Private Company Owners – Cashing In One’s ‘Chips’

Ken Moody looks at various strategies for private company owners to ‘exit’ the business, and their tax implications.

The ‘endgame’ for many private company shareholder-directors is realising their investment in the company when they either wish to retire or pursue other opportunities. This article takes a whistle-stop tour through the main options available and their tax consequences.

The most obvious way for shareholders to realise their investment in the company is to sell it. The ideal may be a sale for cash, but sometimes part of the selling price will be deferred and conditional/contingent upon future results/events – often referred to as an ‘earn-out’. 

In calculating the capital gain on disposal, no adjustment is made for part of the consideration being conditional or contingent (TCGA 1992, s 48), but if the condition or contingency is not met the capital gains tax (CGT) paid on disposal may be reworked in line with the consideration actually received. CGT entrepreneurs’ relief (ER) is potentially available subject to the various conditions for the relief (see TCGA 1992, ss 169I-S), so the rate of CGT may be only 10% (on gains up to £10 million). 

Where the amount receivable under an earn-out is unknown at the time of sale (e.g. where it is based on a percentage of future profits), the value of the right to receive further consideration (known as a ‘chose in action’) is taxable ‘up front’ as part of the sale proceeds, and when the further consideration is received this may give rise to a further capital gain or loss (depending upon the value attributed to the right). However, the problem in that case is that a chose in action is not a business asset for ER purposes, and so CGT at 18%/28% would be payable on any gain, although a loss may be carried back against the original gain under TCGA 1992, s 279A.

Similar problems arise where part of the sale consideration consists of shares in the purchasing company (which might not meet the conditions for ER (e.g. because the holding is below 5% and the ‘personal company’ test is not met – see TCGA 1992, s 169S(3)), or where part of the consideration is in the form of loan notes. Loan notes are usually ‘qualifying corporate bonds’ (QCBs) which are exempt from CGT, and in the computation of the gain on the disposal the part of the gain which relates to the QCBs is deferred and falls into charge as and when the loan notes are redeemed. The deferred gain in that case will not qualify for ER unless the conditions for relief (employment, personal company test) continue to be met. 

In these circumstances, the legislation provides a remedy in the form of elections under TCGA 1992, s 169Q or s 169R to pay CGT on the value of the whole of the consideration ‘up front’, in which case the whole gain benefits from ER (the downside in the case of QCBs is that if they ‘go bad’ the loss is not an allowable loss). 

The other obvious route for realising the value of the company is to wind it up. Informal dissolution by application under CA 2006, s 1003 is possible, but will probably not be attractive from a tax point of view unless the company has assets of no more than £25,000. Distributions up to that amount after the decision to apply for dissolution is made are regarded as capital distributions (CTA 2010, s 1030A). If the distributions exceed that amount they are treated as income distributions (in whole).

Distributions by a liquidator in the course of winding up are regarded as capital distributions, which are therefore treated as a disposal of the shares (TCGA 1992, s 122). Again, provided various conditions are met for one year ending with the disposal or when the company ceased to trade, ER is potentially available.

It may well be that a purchaser wishes to buy the company’s business but not the company itself, the reason often being to avoid any claims against the company. This is less attractive to the vendor shareholders, as the company will pay corporation tax on any gains on the assets sold and the shareholders will then pay CGT on winding up (though ER is potentially available).

A company purchase of own shares out of distributable reserves under the auspices of CA 2006, s 690 could be used to enable one or more shareholders to retire from the company and to realise their investment, which may be useful in succession planning. CA 2006, s 691 requires that the shares must be paid for on purchase.

If the requirements of CTA 2010, ss 1033–s 1048 are met, the buy-back consideration is excluded from being an income distribution and therefore is liable to CGT and may qualify for ER.

A fundamental test is that the buyback must be for the purpose of benefitting the company’s trade.

1. the shares must normally have been owned for five years;

2. the vendor’s holding must be ‘substantially reduced’ to no more than 75% (based on the reduced issued capital) of their prior interest; and

3. the vendor must not remain ‘connected’ with the company by possessing more than 30% of the company’s share and loan capital.

For the purposes of requirements 2 and 3 above, the rights of ‘associates’ are combined: a spouse or civil partner is an associate for this purpose, while an adult child is not. 

HM Revenue and Customs (HMRC) guidance in SP2/82 (reproduced in their Company Purchase of Own Shares Help Sheet) suggests that the ‘trade benefit’ test may be met (among other situations) where there is some disagreement between the shareholders over the running of the company, or where a shareholder wishes to depart to make way for new management. Retention of any shares in the company is problematic even if the substantial reduction test is met, since HMRC will usually not accept that the retention of more than 5% of the share capital ‘for sentimental reasons’ meets the trade benefit test. HMRC also consider that a continuing involvement with the company as a director or consultant will usually also fail the trade benefit test. 

A clearance procedure is available (CTA 2010, s 1044) which is not mandatory but should always be applied for unless capital treatment is not required. 

A management buy-out (or buy-in) may be used as an alternative to a company purchase of own shares where the requirements of CTA 2010, ss 1033–s 1048 cannot be met (e.g. where the shares have not been owned for at least five years). 

‘Holdco’ is formed, which issues shares/cash/loan notes to the shareholders of ‘Target’ in exchange for their shares in Target. The shareholders wishing to depart accept the cash/loan note alternative. The exchange will normally be regarded as a company reconstruction within TCGA 1992, s 135 whereby, except as regards any cash element, there is deemed to be no disposal of the shares in Target and no acquisition of shares in Holdco. As loan notes will usually be QCBs, their treatment is as described earlier. 

Retention of anything other than a small percentage shareholding by the shareholders accepting cash/loan notes may be perceived by HMRC as tax avoidance, in which case TCGA 1992, s 135 (see above) may be disapplied and the shares in Target would be deemed to have been disposed of for market value. More importantly, the ‘transactions in securities’ (TiS) rules may apply, whereby the cash/loan note elements of the deal could become liable to income tax as dividends in effect.