Are we there yet?
If we had a penny for every time we said: “deals are taking so much longer to get over the line”, we’d have a stash of pennies in the piggybank! Whilst the delay can be frustrating, it is to no surprise given the slow growth in the economy and the uncertainty this brings.
This uncertainty, and conflicting objectives with sellers and buyers – for sellers who want the best (invariably higher) price for their business against willing buyers who are nervous about overpaying.
To bridge the gap between expectations of both parties, we are seeing greater focus on the structure of consideration. For example, part of the consideration may be payable in the future only if certain key conditions (financial or otherwise) are met. This appeases both parties as it means the seller could still get that ideal price for business, and for the buyer it takes away the risk of overpaying for the business on day one.
In a typical transaction, we are seeing consideration being structured to include some or all of the following:
- Initial cash consideration,
- Equity (shares and/or loan notes) in the acquisition vehicle,
- Earn-out, which is based on the future financial performance of the business, and
- Deferred consideration.
It is the latter two bullet points where we have seen a real focus for buyers and how value is being made conditional upon future events. This article will examine the general tax implications of earnouts and deferred consideration and the idiosyncrasies that can arise.
Earn-outs and deferred consideration
The proceeds received by an individual on a sale of their shares in a company will often be in the form of cash payable at the time of the transaction. However, there may also be some form of ‘deferred consideration’ to be paid at a later date, which can be used as an incentive to tie key individuals into continuing to work for the business after the disposal.
The deferred element of the consideration may be quantified at a later date, typically using a formula based on two to three years’ post-acquisition profits. These arrangements are known as ‘earn-outs’.
The way in which the consideration is structured governs when the capital gains tax (‘CGT’) liability arises.
Date of disposal for CGT: the basic rules
The date of disposal for CGT is the date when there is an unconditional contract for sale. If a contract is subject to a condition being fulfilled, the date of disposal for CGT purposes is the date that all of the relevant conditions are met.
It is important to identify the correct date of disposal as this will determine in which tax year the gain will arise and when the CGT is payable to HMRC.
Ascertainable deferred consideration
As discussed above, it is common for consideration payable on the sale of a company to be split such that the vendor receives a sum of cash at the point of disposal and an additional amount on the satisfaction of a condition or on the occasion of a future event. That future event may be the company reaching a prescribed profit target, the company floating on the stock exchange, or as simple as meeting certain post sale integration objectives.
If the additional consideration is a fixed or known amount at the date of disposal, then it will be ‘ascertainable’ at the date of disposal. This means the amount to be received in the future must be included in the CGT calculation at the date of disposal, and therefore the liability due on the whole amount. No discount is applied to reflect the deferred and/or conditional nature of the consideration. Consequently, all proceeds, i.e. initial cash consideration plus the future consideration, are brought into the capital gains tax computation.
The seller may be able to claim Business Asset Disposal Relief (“BADR” and formerly known as Entrepreneurs’ Relief) at the 10% CGT rate (subject to a £1m lifetime allowance). This would of course depend on whether the seller meets the qualifying conditions..
If the additional payment is more than 18 months after the date of disposal, the vendor may be able to elect under to pay some of the CGT liability in instalments.
If all or part of the ascertainable deferred consideration is not ultimately received, a claim may be made to adjust the sale proceeds in the initial CGT computation and any excess tax paid reclaimed from HMRC.
Whilst there is a cash-flow disadvantage with paying tax in advance of receiving the proceeds, this should be contrasted with the advantage of locking in the CGT rate now against tax rises in the future, as well as the ability to claim BADR where appropriate.
If the circumstances permit, it may be possible to manage the tax by using loan notes instead of ascertainable deferred consideration. The tax implications of using loan notes are outside the scope of this article but it is something to consider.
Earn-outs and deferred consideration
The proceeds received by an individual on a sale of their shares in a company will often be in the form of cash payable at the time of the transaction. However, there may also be some form of ‘deferred consideration’ to be paid at a later date, which can be used as an incentive to tie key individuals into continuing to work for the business after the disposal.
The deferred element of the consideration may be quantified at a later date, typically using a formula based on two to three years’ post-acquisition profits. These arrangements are known as ‘earn-outs’.
The way in which the consideration is structured governs when the capital gains tax (‘CGT’) liability arises.
Date of disposal for CGT: the basic rules
The date of disposal for CGT is the date when there is an unconditional contract for sale (which has been a key issue with completing transactions before the Budget). If a contract is subject to a condition being fulfilled (i.e. what is legally referred to as a “condition precedent”), the date of disposal for CGT purposes is the date that all of the relevant conditions are met.
It is important to identify the correct date of disposal as this will determine in which tax year the gain will arise and when the CGT is payable to HMRC.
Ascertainable deferred consideration
As discussed above, it is common for consideration payable on the sale of a company to be split such that the vendor receives a sum of cash at the point of disposal and an additional amount on the satisfaction of a condition or on the occasion of a future event. That future event may be the company reaching a prescribed profit target, the company floating on the stock exchange, or as simple as meeting certain post sale integration objectives.
If the additional consideration is a fixed or known amount at the date of disposal, then it will be ‘ascertainable’ at the date of disposal. This means the amount to be received in the future must be included in the CGT calculation at the date of disposal, and therefore the liability due on the whole amount. No discount is applied to reflect the deferred and/or conditional nature of the consideration. Consequently, all proceeds, i.e. initial cash consideration plus the future consideration, are brought into the capital gains tax computation.
