Last November, the Treasury responded to the Office of Tax Simplification’s review of capital gains tax (‘CGT’). While Rishi Sunak stopped short of saying he had shelved the recommendations that rates of CGT should be aligned with those of income tax, no new announcements were forthcoming, and the position is being kept “under constant review”. Consequently, nervousness remains that the current mainstream rate of CGT of 20% could increase in the short to medium term.
For shareholders receiving cash (or a simple debt) for the sale of their shares, their entire gain comes into charge in the tax year in which a binding contract for sale is agreed. Assuming this takes place in this current tax year i.e. 2021/22, any prospective CGT rate increases should not impact on the CGT liability.
The exposure to tax increases instead where consideration is received as loan notes and/or shares. Generally, the gain attributable to such consideration is deferred until the realisation of those assets. Whilst this means a vendor only pays CGT when value is received as cash, it could, result in additional liabilities if there’s an increase in the rate of CGT.
Shareholders who qualify for Business Asset Disposal Relief (‘BADR’, formerly Entrepreneurs’ Relief) can generally make an election to tax the gain attributable to non-cash consideration in the tax year of the sale contract. Such elections may be made prior to the first anniversary of the 31 January following the end of the tax year of the transaction. However, beware if hedging your bets: anti-forestalling legislation following the reduction of the BADR lifetime allowance restricted the benefit of elections made after the Budget announcement, and it is possible that something similar could happen again.
Shareholders who do not qualify for BADR (for example, vendors who are not employees or directors and/or who have not held enough shares for a minimum period) are unable to make the same election. If they wish to ‘bank’ current rates of CGT on share and/or loan note consideration, this may be achieved through the structure of the transaction. For example:
- Loan note consideration could be replaced by a simple debt. This should be taxed in the tax year of the transaction.
- Vendors could receive consideration solely as cash and then reinvest in loan notes and/or shares. This should result in the entire gain being subject to tax in the year of the transaction.
It is important that the tax aims of vendors are understood early on, so that the drafting of the transaction documents can facilitate these wishes. Lawyers and Corporate Finance advisers do not take kindly to fundamental changes at the 11th hour!
Where consideration is tied up in shares and/or loan notes, whether or not it will ultimately be received will depend upon the future performance of the target. If vendors elect or structure the transaction to ‘pay the tax up-front’, this can result in CGT being paid on a greater gain than is ultimately received as cash.
In certain circumstances, a repayment of CGT can be claimed where a simple debt is not fully repaid. Electing to pay the tax up-front on loan notes or shares is irrevocable. If these assets are realised for cash that is less than their value at the time of issue, there is no method of reclaiming the additional tax that was paid due to the election. Similarly, where cash is received and then reinvested in shares and/or loan notes, it is not possible to claim back tax. In such circumstances, capital losses may arise, but these will only be of value to taxpayers who realise gains in the tax year of the loss or in subsequent tax years.
Determining the correct structure for a deal can be a delicate process, and hence it is important to get the right advice early on to achieve, as far as possible, the optimum outcome.
