement to the future contingent consideration being reassessed each time as part of a partial transfer calculation!!
There are two important practical questions:
• the right to receive unverifiable contingent consideration must be assessed, which may require negotiations with HMRC; And
• future disposals are not linked to the original disposal, so reliefs (such as business asset disposal relief) will not apply to the disposal derived from the contingent consideration (except in circumstances limited circumstances)
So, what happens if the future amount received is significantly less than expected? What happens if it is lower than the market value of the fee imposed on completion?
In this situation, the seller will suffer a loss and may choose to carry back the loss on the assignment of the earn-out right to offset it against the gain on the original asset.
Other types of consideration
Equity counterpart
Sometimes the seller of a business will receive other shares in consideration for the sale of their company’s stock.
This usually happens if the purchasing company is a listed company or could become one after the transaction.
What is the tax treatment of the share consideration?
Subject to certain conditions being met:
• the seller may defer any capital gains tax payable on the sale of the shares where the consideration is in the form of shares of the purchasing company; And
• the new shares are considered to have been acquired on the same date and at the same price as the original shares.
Considered in loan notes
Sometimes the seller receives loan notes as part of the consideration for the sale of his shares. These loan notes will likely be Qualifying Corporate Bonds (QCBs).
What is the tax treatment of debt securities?
If QCBs are received in exchange for shares, there is no disposal for capital gains tax purposes. However, the gain made on these shares is calculated on the date of the exchange and then “frozen”. It will therefore only crystallize at the time of the transfer of the QCB.
If the loan notes are not QCBs, there is also no disposal for capital gains tax purposes and the new asset (the loan notes) will substitute for the old one. active, so that a gain appears when paying off the loan notes.
Determining the tax treatment of different types of consideration can be very complex, and as sellers and buyers increasingly opt for more complex consideration mechanisms in transactions, and the use of earnouts in sales even ” “friendly parties”, such as MBOs, it is difficult to determine the tax treatment of different types of consideration. It is important that advisors understand how to manage contingent consideration.
Next steps
We have a lot of experience in this field and are happy to help you “make complex things simple”, please contact us.