The seller may be able to claim Business Asset Disposal Relief (“BADR” and formerly known as Entrepreneurs’ Relief) at the 10% CGT rate (subject to a £1m lifetime allowance) which will change to 14% from April 2025 and 18% from April 2026. This would of course depend on whether the seller meets the qualifying conditions.
If the additional payment is more than 18 months after the date of disposal, the vendor may be able to elect under to pay some of the CGT liability in instalments.
If all or part of the ascertainable deferred consideration is not ultimately received, a claim may be made to adjust the sale proceeds in the initial CGT computation and any excess tax paid reclaimed from HMRC.
Whilst there is a cash-flow disadvantage with paying tax in advance of receiving the proceeds, this should be contrasted with the advantage of locking in the CGT rate now against tax rises in the future, as well as the ability to claim BADR where appropriate. The Chancellor has been quoted that she cannot promise there will be no further tax rises. So, in light of the “black hole” in our public purse and the recent Budget, it is something that should be considered.
If the circumstances permit, it may be possible to manage the tax by using loan notes instead of ascertainable deferred consideration. The tax implications of using loan notes are outside the scope of this article but it is something to consider.
Earn-outs: unascertainable consideration
Sometimes the additional amount that the vendor will receive cannot be ascertained at the date of disposal. This because the amount can only be determined by some future event. For example, consideration could be payable as follows:
- cash £1m, plus
- the right to three payments of deferred consideration in cash, the amount calculated by reference to the profits of the business for the next three years.
As the amounts for the three further payments are not known at the date of disposal (because they are dependent on an unknown future event), this part of the consideration will be unascertainable.
When a vendor is given the right to receive unascertainable deferred consideration, the right itself is treated as part of the consideration. In legal terms this asset is called a ‘chose in action’. Therefore, the value of the earn out right is included as part of the consideration for the sale and is taxable on completion along with the cash proceeds payable on completion (and any other ascertainable consideration). This means the taxpayer is paying tax now on something of which they do not yet know the value.
The practical difficulty with a chose in action is how to determine its value. This is clearly important since it is the value on which CGT becomes payable. Whilst valuation matters are outside the scope of this article, it is imperative a thorough valuation exercise is undertaken. This will certainly help defend against any HMRC enquiry.
When the future amounts are paid
The right to receive cash in the future is a capital sum derived from an asset (being the right to receive deferred unascertainable deferred consideration) and is chargeable to CGT at the time it is received.
Therefore, the vendor will be subject to CGT every time a payment is made in the future. The rate at which CGT is payable is the prevailing rate at the time of payment. The amount subject to CGT is calculated by deducting the value attributed to right to receive the deferred consideration from the cash received (or an appropriate part of the value, where multiple payments are received).
Earn-out payments do not qualify for BADR because there is no disposal of shares. Therefore, gains arising as a result of earn-out payments are taxed at 20% for higher rate taxpayers or 10% for basic rate taxpayers, if current CGT rates remained unchanged.
When valuing the earn-out right, discounts may be applied to reflect uncertainty around the value that may ultimately be realised. This would reduce the amount subject to CGT at the time of the original disposal. It would, however, mean that the realisation of the earn-out may be exposed to increases in the prevailing rate of CGT – i.e. where the amount ultimately received exceeds the value attributed to the right. This contrasts with the position where deferred ascertainable consideration is used (see above).
If circumstances permit, it could be possible to change the structure of the consideration in order bring forward the tax liability on the full value of the earn out. This would also allow the seller to utilise BADR and pay CGT at current rates. This is a complicated matter and formal advice should be taken.
Loss on disposal of right to receive future consideration
So, what if the future cash received is significantly less than expected and is less than the market value of the right which was taxed on completion? This means that on the disposal of the right the taxpayer will be making a loss.
In these circumstances the taxpayer can make an election to carry back the loss on the disposal of the earn-out right and set against the gain on the original asset. For this to be effective, the gain must have resulted in a CGT liability in that earlier tax year. This means that in most instances, the election to carry back the loss will generate a CGT repayment.
Exchange of securities for those in another company
If a vendor exchanges old shares for new shares plus the right to future consideration, the normal share for share exchange rules will not normally apply to the earn-out element, because the right to receive future consideration is a ‘chose in action’ and is not shares. Consequently, a capital gain will arise on the receipt of the earn-out right; see above on how the earn out will be taxed.
If the earn-out is to be satisfied only by the issue of shares or non-qualifying corporate bonds (“NQCB”) loan notes rather than cash or partly in cash, CGT is effectively deferred.
In these scenarios, it may be possible to look at making a tax election to achieve the best possible CGT position for the taxpayer. Whether to make the election depends on the facts of each case, and careful consideration will be needed as essentially the seller could be triggering a “dry tax charge”. However, the seller may have other cash resources available to pay the CGT liability.
Final thoughts
As ever, it is never simple with tax! A small change in the structure of the consideration could lead to a tax charge a lot sooner than expected. Therefore, seek formal advice on such matters and ideally at a very early stage. Otherwise, you may well find yourself raiding those piggybanks to pay that dreaded tax bill!
Disclaimer
The matters covered in this article should not be taken as providing formal advice as each matter should be considered on its on facts. The matters set out in this article are for general awareness only.
