The loan arrangers!

Peter Rayney looks at some of the practical tax issues concerning loan notes.  

Many company sales involve part of the consideration being satisfied in the form of loan notes issued by the purchaser.  

The sale of owner-managed companies often involves part of the sale consideration being satisfied in the form of loan notes issued by the purchaser. In effect, the owner manager is agreeing to finance the deferral of part of their sale proceeds.  

Many sellers could be forgiven for thinking that they would automatically be entitled to business asset disposal relief (BADR) on their ‘loan note’ consideration in the same way as the immediate cash proceeds. However, as this article demonstrates, this is not a simple matter. 

QCB loan notes 

Most straightforward ‘vanilla’ loan notes issued to individual sellers constitute qualifying corporate bonds (QCBs) (TCGA 1992, s 117 (1).  

Where part of the sale proceeds for shares is satisfied in the form of QCBs (and HMRC accepts that the transaction is for genuine commercial reasons and not for tax avoidance), the normal capital gains tax (CGT) share reorganisation rules in TCGA 1992, ss 135 and 127 are disapplied. 

QCBs are not a chargeable asset for CGT purposes (TCGA 1992, s 115(1)), so the relevant gain must be captured at the date of the share sale. This is achieved by TCGA 1992, s 116(10), which provides that: 

• there is no CGT disposal of the original shares; 
• the gain relating to the QCB consideration is computed at that time; and 
• this gain is carried forward and an appropriate part is subsequently taxed (or arises) when a corresponding part of the QCB loan note is disposed of (typically when it is repaid). 

In the vast majority of cases, even where the seller has unused BADR capacity (i.e., still has some of their lifetime £1 million BADR gains limit left), they will not be able to benefit from BADR when their loan note is repaid. This is because the acquiring company will not be their ‘personal company’ for BADR purposes (TCGA 1992, s 169(6)). The seller will therefore be liable to CGT on their deferred QCB gain(s) at the prevailing tax rate in the tax year of repayment. 

However, where sellers have sufficient BADR capacity - some of it will probably have been used against the gain on the cash element of their sale proceeds - they can also elect to access BADR by making an election under TCGA 1992, s 169R.   

Electing under section 169R 

Where an individual seller makes an election under TCGA 1992, s 169R, they are effectively opting to treat the QCB loan note consideration as having been given for the disposal of the ‘old’ shares. There is no deferral of the gain.  

Where the seller makes the election, the entire gain on the QCB loan note becomes chargeable in the tax year of the share sale.  All the gain is taxed – it is not just restricted to the seller’s available BADR limit.  Consequently, in some cases, the seller could be subject to a combination of 10% CGT up to their available BADR entitlement, with the balance being taxed at the main 20% CGT rate. On the other hand, if no election is made, all the gain would be deferred and taxed in the tax year of the repayment(s). While the current CGT rate is 20%, this is by no means guaranteed for future years. The decision whether to make the election is not a straightforward one. 

Where an election is made, sellers must ensure that they have sufficient funds from the deal to pay their CGT on both their cash and loan note consideration by 31 January following the tax year of sale.  

In cases where the seller has no BADR capacity, they will generally prefer not to make the election and hence defer the CGT on their loan note gain 

Example: QCB loan notes – electing under section 169R 

Diana has owned 100% of the share capital of her company, Krall Productions Ltd (KPL), for many years, subscribing for 20,000 £1 ordinary shares in 2012. She has always been KPL’s managing director. KPL is a qualifying trading company for BADR purposes. 

Since April 2021, Diana has been in negotiations with Costello plc, which is seeking to purchase a 100% stake in KPL. The sale consideration for Diana’s 100% holding in KPL has been agreed at £1,100,000, made up as follows:  

 
The sale is expected to be concluded in September 2021. 

If Diana makes a section 169R election for the loan note, her CGT liability on the sale of her KPL shares in 2021/22 is likely to be £113,540, calculated as follows:  

Diana would have to make her section 169R election by 31 January 2024. 

If she does not elect, the gain on the loan note of £687,272 (i.e., £700,000 less pro-rata base cost of 12,727) would be (probably) taxed at 20% in 2023/24 (subject to her available annual CGT exemption). 

Potential issues with section 169R elections 

One of the potential difficulties with the election is that there is no statutory mechanism for unwinding the CGT disposal treatment if all or part of the QCB consideration becomes irrecoverable.  

If a seller anticipates making a section 169R election, consideration might be given to seeking bank guarantees on the QCB loan notes.  This removes the ‘bad debt’ risk. Although purchasers will often resist providing bank guarantees (the amount guaranteed generally forms part of their borrowing facility), sellers are often advised to push for it and accept the inherent cost. 

If the loan notes are not secured/guaranteed, it may be possible to keep the election open so that a ‘wait and see’ approach can be taken. The decision to make a section 169R election would have to be made by the first anniversary of the 31 January following the tax year of sale (i.e. just less than 22 months following the tax year of sale). 

Can non-QCBs solve the problem? 

The CGT deferral mechanism for non-QCBs works in a completely different way to QCBs. In practice, some alteration may be required to the terms of conventional loan notes to give them ‘non-QCB’ status, such as by the insertion of a suitable ‘foreign currency’ conversion clause (TCGA 1992, s 117 (1)(b)). 

Where non-QCBs are received as part of the consideration for a share sale, the normal share/security exchange rules in TCGA 1992, s 135 come into play. Consequently, the non-QCBs (being a chargeable asset) are deemed to have been acquired at the same time and the same (pro-rata) base cost as the original shares in the target company (TCGA 1992, s 127). Therefore, unlike QCBs, non-QCBs do not carry any deferred gain from the share sale.   

Instead, they will generate a normal capital gain/loss on disposal (i.e., typically on encashment), based on the excess of the redemption proceeds less the relevant base cost (inherited from the original shares). Therefore, without any election, if a non-QCB proves to be fully irrecoverable, the result is simply a capital loss equal to the original (low) base cost. 

Since non-QCBs are securities, they can qualify for BADR when they are encashed (see TCGA 1992, s 169I(2)(c)). However, as with QCBs, this will rarely be the case due to the seller’s inability to satisfy the BADR ‘personal company’ conditions. Thus, if BADR is unlikely to be secured on the subsequent ‘disposal’ of a non-QCB, some ‘BADR-eligible’ sellers may wish to access their 10% CGT rate by making a TCGA 1992, s 169Q election to tax it at the time of the share sale. 

The CGT effect of a section 169Q election is to displace the ‘new for old’ CGT reorganisation rules. This ensures the seller makes a CGT disposal with the non-QCB loan notes forming part of the taxable consideration. The initial CGT effect of the section 169Q election is therefore exactly the same as the section 169R one for QCBs. 

Thus, in the worked example above, if Diana had taken non-QCBs instead and made a section 169Q election, her initial capital gain would be calculated in exactly the same way. However, her non-QCB loan notes would then have a much higher market value base cost (£700,000). Once again, this means that if the non-QCB loan note proves to be irrecoverable, the CGT charge is fixed and cannot be adjusted. 

Practical tip 

Sellers should understand the various tax outcomes when negotiating the structure of the sale consideration in any proposed deal.