Alan Pink considers the tax planning implications of the sale of a business, and whether it should take the form of a sale of shares in a company or of assets of the business.
From a tax adviser’s point of view, ‘assets or shares?’ is one of the most obvious and immediate questions that need to be answered when a client comes to him and says that he is either considering buying a business or selling a business.
Key question
Perhaps surprisingly though, clients themselves and those with whom they are dealing in the negotiations very often don’t seem to see the importance of the question. Both sides commonly need educating, and it’s better if that education takes place earlier in the process of negotiation than later, when fixed ideas about values, etc., have been formed. So, cut out this article, keep it, and read it before you make your first approach to either a potential purchaser or seller!
The big assumption I am making at the outset of what follows is that the business concerned is currently being conducted through the medium of a limited company. Where the business is being carried on through a partnership, limited liability partnership, or sole trader, the dilemma that I am talking about here doesn’t apply. It is likely to be a straightforward question of a purchase of the assets of the business.
However, assuming for a moment that you are the person wanting to sell the business, and that this business is operated by your company (‘You Limited’), what should you be offering to the buyer? Should you be offering to sell him the shares in You Limited, or should You Limited be offering to sell the business assets, including things like equipment, goodwill, stock, debtors, etc., to the purchaser?
Seller vs buyer
The point needs to be made straight away that the interests of the buyer and seller are likely to be opposite. If the seller is running a trading business and qualifies under the usual criteria he will get, all in all, a pretty reasonable result if he sells the shares in the company. This is because the shares in a trading company will normally qualify for capital gains tax ‘entrepreneurs’ relief’, resulting in a tax charge of 10% (assuming that the total gains per person don’t exceed the lifetime allowance of £10 million).
For example, if the seller disposes of his shares in Target Limited for £5 million, and the ‘usual’ situation applies that these shares have a very low original base cost when the company was incorporated, the tax on the nearly £5 million gain will be £500,000, and the seller(s) will be able to walk away with £4.5 million, or 90%, of the proceeds. All post-tax and in individual hands.
By contrast, where the company sells its business to the purchaser, there will be corporation tax on any gains in value of the assets sold. Typically, the biggest asset in a trading business will be its goodwill, that is its ability to make profits on a consistent basis. The tangible assets of Target Limited, in our example, may only stand at (say) £1 million, meaning that the goodwill, which is the difference between the separable assets and the value of the business as a whole, will come in at a £4 million valuation. Because, again typically, goodwill has no base cost for the company, the whole £4 million will therefore end up paying corporation tax. At current rates, this would be nearly £800,000. So, the company has immediately suffered a higher tax charge than the individual would have done from selling the shares.
But of course, it’s worse than that, because the tax at company level isn’t the end of the story. Having sold the business, the individuals will then, understandably, wish to extract the proceeds from the company and pay them into their personal bank accounts.
Assuming that the most tax-efficient way of doing this is chosen, which will normally be by way of winding up the company, there is likely to be another 10% tax charge, or (say) £420,000 in our example, to pay at personal level. If the new rules against ‘Phoenixism’ apply, such that the extraction of funds from the company is treated as income, you could be talking about personal tax at a very much higher level, of something like £1.5 million in our example.
Ignoring ‘Phoenixism’, however, and assuming that we can wind up the company and pay 10% CGT, you will see, in our example, that we have a total tax charge of just over £1.2 million, against a £500,000 tax charge payable if what is sold are shares. No wonder sellers generally want to sell the shares not the assets.
The buyer’s perspective
However, as we said, unfortunately, the interests of the buyer and the seller are opposed, as far as the tax treatment is concerned. The buyer will want to buy assets if he can, in most cases, for the following reasons:
- if he buys the shares in a company, he is effectively buying an inherent capital gain. If Target Limited ever went on to sell the asset, it would end up with the original base cost being offset against any proceeds in computing the company’s gains. Using our example, if Target Limited was purchased, and subsequently sold its goodwill for, say, £6 million, the full £6 million would be a gain in the company’s hands – even though the purchaser has paid £5 million effectively to get control of that goodwill. So, there is an inherent ‘deferred tax’ liability in a company where it has assets which are worth more than they cost the company;
- in the case of many sorts of assets, the buyer can claim tax relief for buying these where he couldn’t if he bought shares. For example, if you have intellectual property like patents or software, the purchase of these as direct assets qualifies the purchaser for relief, by annual write-down, against his corporation tax bill. Similarly, if the subject matter of the purchase includes property with inherent fixtures, the value of these can be made the subject of a tax write-down claim. In none of these cases would any relief be available to the buyer if he simply purchases the shares in the company which owns the assets; and
- when you are buying a company, as opposed to buying the assets of a business, you are buying all the ‘skeletons in the cupboard’ – that is, liabilities accrued over past periods which may not be fully reflected in the books (perhaps because they are not known about). Whilst this problem can to some extent be got around by asking the seller to give warranties and indemnities, these aren’t by any means a wholly watertight way of protecting the buyer’s financial position.
There’s just one principal exception to this general rule, that the buyer will prefer to purchase assets. This is where the assets being acquired are to a large extent real property in the UK. Buying a company which owns these properties will give rise to a liability to stamp duty only, in normal circumstances, which is 0.5%. With the rates of stamp duty land tax (SDLT) having escalated in recent years, the difference can be a huge one, as in the following example.
SDLT or stamp duty?
John is considering whether to acquire a £2 million property in London, subject to a £1 million mortgage, or acquire the shares in the company that owns it. His accountant calculates that buying the company for £1 million (it has no other significant assets) would give rise to a stamp duty liability, at half a percent, of £5,000.
By contrast, acquiring the property for £2 million, if it is chargeable at the residential property rates, would give rise to SDLT of £300,000.
I have no objection if you want to refer to this as a ‘no brainer’! The only thing you do need to be careful of, though, is the fact that, by buying the company, you are of course buying any inherent capital gain. If, say, the property only cost the company £200,000 originally, there is an inherent £1.8 million capital gain, which at some point is likely to be triggered and the tax payable.
The practicalities
What does one actually do, then, if one is faced by the buyer versus seller dilemma, with the seller insisting on selling shares, and the buyer very much preferring to buy assets? Does the deal fall through because both sides can’t get what they want?
What ought to happen, in my submission, would be that the important differences in the tax effects of the two methods of transferring a business should be factored into the negotiations on price. If I were advising a buyer, I would say to him that, if the seller insists on selling shares to suit his own tax convenience, he should give the buyer a discount on what would otherwise have been the price of the business to take account of all the disadvantages of this way of doing things from the buyer’s point of view. Alternatively, if I were advising the seller, I would say that he should only agree to sell assets rather than shares if the buyer will agree to ‘gross up’ his additional tax liabilities and add them to the amount he was willing to pay.
In practice, unfortunately, all of this consideration of what ordinary commercial business people regard as ‘detail’ often comes far too late in the process. Once a basic price has been agreed for the business, the tax advisers are then brought in and asked to advise on the tax implications. But by this time, it is generally too late for the very significant tax implications of the way the sale is done to be factored into the price negotiations.
Practical Tip:
Consider the tax issues before you arrive at any kind of ‘handshake’ deal on the price of the business.
