Why it’s always important to ‘consider your consideration’ carefully when selling your business
As a Chartered Tax Adviser, one case that stands out from my study days is Marren v Ingles and the curious reference to a “chose in action”.
For those that are interested(?), the dictionary (or legal) definition of a “chose in action” is
An intangible property right or property. which is legally not in a person's possession. but is only enforceable by legal process.
Makes perfect sense right?
Before you stop reading, let me explain why it is important in the context of deferred consideration.
Deferred consideration is becoming increasingly more common in business sales, as it allows sellers to achieve their desired price while reducing the buyer’s risk of overpaying upfront, especially in an unsettled market.
Often deferred consideration is contingent on certain future events occurring and payment of that amount will be deferred until that event occurs.
Deferred consideration can also be used to incentivise key individuals to stay with the business after the sale.
Usually, the deferred amount is calculated later, often based on the business’s profits over the next two to three years.
It matters, because the structure of consideration determines when the capital gains tax (‘CGT’) liability arises.
As mentioned above, deferred consideration is often paid once certain conditions are satisfied or events have occurred. This could be things like the company being floated on AIM, meeting certain profit targets, or winning a new contract.
Although the seller will not know when the consideration will be paid, they do know how much will be paid i.e the deferred element is fixed (or can be easily calculated) at the date of sale.
Deferred ascertainable consideration must be brought into account at its full value at the date of disposal, and will be taxed in full in that tax year.
No discount is given due to the consideration being paid over several years. So, although consideration that will be received in three years’ time is clearly worth less than consideration received immediately, no reduction is applied.
The only concession is that if the deferred consideration will be 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 instalments.
Additionally, if, not all of the deferred consideration is paid a claim can be made to adjust the sale proceeds and the seller can reclaim some of the capital gains tax they have paid.
Sometimes the deferred consideration element cannot be calculated at the date of sale – it is unascertainable. This is your classic “earn-out”. This is usually because the amount of that consideration is directly linked to the outcome of future events.
I take you back now to the start of this article, and that is because when this happens the right to the future consideration (the “chose in action”) is treated as an asset in its own right.
Unascertainable contingent consideration is not brought into the original capital gains tax calculation.
Instead at the date of sale, the seller is charged capital gains tax on the cash received plus the value of the right to the future contingent consideration. This essentially means the seller pays tax on something that they do not know the value of.
The valuation of this right can be tricky and can require specialist help. (This is something ETC Tax can assist with if required).
When the future contingent consideration is received, this is treated as a disposal of the right and therefore a further capital gains tax computation will be required!
And it gets even more complex….as, if the contingent consideration is received in stages more capital gain tax calculations will be required, with the right to future contingent consideration revalued each time as part of a part-disposal calculation!!
There are two important practical issues:
• the right to receive unascertainable contingent consideration must be valued which may require negotiations with HMRC; and
• the future disposals are not related to the original disposal, so any reliefs (such as business asset disposal relief) will not apply to the disposal derived from the contingent consideration (except in limited circumstances)
So, what if the future amount received is significantly less than expected? What if it is less than the market value of the right which was taxed on completion?
In this situation, the seller will make a loss, and can make an election to carry back the loss on the disposal of the earn-out right to be set against the gain on the original asset.
Sometimes the seller of a company will receive other shares as consideration for the sale of the shares in their company.
This usually happens if the buying company is a quoted company, or might become one after the transaction.
What is the tax treatment of consideration in shares?
Provided that certain conditions are met:
• the seller can defer any capital gains tax liability on the sale of the shares where the consideration is in the form of shares in the buying company; and
• the new shares are treated as having been acquired on the same date and at the same price as the original shares.
Sometimes the seller receives loan notes as part of the consideration for the sale of their shares. These loan notes are likely to be qualifying corporate bonds (QCBs).
If QCBs are received in exchange for shares, there is no disposal for capital gains tax purposes. However, the gain which arises on those shares is calculated at the date of the exchange and then ‘frozen’. It will therefore only then crystallise when there is a disposal 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 stand in the shoes of the old asset, so that a gain arises when the loan notes are redeemed.
Working out the tax treatment of different types of consideration can be very complex, and with sellers and buyers increasingly opting for more complex consideration mechanisms in transactions, and the use of earn-outs in even “friendly” sales, such as MBOs, it is important that advisers understand how to deal with contingent consideration.
We have lots of experience in this area, and are happy to help you ‘make the complex simple’, please get in touch
