It is common when selling your trading company that part of the total consideration will be received at a later date, in the form of an earn-out. An earn-out refers to a pricing structure whereby the sellers ‘earn’ part of the purchase price based on the business’ performance following acquisition and could be in cash, shares or loan notes. Careful tax planning is needed if you would like to maximise the proceeds benefitting from the Entrepreneurs’ Relief (ER) tax rate of 10%.
Basic tax treatment
Any proceeds received on the date of disposal, plus any deferred cash consideration is subject to capital gains tax on the transaction date, even though part of the proceeds will not be received until a later date. The advantage of this treatment is you can secure the 10% tax rate. The disadvantage is that the deferred consideration may be received after the tax has become due resulting in a dry tax charge. It is possible to pay the tax in instalments where certain conditions are met.
Loan notes and shares receipts
A complication arises where the earn-out is in a form which is not cash e.g. loan notes or shares. Any earn-out element of the proceeds is an asset in its own right. Dependent on the type of asset received, it could be possible to defer the gain on receipt of these assets by applying the paper for paper rules which avoids a dry tax charge.
An issue can arise when applying this treatment as it is unlikely on the future disposal that you will continue to work for the business or own the necessary 5% shareholding for ER to apply. In this case the realisation of the earn-out will be taxed at the full capital gains tax rate of 20%.
It is possible to disapply the paper for paper rules and tax the gain upfront at the time of the original disposal and bank the ER, therefore securing the 10% tax rate. When the earn-out asset is realised in future, any gain above that taxed previously will be taxed at 20%, any loss can be carried back to the original share disposal and a tax repayment reclaimed from HMRC.
The intricacies of the tax legislation means the tax analysis of any sale should be planned carefully and will be unique to each deal. Considerations such as the lifetime limit of £10million for ER may be reached from the cash proceeds received and therefore disapplying the automatic tax treatment is not required, although other tax planning may be appropriate.
Careful consideration is needed when structuring the terms of your company sale, especially when including an earn-out element. The terms of deferred consideration could be contingent on the company meeting a certain profits level, your continued involvement in the business or any other condition being met. Make sure you involve your Kreston Reeves adviser to ensure your transaction is as tax efficient as possible.
With advance planning it is still possible to claim ER on the total consideration, including the earn-out elements.
Please note: the Autumn Budget 2018 has proposed changes to the ER rules for share disposal from 29 October 2018. Please get in touch with your Kreston Reeves adviser to ensure your shareholding still qualifies.
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