Ken Moody considers the use of preference shares on the incorporation of a business as a way of deferring capital gains tax and maximising the benefit of annual exemptions.
The reduction in the lifetime limit for capital gains tax (CGT) business asset disposal relief (BADR) from £10 million to only £1 million was something of a shock, even if, arguably, justified.
How to incorporate?
On incorporation of a business, it had become optimal in many cases to sell the business to the new company at full market value. This made use of BADR and left a substantial credit balance on director’s loan account (DLA), which could then be drawn tax-free to top up remuneration or dividends above the basic rate limit.
A rather large dent in that strategy was made by FA 2015 introducing TCGA 1992, s 169LA, which excluded goodwill from the ‘relevant business assets’ comprised in a ‘qualifying business disposal’. Quite often, goodwill will be the major asset comprised in the disposal, though there may be something to be said for the strategy even with the part of the gain relating to goodwill liable to CGT at 20%.
Alternatively, incorporation relief under TCGA 1992, s 162 may enable all or part of the gain to be rolled over into the CGT cost of the shares. But what kind of shares? Section 162 simply refers to the transfer of a business in exchange for “… shares issued by the company to the person transferring the business.”
Your ‘preference’?
One might expect it to stipulate ordinary shares, but it does not. For BADR purposes, TCGA 1992, s 169I(6)(a) requires the company to be the individual’s ‘personal company’, through holding, broadly, 5% of the ordinary share capital. But that test can easily be met with only a small nominal equity capital in most situations, so there is no reason why part of the consideration for the transfer of the business should not consist of preference shares.
Why would one wish to do that? Well, if most of the value of the business is in goodwill, BADR will not be available anyway. So, if part of the gain on incorporation is rolled over under section 162 into redeemable preference shares, these can be repaid over several years, which will defer CGT and maximise the use of the CGT annual exempt amount for each year. It is not so much different from incorporation partly for cash except that:
- cash may result in a larger up-front CGT charge; and
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while a healthy balance on DLA to draw upon looks good, the company needs to earn sufficient profits to fund withdrawals, which may need to be spread over a few years anyway.
Now, here is an interesting thing. While goodwill itself is excluded from BADR on incorporation, shares in a trading company, of course, qualify after two years’ ownership. “Et voila!” as Poirot might say. Subject to the personal company test being met, therefore, the redemption of preference shares (after two years) will qualify for BADR as well as using the annual exemption.
Some number-crunching may be needed to decide on the optimum strategy, and the calculation of incorporation relief can be confusing where part of the consideration is cash; but depending upon the precise circumstances redeemable preference shares could well form a useful part of the strategy.
Practical tip
The issue of redeemable share capital by a company otherwise than for ‘new consideration’ is an income distribution under CTA 2010, s 1000(1). The transfer of the business counts as new consideration, but valuation may be critical, especially for goodwill and other intangibles. A conservative (possibly expert) valuation is therefore suggested, to avoid any excess over market value being treated as a dividend, in effect.
